AUDITING, CASE STUDY
By Katsiaryna Bychkova & Mary Gevorgyan
468595
468608

TABLE OF CONTEST
01
02
03
04
Financial crisis in a nutshell
Company’s overview
KPMG related issues
Questions & Answers

01
Financial crisis in a nutshell
Link for you
https://www.youtube.com/watch?v=N9YLta5Tr2A&t=196s
Highly important before we start…

01
Financial crisis in a nutshell
A bit more about sub-prime mortgages
STATED-INCOME
INTEREST-ONLY
Report annual income during the application process for the loan
Pay only interest on his or her loan balance for a fixed period of the mortgage term (common term –
30 years)

02
Company’s overview
New Century Financial Corporation was a real estate investment trust. The Company was a
full-service mortgage finance company that provided first and second mortgage products to borrowers
nationwide through its operating subsidiaries.
Sub-Industry: Mortgage Finance
Industry: Specialty Finance
Sector: Financials
 Bloomberg.com. [online] Available at: https://www.bloomberg.com [Accessed 1 Nov. 2017].

02
Company’s overview
1995
Founded by Brad Morrice,
Ed Gotschall, Bob Cole
1996
The company made its first loan went public
1998
1,151 employees, 111 offices,
$2 billion in mortgages,
$17.7 million in net profit
2004
Reorganization: real estate investment trust (REIT)
2006, 1st quarter
$56 billion of mortgage loans and securitized $17billion of those loans, resulting in net earnings
of $411 million
“…the best is yet to come…”
Are you sure?

02
Company’s overview
2006,3rd quarter
Increase in loan delinquencies
Feb,2007
Financial condition and operating results deteriorated rapidly
Mar 8, 2007
Stopped accepting new loan applications
Mar 12, 2007
Company's shares lost 90% of their value and its $1.5 billion market capitalization is wiped out
Apr 2, 2007
New Century Financial filed for Chapter 11 bankruptcy

02
Company’s overview
The Tipping Point
Loan Repurchase Agreement
“…loan sale agreements require us to repurchase or substitute mortgage loans in the event we breach
a representation or warranty given to the mortgage loan purchaser or make a misrepresentation
during the mortgage loan origination process. In addition, we may be required to repurchase
mortgage loans as a result of borrower fraud or in the event of early payment default on a mortgage
loan. Likewise, we are required to repurchase or substitute mortgage loans if we breach a
representation or warranty in connection with our securitizations…”
You will need it soon

03
KPMG related issues
“KPMG had failed to warn investors that New Century’s “mortgage freight train was about to runoff
the rails”
1.
2.
3.
KPMG failed to perform its New Century engagements “in accordance with professional standards
KPMG failed to adequately consider serious internal control problems evident in accounting
and financial reporting
system
KPMG failed to properly audit the company’s critically important loan repurchase loss reserve.

03
Engagement
•almost entirely new team of auditors, approximately 15 KPMG employees in total, was assigned in
2005 (13 of 15 members were new)
•the conflict among the audit engagement partner (John Donovan) and the senior manager (Mark Kim)
from one side and New Century’s controller (David Kenneally) from the other
•“near disaster” situation (KPMG’s FDR team refusal to sign off, delaying the release of the 10-K)
what, probably, impaired KPMG’s independence during the remainder of the firm’s tenure with New
Century
•
The bankruptcy examiner:
“In particular, it is possible that Donovan and Kim were not as sceptical as they might otherwise
have been with regard to critical assumptions [underlying New Century’s accounting decisions].”
“Donovan and Kim may have looked for ways to add unique value in order to salvage KPMG’s
reputation, such as by providing proactive (though erroneous) advice in connection with the
repurchase reserve calculation methodology.”

