AICPA Case Development Program

Case No. 96-08: New Horizons, Inc. 1

HISTORY

NEW HORIZONS, INC.

David M. Dennis, Professor University of South Florida, Tampa, Florida

Steven S. Oscher, Managing Director Oscher Consulting, Tampa, Florida

Jackson Borders was a very successful business man. In fact, his friends referred to him as the golden boy or the man with the Midas touch. It seemed that he had success written all over him from a very early age, starting with door to door magazine subscription sales when he was only 13.

When Jackson attended the University of Richmond, he had earned a significant part of his education funds and living expense money by working part time in sales at the local Pontiac dealership. He was doing so well financially that, upon graduation, he stayed at the dealership on a full-time basis. In the early 1960's Jackson had concluded that Japanese imports would be the hot selling cars of the future. Consequently, he had raised some venture capital and acquired the rights to the Toyota franchise in Richmond, Petersburg and Norfolk, Virginia. Needless to say, Jackson's prediction proved true and his dealerships made him a very wealthy man by 1980.

In 1980, in the midst of a mid-life crisis and with the feeling that he had "been there, done that" with respect to the automotive sales industry, Jackson turned over the operations of his dealerships to his two sons and decided to invest his talents in another field. He soon located a nearly defunct manufacturer of mobile homes located in Culpepper, Virginia which he was able to buy at a bargain basement price. He renamed the company New Horizons, Inc. (NHI) and began a serious effort to turn the company into another one of his success stories.

Jackson realized that the majority of mobile homes are sold to individuals who fall into one of three basic population groups: the elderly, lower ranking military personnel and the lower income class which cannot afford traditional homes. Although the predecessor owners of his company had sold their mobile homes through independent dealers, Jackson decided to establish his own dealerships at appropriate sites throughout several Southern states. He created a new entity which he named Horizon Sales, Inc. to serve as the umbrella organization for the various dealerships. He then placed dealerships (called Rainbow Homes) in such locations as Columbia, South Carolina (near Ft. Jackson), Wilmington, North Carolina (near Ft. Bragg), Sebring, Florida (near major retirement communities) and Greenville, North Carolina (near rural farming communities with a high proportion of farm laborers and share croppers). By 1988 there were 140 Rainbow Homes dealerships throughout the sunbelt region of the U. S.

Initially, Jackson financed the production and sales activities of his new venture with a major line of credit from Southeast National Bank. NHI (which served as the holding company for Jackson's operation as well as the manufacturing arm) would borrow funds from Southeast. NHI would then loan funds to Horizon Sales which would use such funds to acquire newly constructed homes from NHI. The units were sold by NHI to

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AICPA Case Development Program Case No. 96-08: New Horizons, Inc. 2

Horizon Sales at an intercompany profit. The loan relationship between NHI and Horizon Sales was recorded in an intercompany account on the records of both Horizon Sales and NHI. Horizon Sales then delivered the mobile homes to its various Rainbow outlets on a consignment basis. The only accounting records maintained by a Rainbow Homes facility were those related to consigned homes on the premises and expenses incurred and paid for out of an imprest disbursement account which was periodically reimbursed by Horizon Sales. All sales and all unsold inventory were carried on the books of Horizon Sales.

During 1980 and 1981, customers who acquired mobile homes from the Rainbow outlets had to arrange their own financing through VA loans, S & L borrowings, etc. During this same period, Horizon Sales had also arranged some of its own financing needs for acquisitions from NHI by borrowing from Hampton Savings & Loan in Richmond. In early 1982, Jackson Borders realized that he would be able to significantly increase sales if he were able to influence the financing of the ultimate buyer's purchase. Therefore, he entered into negotiations to acquire the privately owned Hampton S & L and successfully completed the acquisition by April, 1982. The S & Ls deposits were insured by the Financial Institutions Assurance Corporation.

