Gain on Sale Accounting ... rotten to the core

Dear Colleagues

As a trained Chartered Accountant from the UK, I am appalled at the way in which accounting rules and accounting laws in the United States permit absolutely flawed accounting reports to be prepared. The following from a recent article in the New York Times:

A New Century spokeswoman declined to comment on the company’s use of gain on sale accounting, citing the bankruptcy proceedings.
The use of gain on sale was a factor in the collapse of Enron in 2001 and of major specialty lenders in the late 1990s through this decade. Conseco, a large insurance and finance company that made loans to subprime home buyers, filed for bankruptcy protection in 2002, one of the largest corporate bankruptcies ever.
Critics say that the accounting technique remains ripe for abuse, even though federal accounting regulators tightened up the rules in the wake of Enron.
“The thing about gain on sale accounting is that you can create a machine that just manufactures earnings out of thin air,” said Richard Benson, an expert on securitization and president of the Specialty Finance Group, a financial broker.
The deterioration in recent months of the estimated $1.3 trillion subprime housing market has been tied to rising loan delinquencies and the decision by Wall Street to cut off billion-dollar credit lines to companies like New Century, which last year was the largest independent player in the industry.
But Mr. Benson said that the stock prices of subprime home lenders like New Century Financial had “collapsed so fast because the income and balance sheet had been built on gain on sale, which turns out to be imaginary.”
“The market woke up to the fact that there’s nothing there,” Mr. Benson said.
Other bankrupt or struggling subprime lenders that have used gain on sale accounting, or still do, include NovaStar Financial, Fieldstone Investment, Fremont General and Accredited Home Lenders, according to securities filings.

The problems are deep and have been developing over a very long period of time with very little objection from the professional leadership of the accountancy profession.

I am not sure when the United States first allowed gain on sale accounting ... but it may well date back several decades. From my perspective the guiding principle is to have both costs and the associated revenues come together in the same period ... and revenues are only taken into account when the goods or service are delivered to the customer.

It is, in my view, totally inappropriate to take into account transactions that are perhaps planned for the future, but have not yet taken place ... essentially the costs incurred to this point are now merely work in progress inventory ... and best costed "at cost" for financial reporting purposes.

One has to wonder how much of the balance sheet of all the institutions in the modern banking sector are now pure fiction ... perhaps totally legal ... but also, in old fashioned accounting terms, also completely wrong.

Sincerely

Peter Burgess

Rules trump principles ... and the result is disastrous

Dear Colleagues

Accountancy has been in professional free-fall for a long time ... especially in the United States.

In large part the professional failures of accountancy in the United States have resulted from a legalistic approach to accountancy. In the USA, the legal rules and regulations have more importance than the fundamental principles of accounting. In this arrangement it is easy for a law or rule to be make an accounting treatment legally acceptable when the principles of accountancy would argue that it is absolutely wrong.

About 50 years ago, the Institute of Chartered Accountants in England and Wales (ICAEW) argued for a renewal of its Royal Charter precisely because of this issue ... the principles of accountancy should not be able to be over-ridden by law that has no duty to following accountancy principles. The ICAEW prevailed and there was a new Royal Charter.

But the United States has a different professional framework ... and the rules of accountancy, and laws, are more important than principles. Over the past several decades the rules and the laws have moved more and more to allow accounting practices that are anathama to anyone who has a commitment to the basic fundamentals of accountancy.

The following is an example of accountancy that has lost of sense of its role and its responsibility:

New Century Publishes Gain on Sale White Paper
IRVINE, Calif., May 7 /PRNewswire/ -- New Century Financial Corporation (Nasdaq: NCEN) announced today it has published its "Gain on Sale" white paper, authored by Edward F. Gotschall, Vice Chairman and Chief Financial Officer, on its Website (http://www.ncen.com). This paper provides an in-depth review and explanation of certain gain on sale accounting issues confronted by companies in the specialty finance sector.
"We are very pleased to have Ed Gotschall articulate the very complex issues of gain on sale accounting faced by the issuers of financial reports and the investors / analysts who are required to make informed investment decisions on our stock," said Robert K. Cole, Chairman and Chief Executive Officer. "Ed's done a great job of providing a common basis to understand and compare assumptions used to record gain on sale, and a method by which to evaluate actual results. We believe that the increased detail of financial information presented in our recent first quarter 1998 earnings release and the Gain on Sale white paper should guide investors to be better informed and more confident in their investment decisions."
"We invite you to read the gain on sale article located on the analyst page of our Website and hope that it will provide you with a better understanding of these accounting issues," added Cole.
New Century Financial Corporation is a specialty finance company that originates, purchases, sells, and services subprime mortgage loans secured primarily by first mortgages on single-family residences.

