The American Institute of Certified Public Accountants (AICPA) recently issued Statement of Position (SOP) 03-3 which provides important new guidance on the proper accounting for loans (including used automobile retail sales contracts) acquired by purchase and other transfers. The new SOP, issued earlier this year, must be applied prospectively by finance companies (both related and unrelated) in reporting annual financial results beginning after December 15, 2004. However, earlier adoption is strongly encouraged, so owners must deal with these new requirements now. The issuance of this new accounting guidance is part of a continuing effort by the AICPA to promote more consistency in reporting the results attributable to loan portfolios (and individual loans), which are acquired by purchase and other types of transfers.
The new accounting guidance applies when loans are acquired by either a related finance company (from its affiliated dealership) or from unrelated dealer operators. However, the SOP does not apply if the loans originated directly from the finance company itself (which is not common practice in the buy here, pay here industry, anyway).
In general, the new SOP addresses how finance companies should account for the differences between contractual cash flows actually collected and those expected at the time of acquisition- when such differences are primarily attributable in whole, or in part, to the credit quality of the acquired loans.
It is very important to recognize that, for finance companies with a related dealership affiliate, these new rules only affect reported financial results when the finance company reports separately from its captive dealership. This occurs because the transactions addressed by the new SOP, (like purchase discount and related income) are eliminated when reporting the combined results of the finance company and the related dealership together.
These new accounting rules are for financial reporting purposes only and not for federal income tax. Therefore, finance companies need not change the way they have been reporting their discount for tax purposes.
The new SOP also establishes some new terminology such as accretable yield and nonaccretable differences and provides computational guidance on how to determine both. Although the new pronouncement is very technical, the guidance generally precludes accretion (or recognition) of purchase discount income when actual collections equal those which were expected when the acquisition of the loan portfolio (or individual loans) were made. Additionally, a loss (provided via a valuation allowance) is required when actual collections are less than those expected at the time of acquisition. Only when actual cash flows exceed those expected at the time of acquisition, can the finance company recognize such differences into income subject to certain limitations. These new accounting rules will likely differ from the present accounting practices followed by many subprime auto finance companies, so owners should consult with their C.P.A. or financial advisor and evaluate how the new rules will affect their reported net income and financial results.
In addition to this different accounting treatment, the ability to apply these new rules seems largely dependent on having reasonable expectations about the timing and amount of projected cash flows to be collected at the time the loans are acquired. Therefore, finance companies will need to perform more extensive financial analysis prior to acquiring the loans and more accurately predict portfolio losses are expected over the remaining life of the portfolio. The use of static pool loss analysis to project these losses now seems more necessary than ever, in these circumstances.
When finance company owners consult with their accountants to better understand the new SOP, they should also become familiar with a new audit guide for finance companies that the AICPA issued in January 2004. This new guide outlines the appropriate procedures auditors must now follow in performing attest engagements, like audits and reviews of finance company financial statements. Owners of finance companies should familiarize themselves with the accounting policies and practices described in the new audit guide, because they will be expected to apply them properly when reporting income, determining an appropriate allowance for credit losses, and in implementing credit underwriting procedures.
Before owners conclude that what we've just discussed sounds like something only an accountant should care about, they should remember that these new accounting rules would significantly impact the financial statements that they provide to their bankers, investors, and other third parties who utilize them to evaluate their company's performance.
Therefore, it would seem that the buy here, pay here segment of the automotive industry that depends on these financial statements to obtain the capital needed to fund their operations must quickly understand how both of these new technical pronouncements will impact their financial statements before this year ends. The AICPA believes that providing guidance like this will result in more consistency in financial reporting which also increases the comparability and understanding by those who use them. Users of the financial statements, like bankers and investors, must now become familiar with these new rules before the financial statements that will be provided to them later this year. Therefore, it appears that both of these new pronouncements offer a little something for everyone!