Gain on Sale Accounting

1998 - 2008

Gain on Sale Accounting was a unsustainable accounting practice. Structured finance has long been a challenge to the accounting profession. The standards bodies FASB and IASB got it wrong twice to avoid change. Accounting reports are stylized, static, with standard line items updated annually and quarterly. The focus is the corporation, which is assumed to last forever (“a going concern”) otherwise the model might not work.

Securitization is a completely asset-centric model that finances assets at intrinsic value. Because of U.S. bankruptcy law, it only works when assets are sold off-balance sheet to special purpose vehicles (SPVs), thereby violating every accounting rule: not a going concern; looks at cash flows not income; updates not quarterly or annually but when money actually moves in and out of the SPV. Oh, and the SPV pays the loan servicing, not the corporation.

FASB’s first stab was SFAS 125, Gain On Sale. Companies had to recognize gains at origination. It made sense from an accounting perspective; but value at origination was subjective, deals might go on for years and there was no guidance on how to adjust the books. The only other way was to treat securitizations as loans, not sales—but that would put them back on the balance sheet, defeating the economic purpose.

Announced in 1996, it took effect in 1998 but was replaced by 140 in 2000. Mainstream institutions disliked SFAS 125 because it created uncertainty, but a few bad actors used it to inflate their revenues with securities lending transactions (Lehman, MF Global), engage in sham asset sales (Enron, Qwest) and book gains with frontloaded future profit streams at distorted valuations (Enron, Global Crossing, WorldCom, Tyco, Adelphia, HealthSouth, Fannie Mae, AIG). SFAS 140 failed to correct the damage from 125, so the problems continued until 2008 when the model was updated with a compromise solution.

References:
SSRN - The Role of Accounting in the Financial Crisis: Lessons for the Future