—-—-—'— — - -— _.._ -.——_— AN ANALYSES C}? THE REVENUE mmnmou PROBLEM OF CQNSUMER FINANCE COMPANIES USING PRECOMPUTATION 'é‘hesis for the Degree :2? D. B. A. MICHEGAN STATE UNIVERSITY Ernest Ewing Hanson 19.63 1mmmmnmmrm 311293 01747 5777 This is to certify that the thesis entitled AN ANALYSIS OF THE REVENUE RECOGNITION PROBLEM OF CONSUMER FINANCE COMPANIES USING PRECOI‘IPUTATION presented by Ernest Irving Hanson has been accepted towards fulfillment of the requirements for D.B.A. Accounting degree in JMW . Major professor Date AuguSt 1: 196:7 0-169 Ir \‘ Elms-mi 3’, I ‘1‘; ‘ F “a --¢V -.-~\ .3... 1,..- ‘ra C“ -.". -..'b "“ ‘1...- ‘2'2vc "SC" "’2 ‘3 .U U..- .lv“ .-“~ Q “"" :2— 4s- el-a a- :O-~§u~ ‘“ ---v v‘ ‘~ ‘94 Q .; .4 a ‘ VHS“ “.“.-. ~‘u‘v 4...“- b‘ _ - 9 q. v‘ :.34 that. ‘2': i s uvfl -.U~ .00' g' a #- ' - :99 “Q ‘ ’ ‘ - R " ‘u a“ ‘ ' _‘ ‘ h..- R-“~ ' -“ ‘ A —- ~ b\‘§.c;‘ ‘c S p ‘ v ~v‘u4‘ -::.- ‘ .. _.! “ .“" '0 ”a 1AA v... 2.3,: I.“ w. ' u V~-~ ' " -n a M~~-‘ c- CV. - .. v v-.',, ‘ A .‘.E An! '3“ fi~!fi‘ “I. «A; '2' ‘ ‘ . a. ‘.‘e “c.'GY- ‘ -v. v ‘ .._‘. "‘~J " a .~';‘° a“ ‘ Vbsevv‘rs ‘f: 9..- ‘ :v- " ‘ D ~O s ‘5 -fi. ' . Q N". ”"5 ..~, . “l.. h 3.‘ ‘ d. ‘v- v “C ~13 y. \— A ‘A ‘ ‘VV's' ‘ . Avg t,‘ H“‘ u ‘9 Lfl“. '~.\G-l (u 'U H ¢“‘ar ‘ u“ M“ “an! M. A e Q‘V 9.. ,. e..e f. . ~ .\ "“Ce a...” | v..4~q,'_ .‘~. ABSTRACT AN ANALYSIS OF THE REVENUE RECOGNITION PROBLEM OF CONSUMER FINANCE COMPANIES USING PRECOMPUTATION by Ernest I. Hanson The incorporation of the concept of precomputa- tion into the small loan laws of a number of states in recent years has given rise to a revenue recognition problem in the consumer finance industry. When a loan is made under precomputation the finance charges are cal- culated from the schedule of rates per month specified in the law as if the contract were to be paid exactly ac- cording to schedule. The precomputed charges are then added to the face of the note. This amount is divided by the number of monthly instalments in the contract to ar- rive at an equal amount for each payment. The revenue recognition problem analyzed in this thesis concerns the manner in which the precomputed fi- nance charge is to be allocated over the life of the con- tract. The problem involves differentiating between the amount to be recognized as current revenue of a specific month and the amount to be carried forward in the ”un- earned finance charges" account as being applicable to future periods. The study is divided into five phases. The first phase examines the nature of the phenomenon giving rise to H“‘ vuAd :- -vo‘i' ~-~n O‘ c. A: “A v» ‘... :‘“‘"-: “'Ite“ F“ Ernest I. Hanson the thesis problem-~precomputation--and enumerates the ad— vantages and disadvantages of its use. The second phase deals with current practice and presents the principal methods used to allocate the precomputed finance charges. These are the effective rate. sum-of-the-digits, straight line, liquidation, and fixed percentage procedures. The priority and residuary techniques are also covered. The third phase considers the effects of the various methods