Gain on Sale Accounting

Gain on Sale is an accounting technique that allows firms to report financial gains before they are actually realized. This type of accounting is generally used by financial firms that have enough assets to support losses if the prospective gains fail to realize, “Used properly, gain on sale is legal. Big investment banks routinely employ the technique when packaging securities for sale to institutional investors”, (Browning, p.1). Issues arose as a result of sub-prime mortgage companies using Gain on Sale accounting in the 1990s; generally this was due to the fact that these companies do not have enough reserves to back their losses. Due to the resulting scandals the accounting principles were rewritten by the Financial Accounting Standards Board, (FASB), requiring firms report to their investors what the fair value of their assets actually are in their annual and quarterly SEC filings. FASB attempted to correct inaccurate reporting by repealing FASB 125, the previously abused standard, and issuing FASB 140, a more diligent standard, in September of 2000. The new standard required that companies “report delinquency rates and credit losses on the total pool of assets securitized”, (National Mortgage News Online, 2000 p).

The 2007 mortgage meltdown indicated that many sub-prime mortgage companies were noncompliant with the new FASB standard and continued business as usual. New Century Financial Corporation was one of these noncompliant sub-prime mortgagers and ended up in bankruptcy in early 2007. Their deceit could not have been accomplished without the duplicity of the accounting firm that reviewed their quarterly and annual reports. As a result of their duplicity, KPMG LLP, New Century Financials auditors, are being sued on behalf of investors for one billion dollars. Additionally, former executives of New Century Financial are being sued to recover fraudulently awarded bonuses and other compensation. The court appointed examiner for the New Century Financial bankruptcy, Michael Missal, recommended in his report that the company “recover money for its creditors by suing KPMG for professional negligence and negligent misrepresentation”, (Brickley & Efrati, 2008, p. A12), as a result of KPMG devising “improper accounting strategies that allowed the company to hide its financial problems for years”, (Brickley & Efrati). Furthermore, the Brickley & Efrati article maintains that the bankruptcy examiner stated that in at least one instance a subordinate was reprimanded for questioning the errant practices. Vikas Bajaj concurs with Brickley & Efrati’s observations stating in an article on nytimes.com that, Michael Missal, the bankruptcy investigator, noted that “KPMG auditors had deferred excessively to New Century”, (2008), and that KPMG auditors knowingly allowed New Century Financial to engage in these accounting irregularities. Bajaj reports further on a telephone interview with Missal where Missal recount e-mails he had seen from the partner in charge of the audit stating that he was concerned that KPMG would be replaced as New Century’s auditors, (2008).

In April of 2009, upon filing of a 1 billion dollar lawsuit against KPMG, the trustee in charge of New Century Financial’s bankruptcy proceedings noted in the lawsuit that the partner in charge of the New Century Financial audit did not pay attention to subordinates who tried to alert him to accounting errors in the audit in order “’to protect KPMG’s business relationship with, and fees from, New Century’”, (Kardos, 2009, p. C3). Although an accounting firms primary audit duties are to the shareholders of a corporation, and not the corporation as an entity, there is enormous pressure on the partners from the accounting partnership not to lose accounts as these generate substantial revenues for the firm. Generally, the larger the corporate client, the larger the accounting firm’s fees are. Conflicts can arise when public corporations refuse to act in accordance with fair accounting standards, as advised by their auditors, and mandated by the Securities and Exchange Commission, (SEC), and other regulating agencies, (notably the PCAOB, FASB, and the AICPA). However, as a corporation employs the audit firm, so to can it dismiss them. Partners at KPMG are not only judged on their ability to attract new clients but also to maintain relationships with current clients. Although the partner at KPMG in charge of the New Century Financial Corporation engagement was advised by his subordinates regarding the accounting inconsistencies, Kardos indicated that he not only ignored their advice but attempted to suppress any discussion of the issue. This appears to be in a large part due to the pervasive climate within the large accounting firms to keep major clients satisfied so they will not migrate to one of the other top tier firms.

In addition, New Century executives themselves are being charged with fraud by the SEC. In a complaint that states that the company’s executives, “conspired to mislead investors”, the SEC is hoping to recover bonuses and other compensation paid, (Goldfarb, 2009). The SEC claim states that the officers received repeated warnings about their company’s financial outlook in weekly ‘Storm Watch’ reports issued by their subordinates, but continued assuring shareholders that the company was on sound financial ground, (Kouwe, 2009, p. B1). New Century’s founders reaped over 40 million dollars in profit from sales of stock in the period between 2004 and 2006, (Bajaj, 2008).

Both New Century Financial and KPMG executives were provided with important information by subordinates; yet they chose to ignore this information, in order to ensure continued profits for themselves and their firms. KPMG desired to continue collecting fees while New Century Financial executives collected bonuses based on fraudulent financials. Executives at both firms fell victim to “self-serving reasoning”, described by Bazerman and Moore as when parties “assessments of what is fair are often biased by self-interest”, (p. 94). Both companies not only acted unethically, as their primary responsibilities were to New Century Financial’s investors, but also illegally by disregarding pertinent government financial regulations. Their behavior resulted not only in losses to New Century Financial’s stock-holders, but also in losses to investors who purchased fraudulent mortgage backed securities sold through Freddie Mac and Fannie Mae. Additionally, as Freddie Mac and Fannie Mae are both governmentally sponsored mortgage corporations, ultimately it was the American people that paid for this deception through government economic bailouts of these organizations securities.
Many companies, including KPMG, have introduced “ethics hotlines” where subordinates can report ethical violations anonymously either online or via the telephone. Additionally, the federal government and most states have enacted “whistle-blower” protection laws to protect individuals who file ethical complaints about fraudulent business practices from retaliation by their employers. Presumably, if any of the affected subordinates had reported these violations then a large amount of this substantial loss suffered by New Century’s shareholders and the American public could have been mitigated.


References
Bajaj, V. (2008, March 27). Inquiry assails accounting firm in lender’s fall. The New York Times. Retrieved from http://www.nytimes.com/2008/03/27/business/27account.html?_r=1

Bazerman, M. H., & Moore, D. A. (2009). Judgment in Managerial Decision Making (7th ed.).
Hoboken, NJ: Wiley and Sons.

Brickley, P. , & Efrati, A. (2008, March 27). KPMG aided New Century missteps, report says. The Wall Street Journal, p. A12. Retrieved from Proquest Newspapers.

Browning, L. (2007, May 1). Accounting said to hide lender losses. The New York Times, p. 1. Retrieved from Lexis/Nexis.

Goldfarb, Z. (2009, December 8). SEC charges former New Century Financial executives with fraud; subprime lender’s collapse helped trigger financial crisis. The Washington Post, p.A22. Retrieved from ProQuest Newspapers.

Kardos, D. (2009, April 2). KPMG is sued over New Century. The Wall Street Journal, p. C3. Retrieved from ProQuest Newspapers.

Kouwe, Z. (2009, December 8). Civil suit says lender ignored own warnings. The New York Times, p.B1. Retrieved from ProQuest Newspapers.

Feds, FASB releases residual rules, (2000, September 27). National Mortgage News Online, Retrieved February 24, 2010. Retrieved from http://www.nationalmortgagenews.com/premium/archive/?ts=970070413