Primary business risks did NCF face
One of the biggest subprime loan originators in U.S is New Century Financial Corporation (NCF). NCF sold, originated serviced and retained home mortgage loans that was primarily designed for subprime borrowers whose credit score is ‘six hundred and twenty or below’. According to Harvard Business School’s case Study, after being listed on NASDAQ and going public, the value of NCF sustained to grow at a rapid pace of $56 in 2005. Later in 2005, a number of analysts recognized complexities in the subprime market, but they believed NCF was protected.
According to the final report by Michael Missal, one of the analyst said “based on the data available, NCF is one of the lowest cost originators in the market which is a good sign of long mortgage banking profitability”. Another analyst said that early in 2006, the company’s profitability got backed up. One of the other analyst expressed that there was a little evidence of decline in underwriting and NCF’s credit trend stayed above averages in the industry. But in the year 2007 based on the statement by senator Dodd, almost 80% of the U.S. subprime mortgages were modifiable rate mortgages.
After the second quarter of 2006, when the houses prices turn down, it has become more complex to refinance because of the modifiable rate mortgages increased in the rates higher and mortgage delinquencies soared. NCF identified that there was a misstatement in the financial statement on the year 2006 that leaded to identify that there severe dysfunctional internal control over the company and there was another financial misstatement in the year 2005.
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Another major issue the company faces is the improper accounting practices in GAAP. There were four major accounting practices like residual interest in off-balance-sheet securitizations, repurchase reserve, allowance for loan losses and repurchase reserve that made the company to collapse.
Primary Financial Reporting Items Related to the Business Risks and NCF Financial Reporting Errors
Due to the undertaking of inappropriate loans and reduced quality of monitoring loan, these business risks led to the business accounting practices that were not in accordance to the US Generally Accepted Accounting Principle (GAAP). The investigating committee identified seven kinds of incorrect practices of accounting that went against the US GAAP. These had included the following:
1. Incorrect calculations of repurchase reserves. The calculation of these at the NFC was made on the basis of the old repurchase data of flourishing loan sales but the actual fact was that there was no reliable data repurchases as the claims of the repurchases was made by various different departments. Because the repurchases were decentralized and there were inadequate control systems in place this led to plenty of accumulation of the repurchase reserves.
The above image shows the NCF’s repurchase reverse calculation methodology (Palepu et al., 2009).
2. There was incorrect calculation of the LCM (Lower Cost of Market) valuation of the loans. The common practice in industry used for LCM valuation of loans that are waiting to be sold is that the grouping of loans in done such that it is examined by the categories with or without the presence of loans that are either performing or non performing. Because of these practices, the mortgage firms were able to correctly carry out valuation and at the same time take a note on the performance of loans.
In the case of NFC, it was seen that the kinds of performing and non performing loans were put in as single group and this caused inconsistency in the real net income of the company. This was mainly die to the fact that the NFC loans that were to be sold had been over valued and there was no proper noting down of the loans that were non performing (Landier, Sraer, Thesmar, n.d.).
3. Because of the incorrect valuation of residual interest there were many mis-calculations in the financial statements that had been made in the years 2005 and 2006. the calculation of the residual interest was made through a new valuation model made for Excel. One of the main issues faced was that there was a considerable dearth of the documentation on the working of the residual interest valuation and the way in which model assumptions underwent approval by the senior administration.
The above image shows the estimated impact of misstatements on Earnings. (Palepu et al., 2009)
4. There was incorrect maintenance of records and statement for the losses in loans
5. The LCM valuation allowance was not done adequately.
6. Because therew as also an insufficient valuation in the residual interest, this led the earnings in 2005 and 2006 to be over stated.
Key Internal Accounting Standards
Internal Audit Control was conducted by four member team who had Donald Lange, CEO and president of Pacific Financial Services and he is also the former president of Mortgage Bankers association of US; Marilyn Alexander – an MBA from Wharton and a certified public accountant (CPA); Michael Sachs who was an attorney and CPA (Palepu et al. 2009, p. 6) and also the chair of the audit committee; Richard Zona who was the CFO of U.S. Bancorp, former vice chairman and farmer partner of Ernstand Young. As per SEC requirements, this committee was considered to be the financial experts. This new audit committee provides financial information for external audit control and met to review audit function reports. External Audit for NCF was performed from 1995 to April 2007 by KPMG, when KPMG resigned because of the restatement of restatement of financial statements and accounting policies for 2006 which was announced by NCF in 2007, March. Sometimes during the annual audit and quarterly reviews, NFA provided expert advice from engagement teams that included partners such as Structured Finance Group and specialists from KPMG who had good amount of experience in auditing mortgage companies.