on the flow of reported revenue and other financial data under selected situations of changes in the characteris- tics of loans made. The fourth phase investigates the ac- counting thought underlying revenue recognition in order to establish guidelines to use in the determination of a sound approach to the allocation of precomputed charges. In the course of the analysis in this phase, the distinc- tion between the recognition of revenue and the earning of revenue in many situations is noted. The fifth phase ap- plies the previously established guidelines to the consumer finance company situation and delineates an appropriate al- location approach. Conclusions and recommendations drawn from this study include the following: 1. There are currently a number of "generally ac- cepted" methods by which precomputed finance charges may be allocated over the life of an instalment contract. ~ g .s'.-.A.- a "C‘lfi‘l Av- ;.-:.:I—-v Ina- -av-~... . V i . .-...... ..._ ,A4. to»... -'--c~ ‘; ‘V Gov v 'u‘sv - \ 9-y" fl" “ oo‘v-O -.¢ - u -:.-‘o:‘ ‘2‘” g‘o was --.va uv‘ ‘-O U“ 90" cos. I. . :"". p--‘ ”“5 1 “A. 'o.-.-, a." 6-V ‘aee; v‘ I‘p..~- - -\‘ .--.-.'. 7 I Iflfia-ov. I. I. vvw-fi.. V‘- ,, . '1‘. .‘ ; — V‘R (‘ .«--..,,:5 ““ ‘v-p ww- ‘V- Enos ‘2 :_ .ra‘o; -.. ,\ o‘“‘* . ~u~" %~\..' S's-a,- .- o A-.. Ernest I. Hanson 2. The different allocation methods can cause con- siderable variation in reported financial data. Since these methods do not take full cognizance of the major underlying cost factors which generate the revenue, the variations in reported data are not reflective of differences in economic effort, but are instead distortions in the informational process. 3. Accounting thought does provide appropriate guidelines for the recognition of revenue. The guidelines are based upon such concepts as the active nature of costs and the earning of revenue, the matching of costs and rev- enue, and cost homogeneity. 4. A revenue allocation approach is recommended which is based upon the functional cost activities of con- sumer finance firms. These functional cost activities are composed of the costs of acquisition, the costs of ser- vicing, and the costs of forbearance and risk assumption. The recommended approach is significant since it places the primary emphasis for the recognition of revenue on the earning of the revenue. It represents an application to a specific industry of a current focus in accounting thought which stresses the desirability of recognizing revenue as it is earned rather than recognizing it at the time of the occurrence of a restricted set of events. Copyright by ERNEST IRVING HANSON 1964 A AN ANALYSIS OF THE REVENUE RECOGNITION PROBLEM OF CONSUMER FINANCE COMPANIES USING PRECOMPUTATION By Ernest Irving Hanson A THESIS Submitted to Michigan State University in partial fulfillment of the requirements for the degree of DOCTOR OF BUSINESS ADMINISTRATION Department of Accounting and Financial Administration 1963 ACKNOWLEDGMENTS The author expresses his sincere appreciation to the chairman of his thesis committee, Dr. James Don Edwards, for his