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