New
Century would retain some mortgages for itself (called retained
interests), from which it would receive future cash flows. Also, the
transfer agreements included the right to service the mortgages, for
which New Century charged a fee. New Century valued these retained
interests and servicing rights at current value, based on their
discounted expected future cash flows. Thus, revenue from retained
interests was recognized at the time of retention, and servicing revenue
was recognized at the time of mortgage transfer. These policies
required numerous estimates, as compared to a more conservative policy
of recognizing revenues as cash flows (when retained interests were
received and when servicing responsibilities were rendered).
The
company’s share price increased dramatically, to a high of US$64 in
2004. Its reported net income reached $1.4 billion in 2005.
However,
New Century seriously underestimated the extent of its mortgage
buybacks and resulting credit losses. Of $40 billion of mortgages
granted in the first three quarters of 2006, it provided only $13.9
million for buybacks. Investor concerns about increasing buybacks rose
in 2006 as the 2007–2008 market meltdowns approached. These buyback
concerns added to concerns about early revenue recognition from retained
interests and servicing. Also, the company failed to write down its
retained interests as the current value of the underlying mortgages
decreased.
New
Century was soon unable to borrow money to finance mortgage buybacks.
Its shares lost 90% of their value, and the company was delisted from
the New York Stock Exchange. In April 2007, it filed for bankruptcy
protection.
New
Century’s auditor (KPMG) was drawn into the lawsuits that followed.
KPMG denied liability, claiming that the provisions for buybacks were
deemed adequate at the time and blaming New Century’s failure on the
market meltdowns of 2007–2008. In December 2009, the SEC filed civil
fraud charges against three former executives of New Century, seeking
damages and return of bonuses. Several other lawsuits followed. In
November 2010, financial media reported final settlement of a class
action lawsuit that included a payment of over $65 million by former
company officers and directors, and a payment of $44.75 million by
auditor KPMG.
Required:
- Use the concept of relevance to defend New Century’s policy of recognizing revenue as it securitized and sold mortgages. What was the policy’s major weakness? (5 marks)
- Outline a more conservative accounting policy for New Century’s mortgage sale transactions. Consider both statement of financial position and net income effects of your policy. (Hint: Read Theory in Practice 8.3, textbook, p. 314.) (4 marks)
- Use two characteristics of investor behaviour based on psychology to explain the rapid rise in New Century’s share price. Be sure to identify the specific behavioural characteristics you draw on in your answer. (8 marks)
- Despite your answer in part (c), is the rapid rise in New Century’s share price necessarily inconsistent with (semi-strong) securities market efficiency? Explain. (4 marks)
- Note that retained interests meet the definition of a financial instrument. How would these financial instruments be accounted for under IAS 39? (4 marks)
Question 2 (25 marks)
Efficient
securities market theory has long been under attack from behavioural
finance, which draws on behavioural theories of investor behaviour to
explain why security prices do not always behave as the economic
theories of rational investing and market efficiency predict. These
attacks have increased since the 2007–2008 security market meltdowns.
Required:
- Explain why prospect theory predicts that security prices will differ from their prices under efficient security markets theory. (8 marks)
- Describe two accounting-related efficient securities market anomalies and explain why each is an anomaly. (8 marks)
- The efficient securities market anomalies suggest that investors underreact to the full information content of financial statements. Choose one behavioural theory that predicts this underreaction and explain why it predicts underreaction. (4 marks)
- Should
accountants be concerned that the importance of financial reporting may
decline if behaviourally biased investors do not use all the
information in the financial statements? Explain. (5 marks
-
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