guidance and encouragement throughout the prepara- tion of this dissertation. Thanks are also extended to Drs. Robert W. Johnson and Paul E. Smith for providing their time and counsel as members of the committee. Extreme gratitude is expressed to the Helm Founda- tion for a fellowship which enabled the author to devote his full efforts to the preparation of the dissertation. I am sincerely appreciative for the many hours of careful work spent typing the various drafts of this study by my wife, Diane. ii "mm-«Amrv-c .. I ‘hl'd' A-“ 4'. o~oA . fl "“0 A. \ d... 'oqq A- .TYovn -- ~ -A ": \ ,' \ ~ .- 0... we .dmvu.. ..V. Y':" ' Anny.--~‘~ a... . '\ cochld-'~~ TABLE OF CONTENTS ACKNOWLEDGMENTS . . . . . . . . . . . . LIS T OF TABLES O O O O O O O O O C O 0 LIST OF ILLUSTRATIONS . . . . . . . . . LIST OF APPENDICES O O O O O O O O 0 Chapter I. INTRODUCTION . . . . . . . . . II. Nature of the Problem . . . Significance of the Problem Dissertation Objectives . . . Approach to the Problem . . . THE CONSUMER FINANCE INDUSTRY AND PRECOMPUTATION . . . . . . The Consumer Finance Industry Development 0 o o o o o 0 Role in the Structure of Consumer Instalment Credit . . . Grow—th O O O O I O O O O O Borrower and Loan Characteristics Precomputation . . . . . . Definitions . . . . . . Advantages of Precomputation Objections to Precomputation The Personal Holding Company and Precomputation . . Acceptance of Precomputation Summary . . . . . . . . . . iii Page ii vi vii ix 1O 12 13 15 15 15 2O 23 25 29 29 33 39 43 48 49 ,-- é .' :u n.4, ... I 0.. \"-‘-'__'fl’\q F- a... "~“-V~~ V: ~"|-§~'.‘ III ‘ - huANU-“a P‘F‘A“..' -‘v.‘-‘ c. .903-.“. ~A.HV'-‘E . a \. ., A: . .' _. UM V- v..'_ . e s n..-,. T ‘.“‘L ‘-- ~ . w L“H“‘fi§. ¢1A«§‘u‘-- “ 'I‘\p \ ‘ c‘ 5" v-” ..\,‘ 0:- ‘ a AN~~ ‘5..‘ v ‘ . Q ".““U‘.‘~ '~~n‘... ~‘*—~..:- . ‘ ”I ~A 0.. I. ° ~~~; “‘8‘. "\ Tw‘ .\.~'“-: ,. ‘ ‘ n.» 3.9-, ‘ V '-.. ."‘P.‘ ‘ .. 9 We. _..‘.0 ~ 5 Q Y V' §-‘HQV§F' "'V s ‘ ‘—A‘ A— “‘v‘:‘. A VF . ‘R .V‘:.“ a. \ .1 'Lh‘ ~‘s Cr. ‘v“ N - V- -‘v C..— -v‘ ’N H 5—H d"-‘0- ‘ ‘~_ -‘ «1': ‘F_ u‘.; fi‘ ‘, ‘0'. ‘ '3‘.‘ 5" .‘ “ V-A .. V‘ ”.48- -- Q e.-—- ~«~“ \A‘F.I ‘N In ‘\ As. V \.‘ ‘ ‘ ‘ 'QI \- ~- ' “\ ‘ \ ".‘ “~ ‘h u ‘ ‘\ -‘\\ ~;‘\-‘ ‘ ‘ “,-q ~~ “ ~11“: N “Cg - n .‘ \R‘ ~—. _ ‘K‘s‘a N v x v» ‘n ~_‘ A ‘\ \. V' *- 5 ‘. \ \ HM §‘-. 1 I Chapter Page III. METHODS OF ALLOCATING UNEARNED FINANCE CIIARGES C O O C C O C O . 0 O C O 50 Priority and Residuary Methods . . 50 Effective Rate . . . . . . . . . 54 summOthhe "Digits o o o o o o o o 58 Straight Line . . . . . . . . . 53 Liquidation Method . . . . . . . . 66 Fixed Percentage Method . . . . . . 69 Acquisition Cost Factor . . . . . . 70 Summary . . . . . . . . . . . . . . 71 IV. COMPARATIVE IMPACT ON FINANCIAL RESULTS 0 C O O C . C O O C O O C 73 The Steady State . . . . . . . . . 73 Monthly Revenue . . . . . . . . . 80 Incerased Loan Principal . . . . 80 Increased Finance Rate . . . . 81 Increased Loan Volume . . . . 83 Increased Loan Maturity . . . . 85 Decreased Loan Principal . . . . 88 Decreased Finance Rate . . . . 89 Decreased Loan Volume . . . . 