NextCard

2 pgs

Discuss the issue of an audit client?s business model and the concept of risk in an audit. In today?s environment (rather than the time the NextCard case actually occurred), how should the risk of the client?s business impact the audit plan and process?

Advanced Auditing Summer 2017 NextCard Lecture Notes NOTE: When answering the questions in the test on NextCard, the information contained in the readings that have been assigned for NextCard control; that is, if anything I say during this lecture or anything contained in these lecture notes conflicts with what you encounter in the readings assigned for this case, you should rely on the readings when answering the test questions. (The reason for this statement is simple: For the lecture, I will sometimes draw on sources that are not listed in the reading list for this topic; I have found that dates, names, and dollar amounts can vary among media sources. Therefore, to increase the likelihood that you do well on the tests, I will confine answers to those found in the reading material, including the text, assigned for this case.) I. Background NextCard, Inc. was one of the first issuers of credit cards online, and the first to offer almost instantaneous online approval (in 30 seconds or less). Its headquarters was located in San Francisco, California and also had offices in Livermore, California and in Phoenix, California. NextCard capitalized its fully-owned bank, NextBank by engaging in an IPO that also served to provide it with operating capital for NextCard. NextCard, Inc. was begun during the Internet boom of the late 1990s. A husband and wife team, Jeremy and Molly Lent, founded the company in 1996 as Internet Access Financial Corporation. Later, in 1997, the name was changed to NextCard. During the early 1990s, Jeremy Lent had served as CFO for Providian Financial Corporation, a company that had extensively used direct mail marketing methods "to identify and recruit customers who made extensive use of credit cards." Jeremy Lent left Providian and founded NextCard largely because he thought he could adapt this marketing strategy to the Internet. Lent's business plan was based on two assumptions: 1. The Internet could be used to reduce a key metric in the credit card industry: the average acquisition cost of a new customer. Lent's objective was to reduce it to a level below the level of the average acquisition cost of traditional "brick-and-mortar" competitors, and 2. NextCard would have significantly lower bad debt losses than traditional credit card issuers. The basis for this assumption was marketing research that had found that Internet users were generally more affluent and, thus, better credit risks, than other individuals. Because of these assumptions, NextCard, Inc. offered credit cards at interest rates that were lower than those of its competitors. NextCard issued MasterCard and Visa cards under its own name, and co-branded cards with entities such as Amazon.com. NextCard also issued secured credit cards that were secured by deposits of customers. 1 One way NextCard found customers was to advertise online. NextCard was buying a lot of online advertising in the late 1990s and early 2000s and was paying high fees to do so. Its website was often one of the top 50 financial websites according to Money magazine and, by 2000, attracted more online 'hits' than any other website in the financial services industry. In late 1998, NextCard obtained $38 million in capital from a syndicate of investors who had previously invested in such companies as America Online, Yahoo!, and Amazon. Part of the money was used to establish its bank, NextBank, and part of the funds were used to advertise online, an activity on which NextCard planned to double its expenditures. The company went public in 1999. Not long after its initial public offering (IPO), the Internet 'bubble' in the stock market burst. This created much difficulty for NextCard (and thousands of other struggling Internet companies) to obtain capital in the debt and equity markets. In addition, NextCard's assumptions also proved to be wrong: the acquisition cost per-customer was higher than expected because II. Internet users tended to ignore NextCard's online ads (which were very costly), and The customers were high credit risks who were looking for a \"lender of last resort.\" The Accounting problems NextCard had lost money every quarter since it began. The pressure to report a profit caused it to significantly understate its bad debt expense on the income statement and, accordingly, the allowance for doubtful accounts on the balance sheet. In late 2001, the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC) investigated NextCard's accounting records and operating policies and procedures. It announced that NextCard was under-capitalized and forced NextCard to significantly increase its allowance for bad debts and, thus, bad debt expense. NextCard increased the balance of its allowances to $71.6 million for the third quarter of 2001 (it had been $31 million in the third quarter of the previous year). Its third quarter 2001 loss was $53.1 million, up from a $20.2 million loss incurred in the 2000 third quarter. In 2001, it wrote off $37.1 million of loans as uncollectible compared with $6.4 million in the previous year. Unwilling to admit that its assumptions were incorrect NextCard asserted that the company had been a victim of "fraud losses" (officers said that NextCard was a victim of hackers and 2 other Internet miscreants) but that the OCC and FDIC required it to classify these losses as "credit losses". In other words, the company was trying to call its losses \"fraud\" instead of calling them what they were: bad debt losses from issuing credit cards to people with very poor credit. (Note: The problem is not us, it's \"them\".) So, NextCard: 1. Failed to provide for an adequate Allowance for Doubtful Accounts, 2. Mischaracterized bad debt expense as \"fraud losses\