Centex Corp.'s announcement that its home equity lending unit would scrap gain-on-sale accounting illustrates the industry's growing dissatisfaction with the method.
The Dallas homebuilder said last week in its quarterly earnings report that its Centex Home Equity Corp. unit would switch to the portfolio method of accounting for securitized loans. From now on, the unit will book income from loans as it is received, rather than estimating and booking the entire profit on a loan when it is created.
"Companies' making aggressive assumptions and later lowering them have tainted gain-on-sale," said David W. Quinn, vice chairman and chief financial officer of Centex Corp. "Everybody that uses it is cast in its shadow, and even though we have had no problems [with defaults], we have had to deal with it."
The change will not affect the amount of profit that Centex makes on each loan. It does, however, affect when those profits will be recognized - less now and more later. But Centex will not have to take a hit to earnings as it revises projections.
Despite solid performance from its subprime loans, the home equity unit had to reduce earnings for the first quarter of 2000 by $16 million, because higher interest rates forced it to adjust the current value of future cash flows from the loans.
Mr. Quinn said that despite the immediate negative impact, the change will benefit Centex in the coming years. "Long-term we found that moving to the portfolio method clearly outweighed the short-term benefit of higher earnings over next 12 months," he said.
Gain-on-sale accounting has long been the focus of concerns and frustration by investors and executives, who argue that booking sales based on assumptions - especially in the subprime business - often leads to unmet projections, which hurt companies' earnings and stock prices.
Much of Conseco Inc.'s problem over the last two years - which led to the resignation last week of the company's founder and another key executive - centered on gain-on-sale accounting at its lending unit.
"There has been an intellectual war in the accounting community over the issue," said Lawrence Horan, director of research for Parker/Hunter Inc.
Investors should embrace Centex's change, Mr. Horan said. "The company prefers that what it is reporting is closer to cash, so it doesn't have the potential for writeoffs," which comes with the gain-on-sale method.
Timothy L. Jones, who is the managing director of Ryan, Beck, Southeast Research Group, agreed. "Anything to lower the risk of future writeoffs is a positive, no matter what the short-term impact on earnings is," he said.
Moreover, he added, "I think [portfolio] should be the accounting standard for all companies.
"The accounting guys argue that they want to match earnings with revenues," he said, "but by changing, Centex is being conservative on front years and will know what's coming in."
To address longstanding concerns about gain-on-sale, the Financial Accounting Standards Board is expected to make an amendment to statement 125, the accounting standard in question, sometime in the third quarter.
Though the board considered striking the requirement for companies to compute a gain or loss on a sale of a securitized interest, "it didn't compute," said Halsey G. Bullen, its senior project manager. "If you package [a loan] in a mortgage-backed security and other people buy it, then you've sold it, and accounting standards require you to record it as a sale."
Mr. Bullen said the forthcoming amendment would require companies to disclose more information on how estimates are made - such as the key assumptions, the logic behind the numbers, the sensitivity of the investments, and how the estimates panned out.
"We've asked for more disclosure on what went into the estimate and the sale to shed light on this issue," he said.