The acquired S & L was renamed Horizon Savings & Loan. The new board of directors of Horizon S & L included executives from NHI, Horizon Sales and the new CEO and CFO of the S & L, both of whom Jackson personally recruited. Prior to its purchase, the former Hampton S & L had maintained a loan portfolio of 60% real estate loans, 35% commercial loans and 5% consumer loans. By 1988 the distribution of the loan portfolio was 15% real estate loans, 10% commercial loans and 75% consumer loans. This change was attributable to the heavy financing of mobile home loans by Horizon S & L, primarily for its sister subsidiary, Horizon Sales1. This dramatic shift in the loan portfolio had been accomplished with the full awareness of the S & Ls loan committee

As the loan portfolio composition changed over the years, examiners from the Federal Home Loan Bank Board (FHLBB) periodically expressed concerns about the risks associated with such a high concentration in one type of loan. Subsequently, in 1987 management of NHI adopted a five year business plan which included, among other things, the expressed intention to move toward a more balanced loan portfolio.

The operational structure of NHI and its subsidiaries, after the purchase of Horizon S & L, is shown in Figure 1.

POST 1982 OPERATIONS

From late 1982 through 1988, operations of NHI and its affiliated companies could be described as follows. Using borrowed funds from Southeast, NHI would manufacture new mobile homes. NHI then "sold" the units to Horizon Sales, Inc. for an average unit price of $12,600 and recorded an intercompany profit on such transactions. Horizon Sales included these units in its own "new" inventory account but delivered the units to its various Rainbow Homes sales locations. Financing for sales by Rainbow Homes outlets could be arranged through Horizon S & L with certain guarantees being available on some of these loans through the VA and the FHA. The customer was always free to obtain his own financing, however, through other sources.

Significant pressure for increased sales volume was put on sales personnel at Rainbow Homes locations. This pressure led to a 250% increase in sales between 1983 and 1987. A flurry of memos and incentives had been generated by the VP-Sales at NHI early in this period, all designed to stimulate the sales force. One such memo had encouraged the sales force to actively bird dog people who could make the necessary initial down payment on a mobile home purchase. The memo noted that All sales personnel should diligently seek out potential customers who can make the necessary downpayment. Remember, the more downpayments you can corral, the more sales you can book!!

The typical mobile home sold by Rainbow Homes had a sales price of $21,000 with the purchaser paying 5% down and assuming a 15 year, 12% note for the remaining principle. (The instrument is referred to here as a note rather than a mortgage because, as noted earlier, mobile home loans are regarded as consumer loans, not home mortgages.) All sales by Rainbow Homes were recorded as revenue on the books of Horizon Sales.

1 Mobile home loans are considered to be consumer loans, not real estate loans.

AICPA Case Development Program Case No. 96-08: New Horizons, Inc. 3

To provide for the risk of non-payment of the note, Horizon Sales established a reserve for repossessions. Although the debtor was liable to Horizon S & L for the unpaid balance of the note plus accrued interest (with the mobile home as collateral for the obligation), Horizon Sales always signed a subrogation agreement

under which it agreed to assume any notes which were 12 months or more in default. In a typical repossession scenario, the mobile home buyer would have made six payments prior to default. By the actual date of repossession, six principle payments plus interest would have been skipped. The remaining note balance would be $20,400 with accrued interest of $1000. Horizon Sales would incur transportation costs of $750 to haul the unit to the nearest Rainbow Homes sales center and another $1,500 to recondition the unit. For accounting purposes, Horizon Sales would capitalize the costs associated with the

repossessed unit as follows:

Unpaid balance on note Accrued interest Hauling costs Reconditioning costs

Total cost

Thus, $23,650 was the recorded cost of the repossessed unit. Such units were carried in a "used" inventory account on Horizon Sales' books and were priced to sell at cost. There was no profit incentive on these units and it was the objective of the company to move them out of inventory as quickly as possible. The normal practice was to sell such units to customers with the weakest credit ratings.

