New Century Financial Corporation - Internal Accounting Systems

New Century

Financial Corporation

Case Study

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Contents

Company Overview.................................................................................................................3

External Analysis  Industry...........................................................................................4

Internal Analysis.................................................................................................... .............6

Management, Board of Directors, Audit............................................................... ..............6

Applicable Financial Accounting Standards  FAS 5 and FAS 140................... ..............6

Key Internal Accounting Controls........................................................................ ..............7

Primary Business Risks ........................................................................................ ..............8

Accounting Requirements and Practices Relevant to the Business Risks and Reporting Items...... 12

Primary Financial Reporting Items Related to the Business Risks and NCF Financial Reporting Errors............................................................................................................13

Reasons Why Accounting Failures Went Undetected for so long despite Changes in Governance inthe post-Sarbanes-Oxley Act Era ............................................................................................. 15

Accounting controls that could have prevented or detected errors .................................... 16

Concluding Notes....................................................................................................................18 References.............................................................................................................................. 19

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Company Overview

New Century Financial Corporation was founded in 1995 by Robert Cole, Brad Morrice, and Edward Gotschall. The Company went public in 1996 and was listed on NASDAQ. New Century Financial Corporation operated within the U.S. Subprime Mortgage Industry. The primary activities for the Company included originating, retaining, selling, and servicing home mortgage loans designed for subprime borrowers, who were not eligible to apply for prime mortgage loans. By the year 2006 New Century Financial Corporation expanded its product range to include fixed-rate mortgages, adjustable rate mortgages(ARMs), hybrid mortgages, and interest-only (IO) mortgages. The New Century products were from the two Company's divisions of Wholesale Loan Division and Retail Mortgage Loan Division, which differed in terms of sales channel (indirect and direct). The New Century Financial Corporations employed almost 1,000 account executives and 50,000independent mortgage brokers in 19 states within its Wholesale Loan Division whereas it operated 235 sales offices within Retail Mortgage Loan Division in 35 states. New Century Financial Corporation was able to generate significant sales and income and reach substantial growth with compounded annual return of 70 percent from 2000through 2004 due to its capacity to respond to increasing demand on subprime mortgage loans. Despite increasing competitive pressure in the subprime market, the Company still held strong market positions due to its low cost loan originators. However, despite the aggressive growth, in 2006 New Century Financial Corporations was put under concern dueto its loan quality, deteriorations in underwriting standards, and earnings quality. In 2007 New Century Financial Corporation recognized deteriorations in underwriting and calculating loan purchases and announced a restatement of the financial performance for the previous year. The accounting deteriorations and delinquencies resulted in the liquidity crisis faced in March 2007 and filing Chapter 11 Bankruptcy in April 2007.

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External Analysis  Industry

Although in early 1990s subprime mortgages were only a small pie in the US mortgage industry, subprime grew extensively by 216 percent from 2001 through 2006 to account for 20 percent of all mortgage originations (Figure 1).

Figure 1. Growth in U.S Subprime Mortgages (2001-2006).

Source: Cited in Palepu et al. ³New century Financial Corporation,' Harvard Business School, October 14, 2009, p. 13. (Source: Inside Mortgage Finance, The 2007Mortgage Market Statistical Annual, Top Subprime Mortgage Market Players & Key Data (2006).

Subprime mortgages were given as loans to individuals whose risk profile did not allow them to qualify for a prime mortgage loan. Although subprime borrowers due to their higher default risk had to pay 200 to 300 basis points more over prime rates, they eagerly used subprime mortgages to finance home purchases or to re-finance already existing mortgages.

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The factors that encouraged the extensive growth of the subprime mortgage industry included access to capital markets through loan securitization ± pooling and reselling loans to investors; increased liquidity in the market for mortgage-backed securities; removal of interest-rate caps in 1980s; low interest rates in 2000s; rising house value; proliferation of non-traditional mortgages, etc. The value chain of subprime industry involved a number of participating parties that included borrowers, mortgage brokers, lenders who were represented