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Subprime Lender Urges Investors to Ignore Stated Loan Losses (1)

June 30, 2020, 8:46 AMUpdated: June 30, 2020, 3:40 PM

A new accounting rule clobbered earnings at a major subprime auto lender this quarter, but its management has delivered a message to investors: Ignore it.

Instead of focusing on the numbers required by a new U.S. accounting rule, Credit Acceptance Corp. told investors to zero in on unofficial accounting that the company says better reflects the financial health of its business.

The result: an $83.8 million loss turned into a $175.7 million profit.

This could put the Southfield, Mich. company in the crosshairs of the Securities and Exchange Commission. While the market regulator allows companies to use unofficial accounting metrics to strip out distracting one-off expenses, they can’t use the special metrics to undo the results of a game-changing accounting rule that went live this year, the SEC has warned repeatedly.

The SEC doesn’t believe using measures that omit the impact of the current expected credit loss (CECL) accounting standard on income or earnings—"would be appropriate,” SEC Division of Corporation Finance associate chief accountant Todd Hardiman said at a mid-June conference. The SEC made similar warnings in November and December.

Most companies heeded the SEC’s warnings. Credit Acceptance is a rare example of a company that did not. Below the line in its press release that showed a loss as calculated by U.S. generally accepted accounting principles (GAAP), the company issued what’s called non-GAAP earnings that showed a gain. Chief Executive Officer Brett Roberts told analysts in May his company’s adjusted, or non-GAAP earnings, included no provision for credit losses—an expense that is a central part of the new accounting rules public companies started following in January.

When an analyst pressed for details about the provision in the official accounting included in the company’s quarterly financial statement, Roberts balked.

“I think if we have any shareholders that are still focused on the provision, they need to go back and do some homework,” Roberts said on the May 27 earnings call.

The company has long maintained that the new accounting rule causes it to front-load losses without capturing the money it reaps by charging risky customers high interest rates. Roberts told investors shareholders should focus on the adjusted results, not the official accounting, which reflected the new CECL standard.

American Express Co. used an adjusted measure to convey its finances in the first quarter, though the company didn’t adjust its income or earnings to strip out CECL, as the SEC cautioned against. The company in April presented in its press release a special measure for earnings per share that excluded the effect of building up its loan loss reserves under the new accounting.

‘Misleading Picture’

Credit Acceptance has been on the radar of regulators and watchdogs that allege unfair debt collection practices at the auto finance company. The state attorneys general of New York, Maryland, and Mississippi are scrutinizing the company’s loan origination and collection policies, according to the company’s quarterly filing.The company announcedJune 26 that the Consumer Financial Protection Bureau also was investigating the company.

Potential scrutiny from the SEC is yet another issue.

The regulator “definitely made the statement, in pretty much no uncertain terms, that they would likely object to companies that tried to just adjust for the loan loss provision in its entirety,” said Nerissa Brown, an associate professor of accountancy at the University of Illinois at Urbana-Champaign. “With this company here, they’re essentially trying to do that.”

Using non-GAAP measures to take out the loan loss provision and directing analysts to focus on these unsanctioned results can give investors the impression that the company has no loan loss impairment or no expected losses going forward, Brown said. “So it can paint a misleading picture,” she said.

In the eyes of the auto lender, the results from the new accounting standard are what’s misleading, CEO Roberts said. Billed as the biggest change to bank accounting in decades, CECL aims to make businesses look to the future to calculate losses they expect, instead of waiting for customers to miss payments. It’s an attempt to prevent the financial reporting missteps of the 2008 financial crisis, when bank balance sheets looked rosy despite the imploding economy.

Credit Acceptance, whose motto is “We Change Lives,” has been particularly hit hard by the accounting change. The company doesn’t turn away customers with bad or no credit. Expected losses with subprime borrowers are steep in any market condition. To make up for potentially big losses, the company charges risky borrowers high interest rates. The details of CECL don’t capture the potential to recoup losses via double-digit interest payments.

The ongoing coronavirus pandemic and the mechanics of the new accounting made the company’s expected credit losses balloon in its first quarter. The company in its latest financial statement had to increase the reserve to cover losses on failing loans to $354.7 million, more than triple the $76.4 million provision it recorded at year-end.

“CECL was well intentioned, but going forward it will make it difficult for anyone to fully understand our financial performance using our GAAP financial statements,” Roberts wrote in a letter to shareholders on May 20.

Randy Heck, a partner at Goodnow Investment Group, also believes the new accounting standard distorts the company’s economic picture. He will “never, ever” focus on a noncash accounting change but instead look at the company’s actual record. The adjusted metrics better reflect that performance, he said.

“CECL is completely meaningless when it comes to Credit Acceptance or any other lender that buys loans at a discount,” Heck said.

Controversial Accounting

The company has used for years a unique accounting method compared to its peers, saying it doesn’t originate loans. It says it purchases loans from a network of car dealers. It then accounts for the loans using a version of accounting for purchased assets that are already impaired.

Called level yield accounting, the specialized accounting treatment is outlined in ASC 310-10, formerly Statement of Position 03-3. The method essentially allows a company to determine the yield, or interest, on a loan it acquires and then recognizes the interest over time. Investors and analysts complain that this method front loads—and inflates—earnings.

Investors and analysts also complain that the accounting is opaque, confusing, and masks looming losses. Despite the criticism of Credit Acceptance’s accounting and complaints from short sellers and consumer watchdogs, the company trades at four times its book value.

The new accounting rule that went into effect for public companies on Jan. 1 puts all companies on the same accounting system, including Credit Acceptance. This means the lender can’t use its specialized accounting method for newly originated loans.

But the old method lives on in the company’s non-GAAP earnings.

The SEC declined to comment on Credit Acceptance’s non-GAAP earnings or whether the company sought the agency’s approval before using the metrics to report its earnings. Credit Acceptance didn’t respond to requests for comment.

Alarm Bells

Since 2016, when it first announced a crackdown on overly rosy non-GAAP metrics, the SEC has sent a flurry of warnings to companies via comment letters to watch their numbers.

The debate about official versus unofficial numbers matters to creditors that lend money to Credit Acceptance. The company can’t have two straight quarters of negative net income without breaking some of its debt covenants, the company discloses in its securities filings.

For this, at least, the official accounting numbers matter, said Benjamin Weinger, founder of 3 Sigma Value Investment Management, who has shorted the stock.

“How can you tell people there to ignore GAAP when the very viability, the credit worthiness of your entire company depends on the GAAP earnings?” Weinger said.

—With assistance from Amanda Iacone.

(Updates with comments from Randy Heck from paragraph 19.)

To contact the reporter on this story: Nicola M. White in Washington at nwhite@bloombergtax.com

To contact the editors responsible for this story: Jeff Harrington at jharrington@bloombergtax.com; Yuri Nagano at ynagano@bloombergtax.com; Bernie Kohn at bkohn@bloomberglaw.com

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