Repossession was an important issue for Horizon Sales because of the customer classes with which it dealt. Buyers in the agricultural regions were subject to fluctuating levels of employment or unemployment due to weather conditions or competitive conditions which reduced or eliminated crop yields. In the military market, it was not uncommon for a buyer to default after being posted to another U. S. base or to an overseas assignment. In the retirement communities, buyers who were dependent on social security benefits might die leaving insufficient funds in their estate to liquidate the note. Others defaulted when their private retirement benefits were exhausted and their social security benefits were insufficient to cover basic survival needs as well as the note.

During the period 1983-1988, the company's sales and its income statement charge for possible bad loans were as shown in Table 1 (all data in millions). The large jump in the provision for future losses which occurred in 1988 resulted from the companys rapidly rising default rate on new sales. The default rate rose from 35% in 1986 to 42% in 1987 and then to 57% in 1988. The resulting provision for losses was based solely on an evaluation of the loan portfolio carried on the books of Horizon Savings and Loan.

$ 20,400 1,000

750 1,500

$ ======

23,650

AICPA Case Development Program Case No. 96-08: New Horizons, Inc. 4

TABLE 1 SALES AND LOSS PROVISIONS FOR YEARS 1983 THROUGH 1988 (in millions)

1983 1984 1985 1986 1987 1988

Sales $36 $42 $70 $79 $89 $81

Provision for future losses on credit sales 1.0 1.1 2.1 3.0 3.1 20.2

SALES OF S & L LOANS

With the sales growth that Horizon Sales was experiencing, and with an increasing percentage of the loan funds supporting those sales coming from Horizon S & L, the S & L needed to increase its supply of available cash. One means of doing so was initiated in 1984, a process of selling loan "pools." Horizon would take a group of 100 loans and pool them into mortgage-backed securities which would be guaranteed by the Government National Mortgage Association. Such securities (pool certificates) were then offered for sale in an investment market known as the secondary mortgage (or Jenny Mae) market. Each certificate was sold as a unit investment to an individual investor. As the debtors on the notes comprising a loan pool made their installment payments to the S & L, the S & L would, in turn, forward funds to the pool certificate investors, thereby providing a return of principal plus the contractually stipulated interest yield to the investors.

Some of the loan pools were sold on a "with recourse" basis while other pools did not contain the recourse feature. As of December 31, 1988, outstanding loans sold on a with recourse basis totaled $200 million. This fact was disclosed in the Contingencies footnote in Horizon S & Ls annual report. The financing activities of NHI and its subsidiaries are depicted in Figure 2.

As a natural consequence of the activities described above, the financial statements issued by New Horizons, Inc. were potentially relied upon by three groups of users. This fact led to some necessary audit requirements as described in the next section.

THE AUDIT FUNCTION

Annual and quarterly financial statements were prepared for NHI (full consolidation with all subsidiaries) with separate financial statements also being produced for Horizon S & L. Since the stock of NHI was publicly held, appropriate filings with the SEC were required. Additionally, various third parties relied on these financial statements. Southeast National Bank obtained the financial statements to meet Federal documentation requirements for its line of credit loan file for loans to NHI. Additionally, individual investors who bought the Horizon S & L loan pools in the Jenny Mae marketplace reliedon the separate financial statements of Horizon S & L. Because of such reliance, the annual financial statements issued by NHI and Horizon S & L were audited, and the quarterlies were reviewed, by an independent accounting firm, Garnett & Gold, PA.

In performing the annual audit, Terry Garnett, the partner in charge of the NHI engagement, is concerned with complying not only with generally accepted auditing standards (GAAS) but also Federal guidelines produced by such agencies as the FHLBB.

AICPA Case Development Program Case No. 96-08: New Horizons, Inc. 5

To meet the regulatory requirements related to its active involvement in the secondary mortgage (loan pool) market, NHI had engaged Garnett & Gold to perform a compliance audit covering the companys procedures related to controls over loan documentation. In its report to management, Garnett & Gold noted that there were several control problems. For example, many loan files failed to indicate that (1) a credit check was performed on the borrower, (2) the appraised value of the collateral underlying the loan had been determined, (3) necessary approvals for the loan had been obtained from an authorized S & L officer, (4) the loan had been recorded in appropriate public records or (5) adequacy of insurance coverage related to protection against hazards or validity of title had been evaluated. In addition, many files omitted such documentation as the borrowers loan application, proof of title insurance and settlement statements.