03
Internal Control Problems
Section 404 of the Sarbanes-Oxley Act requires auditors of public companies to audit the
effectiveness of their clients’ internal controls over financial reporting
2004: five significant deficiencies BUT they were not considered as “material weaknesses” ->
unqualified opinion
2005: no significant deficiencies or material
weaknesses in internal controls were identified (take into consideration a new team!)
+ person responsible for internal control had neither experience auditing U.S. clients and no prior
SOX experience
The Examiner found no evidence that the KPMG [2005] engagement team engaged in a formal process to
compare year over year deficiency findings in connection with the 2005 SOX 404 audit. Conducting
this analysis would have been prudent given the wholesale turnover in the KPMG engagement team.
This failure is significant, as it impacted the planning for the 404 audit in 2005, the evaluation
of findings in 2005, and the planning for the year-end audits.

03
Loan Repurchase Loss Reserve
We told you it will be useful (go to slide 7 if you want to refresh the memory)
•2006: New Century changed the method used to compute the period ending balance of the loan
repurchase loss reserve; the calculation methodology was approved by KPMG.
•This change resulted in large increases in the understatements of that account at the end of each
subsequent quarterly reporting period.
“If KPMG had performed adequate tests and calculations, it would have determined that Interest
Recapture was omitted from the repurchase reserve calculation.”

04
Questions & Answers
1.
KPMG served as the independent audit firm of several of the largest subprime mortgage lenders.
Identify the advantages and disadvantages of a heavy concentration of audit clients in one industry
or sub-industry.

04
Questions & Answers
1.
•Develop loyal constituency
•Employee expertise – faster to train, more effective
•Can learn from mistakes of similar clientele
•Provides economy of scale in terms of audit planning and procedures (as well as in term of team
knowledge and expertise)
•The most fundamental benefit is that of industry expertise (providing higher level of assurance)
•The advantage of a performance quality of the overall audit
•
ADVANTAGES
DISADVANTAGES
•Poor diversified client base
•Exposes the audit firm to outside influences such as foreign competition and regulatory changes
•May limit audit firm ability to attract clients outside its key sphere of influence
•When industry weakens lose clients and money
•Employees fall into cycle of overlooking details; become narrow-minded
•Might make generalized assumptions (i.e.: KPMG’s assumption of NC’s internal control for interest
recapture)
•Making one mistake can often lead to repeated mistakes with different clients in the same industry
•False sense of confidence or security

04
Questions & Answers
2.
As noted in the case, there was an almost complete turnover of the staff assigned to the New
Century audit engagement team from 2004 to 2005.
What quality control mechanisms should accounting firms have in such circumstances to ensure that a
high-quality audit is performed?

04
Questions & Answers
2.
It seems reasonable to suggest that KPMG should have emphasized the need for the 2005 engagement
team to make full use of the large firm’s considerable “consultation” resources.  In fact, as
pointed out in the case, certain “specialists” were brought in to review some of New Century’s most
complex transactions.  Unfortunately, those “FDR” specialists did not complete their assigned
procedures.
Other quality control measures that could be implemented when there is a large turnover in the
members of an audit engagement team would include a more rigorous review of audit workpapers and
more input from a “concurring” or “review” partner who has experience with the given client’s
industry.

Section 20.07 of the QC Section 20.07 outlines the five key elements that every accounting firm’s
quality control standards should address: Independence, Integrity, and Objectivity; Personnel
Management; Acceptance and Continuance of Clients and Engagements; Engagement Performance; and
Monitoring. The Engagement Performance element is discussed in QC Sections 20.17 to 20.19. These
sections identify the policies that accounting firms should observe to when performing their
respective professional services. In present context, the pertinent principle is that of
consultation; “Policies and procedures should also be established to provide reasonable assurance
that personnel refer to authoritative literature or other sources and consult, on a timely basis,
with individuals within or outside the firm, when appropriate

04
Questions & Answers
3.
Section 404 of the Sarbanes-Oxley Act requires auditors of a public company to analyze and report
on the effectiveness of the client’s internal controls over financial reporting. Describe the
responsibilities that auditors of public companies have to discover and report (a) significant
deficiencies in internal controls and (b) material weaknesses in internal controls. Include a
definition of each item in your answer. Under what condition or conditions can auditors issue an
unqualified or clean opinion on the effectiveness of a client’s internal controls over financial
reporting?

