Subprime Lender’s Warning Reflects Aim of New Accounting Rule

Nov. 15, 2019, 9:46 AM

When subprime auto lender Credit Acceptance Corp. announced its earnings would drop 30% to 60% in 2020, it pegged the nosedive to accounting rules coming into force in the new year.

Plenty of businesses are predicting the current expected credit losses (CECL) accounting standard will jolt their financial reporting by forcing them to forecast losses on failing loans. Credit Acceptance’s warning sticks out—even among other lenders to customers with shaky credit. But that may not be a bad thing, as some analysts say its shows the biggest loan-accounting overhaul in decades is working precisely as intended.

Because Credit Acceptance accounts for its loans so differently from its peers, its higher loan losses reflect a more transparent and more realistic picture, said Moshe Orenbuch, managing director at Credit Suisse

“They’ll look more like everybody else,” Orenbuch said.

Unique accounting

Credit Acceptance says its business works like this: when customers walk into a car lot catering to buyers with bad credit, they negotiate a loan package with the dealer. Credit Acceptance then takes control of the loan and customer payments through a process the company considers a loan to the dealer, or by purchasing the loan outright.

The Southfield, Mich-based company says it doesn’t originate loans and therefore doesn’t account for them like its peers. Instead, it accounts for 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 recognize the interest over time. It also front loads earnings.

“Under the current accounting, they’ve been able to largely hide the level of losses that occur on the consumer loans that are being made,” said Zach Gast, president of CFRA Research.

None of Credit Acceptance’s main publicly traded peers—Ally Financial Inc., Santander Consumer USA, and Americas Car-Mart Inc.—use that accounting method.

“As a result of this classification, our accounting policies for recognizing finance charge revenue and determining our allowance for credit losses may be different from other lenders in our market, who, based on their different business models, may be considered to be a direct lender to consumers for accounting purposes,” the company said in its February 2019 10-K filing.

The upshot: Credit Acceptance will be on equal footing in 2020 with companies that are in the same line of business, said Giuliano Bologna, director at BTIG Research, which has a “sell” position on the stock.

“The market will see that and that should erode some of the premium I thought they were being awarded for having more stable earnings, which was really the result of the accounting treatment they used—not the underlying assets,” Bologna said.

New Regime

The Financial Accounting Standards Board’s new rule goes into effect for large publicly traded businesses in 2020. The post-financial crisis standard forces businesses to look to the future, consider past experience, and assess current conditions to calculate the losses they expect on loans and other financial products. Businesses expect to book losses much earlier than they do under outgoing accounting.

The new rules also get rid of the concept of purchased credit impaired assets and introduce purchased credit deteriorated assets. These types of loans get a different accounting treatment designed to take losses into account in the purchase price compared to loans a company originates.

While the two terms may sound the same, Credit Acceptance says in its securities filings that its new loans won’t qualify for the accounting treatment for purchased loans in 2020. They won’t qualify because the company takes on the loan “a moment” after the car dealer inks the deal with the customer, so there hasn’t been any credit quality deterioration since origination.

“It’s bad for them,” said Benjamin Weinger, founder of 3 Sigma Value Investment Management, which has shorted the company in the past, according to Bloomberg News. “It’s going to show everyone they don’t have this black box, this secret sauce that enables them to earn, like, a 30% return on equity.”

Going forward

Credit Acceptance didn’t return emails or a call seeking comment. In its securities filings, it said it believes the new accounting method will not reflect the economics of its business. In a Nov. 4 earnings call, an investor asked if the company would present adjusted metrics to analysts in addition to the official accounting figures the new accounting standard requires.

“That’s our plan,” treasurer Douglas Busk said.

Investors who believe in the company’s earnings potential—like Randy Heck, partner at Goodnow Investment Group—will focus on these adjusted metrics. The new, official accounting does not reflect the true economics of the company, Heck said. Heck has owned stock in the company for 21 years, he said.

“I don’t care,” he said of the accounting change. “Because the company, as it’s done in the past 10 years or so, has reported level yield accounting or adjusted earnings. And that’s what the management team reports and what we focus on, regardless of the knucklehead sell-side analysts out there.”

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; Bernie Kohn at bkohn@bloomberglaw.com

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