The concepts described in this paper sound like they are absolutely and totally unacceptable under the accountancy principles that prevailed when I was studying accountancy prior to qualifying. My guess is that the prevailing law and the rules of accountancy allow this ... but it is neither good accountancy nor is it correct accountancy.

New Century Financial Corporation became one of the first casualties of the sub-prime mortgage melt-down ... and now the questions are starting.

It will be interesting to see who gets the blame. According to recent articles it appears that KPMG will get its fair share of criticism ... but the problem is deeper than this firm alone. There is a systemic problem that includes not only the accountancy profession but also the role of law and lawyers as well. There are many fundamental issues of society that need to be put on the table and resolved.

Society ... and people ... are not being well served by our professional classes.

Sincerely

Peter Burgess

Accounting and accountability

Dear Colleagues

Hardly a day goes by without some new revelation about failed accounting and an inability to track resources. There is a disturbing pattern in the reports and the stories carried in the media. The problems are not being found in a timely way. Rather they are coming to light a long time after the accounting failed and the ability to track resources was lost.

One almost has to ask "Why bother?" with the investigation into lost resources when months and years have already past. It is usually way too late to recover the lost items, and arguably too late to hold the responsible parties to account. Which, of course, is probably why the investigations are delayed in the first place.

I don't hear any outcry from the accountancy profession about this epidemic of failed accounting ... nothing from the big name accounting firms ... and hardly a wimper from any quarter. I am amazed, and frankly, absolutely disgusted.

Clearly there is a need for some more rigorous oversight mechanism that reflects either a more appropriate use of modern technology or reverts to a better use of very old fashioned techniques that used to serve quite well. The status quo is unacceptable and needs to change.

Sincerely

Peter Burgess

Original posting by Peter Burgess: Monday, December 10, 2007

Using cost accounting to rate good works

Dear Colleagues

Accounting has the potential to be used much more effectively than what has been happening for the past 20 odd years.

I recently listened to a presentation about a company that was very committed to doing global social good as well as being a profitable company. But it was disconcerting that while there was a complete system of accounting metrics that related to the profit performance of the company ... there were really no metrics whatsoever about the performance characteristics of the social good activities.

The company had identified the problem of orphans in Africa as a priority ... and more specifically the orphans in Rwanda. The company has chosen to fund an orphanage in Rwanda along the lines of the orphan establishments that were organized in Israel afer the Second World War.

There is no question that assistance for orphans is worthy of support ... but the challenge of determining what is best to do should probably be done with considerably more rigor than is now normal.

The number of orphans in Sub-Sahara Africa is huge. The crisis of war and violence, and the crisis of AIDS has resulted in an orphan population of many millions ... probably as many as 20 million (this may be very wrong ... low ... need to check!) compared to a total population around 500 million.

A residential orphanage that serves 100 orphans at a cost per orphan per year of (say) $1,000 works for a small population, but does not work for the size of orphan population there is in Africa. Rather, programs need to be supported that will give orphan children an opportunity at (say) $50 per orphan per year. This cannot be a residential program, but rather must be a community program.

Planners from New York, or San Francisco, or London, or Geneva may not appreciate the potential of the community itself to help the people who live in the community ... but the biggest resource is not external money or external talent but the talent and energy of local people.

And traditional accountancy has failed to do accounting that takes into consideration the value of goods and services that are "costless" because they are freely given.

The conclusion

This Rwanda orphanage is certainly justified in terms of value for a few orphans ... but the cost effectiveness is very low compared to what would have been possible using the same funds in the optimal way for the broader society. A much greater societal value would have been obtained using a community based program that served thousands rather than hundreds.

Sincerely

Peter Burgess

Being informed about performance

Dear Colleagues

One of the reasons for accounting is so that there is information that can be used to inform.

Recently I received an email that talked about an organization ... and it made me think.

The Global Fund for Women gives grants to organizations worldwide that focus on women's human rights. Since 1987, the Fund has awarded over $58 million to 3,450 women's organizations in 166 countries ranging from Africa to Afghanistan. The Global Fund for Women is a recognized leader in the international microfinance arena.

This information tells me something about the organization's size, but nothing at all about the organization's effectiveness.

This is a fundamental problem with the modern global economy. There is little or nothing of substance about performance that enters the public dialog ... and as long as this is the norm of our global society there is going to be obscene waste.

Sincerely

Peter Burgess