04
Questions & Answers
3.
Material weakness
Significant deficiency
IC deficiency
is a deficiency, or a combination of deficiencies, in internal control over financial reporting,
such that there is a reasonable possibility that a material misstatement of the company’s annual or
interim financial statements will not be prevented or detected on a timely basis.
is a deficiency, or a combination of deficiencies, in internal control over financial reporting
that is less severe than a material weakness, yet important enough to merit attention by those
responsible for oversight of the company’s financial reporting.
a deficiency in internal control over financial reporting exists when the design or operation of a
control does not allow management or employees, in the normal course of performing their assigned
functions, to prevent or detect misstatements on a timely basis

04
Questions & Answers
3.
•The financial statements must comprise all statements(Statement of Cash Flow, Income Statement &
Balance Sheet);
•The engagement is following the International Standards of Auditing (ISAs) in all respects;
•Adequate evidences have been gathered to conclude that the three standards of fieldwork have been
met;
•The approved accounting standards, which is the Financial Reporting Standards (FRS) and the
Company Act are used to prepare the financial statements and the financial statements includes
proper and sufficient disclosure of all relevant material matters;
•The financial report is under the condition that is not requiring any additional explanation or
any modification.
For an auditor to issue a standard unqualified audit report, there are five specific conditions
required to be met:

Firstly, standard unqualified audit report, also known as clean opinion because the auditor's
opinion is not necessary to be qualified or modified. It is the best type of report that a company
can receive and also the most common audit opinion. This report is issued when the auditor
concludes that financial statements appear to be presented fairly and there are no any significant
reservations or any material misstatements found within the financial statements presented

04
Questions & Answers
4.
One of New Century’s most important accounts was its loan repurchase loss reserve. Each accounting
period, New Century was required to estimate the ending balance of that account. What general
principles or procedures should auditors follow when auditing important “accounting estimates”?

04
Questions & Answers
4.
1.“Review and test the process used by management to develop the estimate.”
2.“Develop an independent expectation of the estimate to corroborate the reasonableness of
management’s estimate.”
3.“Identify whether there are controls over the preparation of accounting estimates and supporting
data that may be useful in the evaluation.”
4.“Evaluate whether the [underlying] assumptions are consistent with each other, the supporting
data, relevant historical data, and industry data.”
5.“Consider whether changes in the business or industry may cause other factors to become
significant to the [underlying] assumptions.”
6.“Consider using the work of a specialist regarding certain [underlying] assumptions.”
7.“Test the calculations used by management to translate the [underlying] assumptions and key
factors into accounting estimates.”
“Auditing Accounting Estimates”
AU Section 342

AU Section 342, “Auditing Accounting Estimates,” is the authoritative source most relevant to this
question.  Paragraph .04 summarizes the “macro” level responsibilities of auditors regarding client
accounting estimates.
“The auditor is responsible for evaluating the reasonableness of accounting estimates made by
management in the context of the financial statements taken as a whole . . . when planning and
performing procedures to evaluate accounting estimates, the auditor should consider, with an
attitude of professional skepticism, both the subjective and objective factors [that were relied on
by management in arriving at those estimates].”
Paragraph .07 defines the key operational responsibilities of auditors vis-à-vis a client’s
accounting estimates.
“The auditor’s objective when evaluating accounting estimates is to obtain sufficient appropriate
audit evidence to provide reasonable assurance that—
All accounting estimates that could be material to the financial statements have been developed.
Those accounting estimates are reasonable in the circumstances.
The accounting estimates are presented in conformity with applicable accounting principles and are
properly disclosed.”
The remaining two sections of AU 342 provide guidance to auditors that is intended to assist them
in “Identifying Circumstances that Require Accounting Estimates” and “Evaluating Reasonableness [of
accounting estimates].” Listed next are specific procedures that AU 342 recommends that auditors
use in evaluating the reasonableness of management accounting estimates.
-1. “Review and test the process used by management to develop the estimate.”
-2. “Develop an independent expectation of the estimate to corroborate the reasonableness of
management’s estimate.”
-3. “Identify whether there are controls over the preparation of accounting estimates and
supporting data that may be useful in the evaluation.”
-4. “Evaluate whether the [underlying] assumptions are consistent with each other, the supporting
data, relevant historical data, and industry data.”
-5. “Consider whether changes in the business or industry may cause other factors to become
significant to the [underlying] assumptions.”
-6. “Consider using the work of a specialist regarding certain [underlying] assumptions.”
-7. “Test the calculations used by management to translate the [underlying] assumptions and key
factors into accounting estimates.”
Clearly, several of the recommended procedures for auditing accounting estimates would have been
relevant to auditing the period-ending balance of New Century’s loan repurchase loss reserve.
Arguably most relevant would have been the recommendation that auditors consider “changes in the
business or industry” in analyzing the reasonableness of an accounting estimate.  The rapid changes
that were taking place in New Century’s industry during 2005 and 2006 had a substantial impact on
the company’s loan repurchase loss reserve.