Accounting controls that could have prevented or detected errors
The errors could have been identified and prevented on the initial stages itself if there were enough internal control over the financial and auditing reporting standards. Hence NCF among these controls would have effective auditing design that derived from internationally accepted auditing standards and internal control over financial reporting when applied correctly.
The above image shows the NCF origination by categories of revenue
There are 10 accepted auditing standards in US which covers the standards of reporting, standards of fieldwork and general auditing standards.
Standards of Reporting requires auditors to
1) State and determine the reasonable sufficiency of informative disclosure of financial performance.
2) State in the auditor’s report whether the financial statements are there based on the generally accepted accounting standards.
3) Expressing opinions regarding the financial statements, if opinions cannot be expressed, then it has to be mentioned in the auditor’s report.
4) Identify in the auditor’s report when those circumstances in which those principles cannot be observed consistently from the current period to the preceding period.
Standards of Fieldwork forces auditors to
1) Acquire appropriate and adequate audit evidence by conducting audit procedures to afford a rational basis for an opinion regarding the financial statements under audit.
2) Acquire an adequate understanding of the environment and entity including its access to the risk of material misstatement of the financial statements whether due to fraud or error, its internal control, extent of further audit procedures and to design the timing and nature.
3) On top of all, supervising the assistants properly and plan the work adequately.
The general auditing standards highlights auditor’s obligation to
1) Exercising professionalism during the audit and the preparation of the report
2) Maintain independence in mental attitude such as appearance and fact in all matters related to audit.
3) Have enough proficiency and technical training to conduct the audit.
Even though to the major points, these standards were performed by the outside auditors from KPMG, the auditors can provide higher level of internal control over the auditing and reporting standards by persuading the board of the company and the management. Internal controls that could have prevented the errors at NFC include an efficient framework that could have incorporated processes designed in order to make sure that the transactions were performed properly based in the standards and the corporation’s financial statements.
Even though most of the transactions were properly recorded, the assessment of appropriateness of the records was not performed (Bartel, 2008). Also, internal controls of NCF were subject to bias since the internal auditors did not employ and show the appropriate level id independence over financial reporting and auditing. Usually it is principal financial officers, top management and managerial bodies who has responsibilities to design and implement the system for internal control over the financial reporting. But, both the Board of management and company’s management failed to state that the system was implemented in an appropriate manner.
Accounting Requirement s and Practices Relevant to the Business risks and reporting items
The major ways in which the New Century Financial creates and finances the loans included whole-loan sales, securitization structured as sales with or without loans held for sale and the securitization structure that finances with or without loans that have been held for the purpose of investment. The direct auctioning of the whole sale loans was made to investors and the securitization that had been left on the balance sheet of NCF its financing was done by the help of collaterized bond issues.
The reporting of the account policies at NCF was done in two subtypes of whole sale loan and Retail Mortgage Loan. The securitized mortgage was done on the basis of the loans present on their balance sheet under the term of ‘mortgage-based securities’. The acts that were put forth to finance mortgages included what has been named ‘warehouse loans’ and which was done by usage of temporary credits that were obtained from other financial hubs so that liquidity could be provided for ongoing loan creations. In order to make sure that credibility was sustained whole using warehouse loans for the financing of mortgages, a particular level of liquidity and debt ratios had be maintained by the NFC, and also for the purpose of providing financial statements that could be use for reviewing lenders and working in a timely way so that the rules of GAAP (Generally Accepted Accounting Principle) are adhered to (Missal, 2008).
The accounting policies that were made by the New Century Financial were molded on the fact that there were a few differences in the rates of interest, that is the interest rate that was due on mortgagors and the interest rate that was being given by the company in order to sell the loans of mortgage to the investors, or to financially supply them with temporary credits. By servicing of loans, the rest of the income and revenues were provided which had been sold by New Century Financial or had been securitized. The policies for accounting of the NFC stressed that the loans waiting to be sold rather than invested at a much reduced cost or a as a fair market value of the account sheet date. It was recorded the cost of excess of the fair market value, and this was named as the valuation allowance. The changes that were made in it were to be considered as a part of the net income in the accrual based period.
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