Garnett & Gold viewed the audit of NHI subsidiaries to be a part of the audit of NHIs consolidated financial statements. For example, the general audit file for the audit of Horizon S & L had the following notation:

See the NHI corporation files for the following items:

Management letter

Attorneys letters

Review workpapers

Evaluation of potential for management override

Discussion with client regarding possible incurrence of illegal acts

Review of subsequent events

Computation of materiality threshold

The NHI engagement called for the issuance of an audit opinion on the consolidated financial statements of NHI and consolidated subsidiaries with a separate opinion being rendered on the financial statements of Horizon S & L. The single most important item on the S & L financial statements was labeled Mobile home installment sales contracts and mortgage-backed securities, net of allowance for future credit losses. All of the audit working papers related to this set of accounts was maintained in the NHI audit files. An allowance for future credit losses for the entire companys operations was made at that level and then allocated to the subsidiaries. The allocation to Horizon S & L was for managements estimates of losses in excess of amounts covered by FHA and VA insurance.

In reviewing the allowance for credit losses, the auditors found a document called Indemnity Agreement which was made by Horizon Sales Inc. This agreement was designed ...to indemnify and hold harmless Horizon S & L from certain customer defaults.... Garnett & Gold had identified the reserve for loan losses as a critical audit area for this engagement. One reason for this designation was that the VA had begun an investigation of the S & Ls policies regarding credit extension and loan file documentation. One current result of this investigation had been that the S & L was suspended from originating any new VA business, pending the outcome of the investigation. The VA investigation, and related FHA concerns about the policies of the S & L, related to the quality of the mobile home installment sales contract portfolio and VA and FHA loans which had previously been sold by the S & L.

The Inspector General of the federal department of Housing and Urban Development had also performed an audit of the operations and procedures of Horizon S & L for the period from July 1, 1987 through June 30, 1988. The result of this investigation had led to the requirement that the S & L refund certain claims previously paid by the government insurers for defaulted loans. In addition, the S & L had agreed that it would not submit a claim on 512 loans that were currently in a serious delinquency state.

AICPA Case Development Program Case No. 96-08: New Horizons, Inc. 6 QUESTIONS BASED ON THE CASE FACTS

How should the carrying value of repossessed inventory be determined?

What factors should be considered in attempting to assess the necessary increase in each years provision for loan losses?

Was it appropriate to allocate the provision for mortgage loan losses between Horizon S & L and New Horizons, Inc. or Horizon Sales?

Considering the applicable GAAP rules during the time period of the case (1980s), what disclosures should have been made in Horizon S & Ls financial statements regarding its indemnity agreement with Horizon Sales (and indirectly with New Horizons, Inc.)?

Given managements awareness of such factors as

(a) the wholesale and retail values applicable to repossessed inventory,

(b) the poor credit worthiness of many of its customers, and

(c) the potential for VA and FHA rejection of insurance claims for loan losses on insured loans

and, given the recorded value of the provision for loan losses in 1987, would it be appropriate to describe the 1987 consolidated financial statements for New Horizons, Inc. and/or the financial statements of Horizon S & L as materially false and misleading (i.e., fraudulent)?

Since its stock is publicly held, what legal responsibility does New Horizons, Inc. have, if any, to insure that its financial statement information is produced in an accounting system which is protected by adequate internal controls?

Identify the major concerns that the engagement team from Garnett & Gold should have addressed in planning the audit of Horizon Savings & Loan. Drawing strictly on the limited description of Garnett & Golds audit activities and working papers, are there any issues raised in your mind regarding the firms compliance with generally accepted auditing standards? Why or why not?