04
Questions & Answers
5.
New Century’s bankruptcy examiner charged that KPMG did not comply with applicable “professional
standards” while auditing the company. List specific generally accepted auditing standards (GAAS)
that you believe KPMG may have
violated on its New Century engagements. Briefly defend each item you list.

04
Questions & Answers
5.
Field Work Standards
Reporting Standards
•Adequate planning and proper supervision of subordinates
•Obtaining a sufficient understanding of the entity, its environment, and its internal control
•Obtaining sufficient appropriate audit evidence
•Presentation in accordance with GAAP
•Consistent application of GAAP
•Assessment of adequacy of disclosure
•Expression of an opinion
General Standards
•Technical training and proficiency in auditing
•Maintaining an independent mental attitude
•Exercising due professional care

General Standards and Possible Violations
Technical training and proficiency in auditing: Certainly, the bankruptcy examiner’s report raised
legitimate concerns regarding the issue of whether the 2005 New Century audit engagement team was
properly staffed.  As noted in the case, even New Century management questioned the appointment of
Donovan as the new audit engagement partner given his lack of familiarity with the mortgage
industry.  Likewise, the appointment of Debbie Biddle to oversee the 2005 SOX internal audit seemed
to be a questionable decision since she had no prior SOX experience and “virtually no experience
auditing U.S. clients.”  Making matters worse was the fact that nearly all of the subordinate
members of the audit team were new to the New Century engagement.
 Maintaining an independent mental attitude: As mentioned in the case, the bankruptcy examiner
“speculated” that the 2005 10-K “incident” impaired the independence of Donovan and Kim.  After
that awkward and embarrassing incident for KPMG, the two senior members of the audit team may have
attempted to “bend over backwards” to get back “in the good graces” of client management.
Exercising due professional care: This standard is a “catch-all” professional standard.  If it is
proven that an auditor violated one of the other nine GAAS, then it would be easy to maintain that
this standard was violated as well.
Field Work Standards and Possible Violations:
Adequate planning and proper supervision of subordinates:  The bankruptcy examiner pointed out that
the 2005 audit team apparently did not properly review the prior year workpapers, at least with
regard to the internal control deficiencies discovered by the 2004 audit team.  AS No. 5 notes
specifically that, “In subsequent years’ audits, the auditor should incorporate knowledge obtained
during past audits he or she performed of the company’s internal control over financial reporting
into the decision-making process for determining the nature, timing, and extent of testing
necessary.” [Paragraph 57]  Although AS No. 5 was not in effect during the 2005 New Century audit,
this general audit planning principle would still have applied to that audit.  If this general
principle was not invoked by the subordinate members of the 2005 audit team, then certainly one
could argue as well that those individuals were not properly supervised by their superiors.
Obtaining a sufficient understanding of the entity, its environment, and its internal control: The
most serious allegations made by the bankruptcy examiner against KPMG involve this field work
standard and the next.  In retrospect, it does not seem that KPMG fully considered the impact that
rapid and dramatic changes in the housing market were having on New Century’s business model.
Likewise, the severity of the internal control problems evident in New Century’s accounting system
may not have been fully understood by the KPMG auditors.  In particular, KPMG’s decision that the
internal control problems related to the loan repurchase loss reserve were “inconsequential” seems
extremely curious in retrospect.
Obtaining sufficient appropriate audit evidence: Whether KPMG obtained “sufficient appropriate
audit evidence” to support the period-ending balances of the loan repurchase loss reserve is a
question that will likely be debated ad nauseam in coming years.  Based upon the information
available in the bankruptcy examiner’s report, it is easy to question the adequacy and propriety of
that evidence.
Reporting Standards and Possible Violations:
Presentation in accordance with GAAP: KPMG stated in its 2005 audit report that New Century
complied with GAAP.  Certainly, a reasonable argument can be made that the 2005 year-end balance of
the loan repurchase loss reserve may not have been determined in compliance with GAAP.  The absence
of an adequate system to track loan repurchase requests and the failure of New Century to consider
the “interest recapture” issue in the reserve computation cast doubt on the integrity of that
account balance.  It is important to point out to your students that the improper accounting change
made for the loan repurchase loss reserve did not affect the 2005 balance of that account or prior
year balances of the account.  That improper accounting change only impacted the reserve balance at
the end of each of the first three quarterly reporting periods for 2006.  Of course, KPMG only
“reviewed” the financial statements for those three periods.
Consistent application of GAAP: Again, this standard is most directly relevant to the accounting
change made in early 2006 for the loan repurchase loss reserve.  Since this issue did not affect
the pre-2006 audit reports, KPMG was not responsible for commenting on that consistency violation
in those audit reports.
Assessment of adequacy of disclosure: One could certainly argue that New Century’s financial
statements did not properly disclose the potential impact that rapidly changing conditions in the
housing market were having on the material accuracy of the loan loss repurchase reserve and related
account balances.
Expression of an opinion: Was KPMG’s 2005 audit opinion the most appropriate opinion?  Again, that
is an issue that may well be debated for years to come.

04
6.
Questions & Answers
Mortgage-backed securities (MBS) produced by New Century and other major subprime lenders have been
a focal point of attention during the recent financial crisis. Many parties have maintained that
the mark-to-market rule for securities
investments such as MBS has contributed significantly to that crisis and that the rule should be
modified, suspended or even eliminated. Briefly summarize the principal arguments of those parties
opposed to the mark-to-market rule. Do you believe that those arguments are legitimate? Why or why
not?

04
6.
Questions & Answers
•Earning fluctuate dramatically from quarter to quarter due to large gains/losses on market value
(provides no basis to calculate earnings expectations)
•Much more arbitrary and subjective than historical cost
•In general, it’s high risk (allow companies the opportunity to post large gains, but there always
remains the danger of a huge loss)
•Yes, they are legitimate, as they reflect the a higher degree of conservatism

04
7.
Questions & Answers
Identify what you consider to be the three most important “take-always” or learning points in this
case. Rank these items in order of importance (highest to lowest). Justify or defend each of your
choices.

04
Questions & Answers
7.
2
3
Auditors should consider internal control deficiencies when determining the nature, extent, and
timing of substantive audit procedures.
When planning an audit, auditors should pay close attention to important industry developments that
may impact the integrity of the client’s financial statements
1
Proper staffing of an audit engagement is critical to the performance of a high quality audit.
May influence on all the further stages

General Standards and Possible Violations
Technical training and proficiency in auditing: Certainly, the bankruptcy examiner’s report raised
legitimate concerns regarding the issue of whether the 2005 New Century audit engagement team was
properly staffed.  As noted in the case, even New Century management questioned the appointment of
Donovan as the new audit engagement partner given his lack of familiarity with the mortgage
industry.  Likewise, the appointment of Debbie Biddle to oversee the 2005 SOX internal audit seemed
to be a questionable decision since she had no prior SOX experience and “virtually no experience
auditing U.S. clients.”  Making matters worse was the fact that nearly all of the subordinate
members of the audit team were new to the New Century engagement.
 Maintaining an independent mental attitude: As mentioned in the case, the bankruptcy examiner
“speculated” that the 2005 10-K “incident” impaired the independence of Donovan and Kim.  After
that awkward and embarrassing incident for KPMG, the two senior members of the audit team may have
attempted to “bend over backwards” to get back “in the good graces” of client management.
Exercising due professional care: This standard is a “catch-all” professional standard.  If it is
proven that an auditor violated one of the other nine GAAS, then it would be easy to maintain that
this standard was violated as well.
Field Work Standards and Possible Violations:
Adequate planning and proper supervision of subordinates:  The bankruptcy examiner pointed out that
the 2005 audit team apparently did not properly review the prior year workpapers, at least with
regard to the internal control deficiencies discovered by the 2004 audit team.  AS No. 5 notes
specifically that, “In subsequent years’ audits, the auditor should incorporate knowledge obtained
during past audits he or she performed of the company’s internal control over financial reporting
into the decision-making process for determining the nature, timing, and extent of testing
necessary.” [Paragraph 57]  Although AS No. 5 was not in effect during the 2005 New Century audit,
this general audit planning principle would still have applied to that audit.  If this general
principle was not invoked by the subordinate members of the 2005 audit team, then certainly one
could argue as well that those individuals were not properly supervised by their superiors.
Obtaining a sufficient understanding of the entity, its environment, and its internal control: The
most serious allegations made by the bankruptcy examiner against KPMG involve this field work
standard and the next.  In retrospect, it does not seem that KPMG fully considered the impact that
rapid and dramatic changes in the housing market were having on New Century’s business model.
Likewise, the severity of the internal control problems evident in New Century’s accounting system
may not have been fully understood by the KPMG auditors.  In particular, KPMG’s decision that the
internal control problems related to the loan repurchase loss reserve were “inconsequential” seems
extremely curious in retrospect.
Obtaining sufficient appropriate audit evidence: Whether KPMG obtained “sufficient appropriate
audit evidence” to support the period-ending balances of the loan repurchase loss reserve is a
question that will likely be debated ad nauseam in coming years.  Based upon the information
available in the bankruptcy examiner’s report, it is easy to question the adequacy and propriety of
that evidence.
Reporting Standards and Possible Violations:
Presentation in accordance with GAAP: KPMG stated in its 2005 audit report that New Century
complied with GAAP.  Certainly, a reasonable argument can be made that the 2005 year-end balance of
the loan repurchase loss reserve may not have been determined in compliance with GAAP.  The absence
of an adequate system to track loan repurchase requests and the failure of New Century to consider
the “interest recapture” issue in the reserve computation cast doubt on the integrity of that
account balance.  It is important to point out to your students that the improper accounting change
made for the loan repurchase loss reserve did not affect the 2005 balance of that account or prior
year balances of the account.  That improper accounting change only impacted the reserve balance at
the end of each of the first three quarterly reporting periods for 2006.  Of course, KPMG only
“reviewed” the financial statements for those three periods.
Consistent application of GAAP: Again, this standard is most directly relevant to the accounting
change made in early 2006 for the loan repurchase loss reserve.  Since this issue did not affect
the pre-2006 audit reports, KPMG was not responsible for commenting on that consistency violation
in those audit reports.
Assessment of adequacy of disclosure: One could certainly argue that New Century’s financial
statements did not properly disclose the potential impact that rapidly changing conditions in the
housing market were having on the material accuracy of the loan loss repurchase reserve and related
account balances.
Expression of an opinion: Was KPMG’s 2005 audit opinion the most appropriate opinion?  Again, that
is an issue that may well be debated for years to come.

THANK YOU FOR YOU ATTENTION