89 Decreased Loan Maturity . . . . 92 Cumulative Revenue and Net Income . 94 Unearned Finance Charges . . . . 98 Summary . . . . . . . . . . . . . 99 V. ACCOUNTING FOR THE RECOGNITION OF REVENUE O C O C C O C O C O O O O 101 Earning of Revenue . . . . . . 102 Bases of Revenue Recognition . . . 10} Sales Basis . . . . . 103 Completed Production Basis . . . 108 Collection Basis . . . . . . . . . 111 Production Basis . . . . . . . . . 112 iv Chapter Summary . . . . .. Matching of Costs and Revenues Cost Homogeneity . . . . . Cost Classification . . . . Matching Paradox . . . . . Summary . . . . . . . . . . VI. AN APPROACH TO THE.ALLOCATION OF PRECOMPUTED FINANCE CHARGES . Consumer Finance Company Costs Object Classification . . . Functional Classification . Functional Classification of Natural Expense Items . A Sound Approach to the Allocation of Precomputed Finance Charges Implementation of the Approach Cost Behavior . . . . . . Cost Proportions . An Illustration of the Application Of the ApprOaCh o o o o 0 Limitation o o o o o o o o Integrative Aspects of the Proposed Approach . . . . . summary 0 O O O O O O O O O VII. SUMMARY AND CONCLUSIONS . . . Current Practice and Its Impact Accounting Concepts and Their Application 0 e o e o o o 0 Conclusions and Recommendations APPENDICES O O O O O O O 0 O O O 0 0 O B BLIOGRAPHY O O O O O O O 0 O 0 O O O Page ._s—a NJU'I 122 124 126 128 128 128 130 134 137 140 140 142 144 149 149 150 152 154 156 158 160 170 arc-“I- V“ "‘ ‘ H raw ‘4 ~ {3.7 d-S .1‘- ._ "R‘l 8.x. VO-V ‘ u .1 ~\H a. . “A“ A u n.. .v 1y . o and Table 9. 10. 11. 12. 13. LIST OF TABLES Consumer Instalment Credit Outstanding by Type of Credit and Institution . . . . Consumer Instalment Credit Outstanding . Michigan Borrower Occupation . . . . . . Purpose of Loan . . . . . . . . . . . . Comparison of Finance Charges Retained upon Prepayment under Simple Interest and the R1119 Of 78th?» c o o o o o o o o o o 0 States permitting Precomputation . . . . Distribution of Finance Charges by Priority MethOd O O O O O O O O O O O O O O O 0 Distribution of Finance Charge by Residuary Me tho d O O O O O O O O O O O O O O O O Allocation of Finance Charge by Effective Rate Me tho d O O O O C O O O O O O O O Allocation of Precomputed Finance Charges by Sum-of-the-Digits Method . . . . . Comparison of Effective Rate and Sum-of- the-Digits Results . . . . . . . . . . Allocation of Precomputed Finance Charge by Straight Line Method . . . . . . . . . Cumulative Revenue Recognized by Straight Line and Sum-of-the~Digits Methods . . vi Page 21 24 26 27 36 48 51 52 55 6O 6O 53 65 _. \J‘ 'K .v. "4 ‘I. ‘- 0 Irrfi‘“ 48 vvom‘.hLfl v- ‘1 l...‘ ‘ ca nu fig‘u . navy-A fl‘ QR y- Vv-nu. .guy so . ‘va Vc‘v -AAU 00V "'n Y'c-1'Ar' . ‘. w 0. o. R"~“‘F‘“OO V-h-Aghu- I H fiwfif‘ “n ‘A V' P L-veuS:~ ‘9“ , .- hp . J'Ve—yt 1a A..'ca::c "f‘nv—lp ny. ,‘u Table 14. 15. 16. 17. 18. 19. 20. 21. LIST OF TABLES Page Determination of Monthly Revenue by the Liquidation Method . . . . . . . . . . . 67 Comparison of Liquidation and Straight Line Methods . . . . . . . . . . . . . 68 Twelve-Month Cumulative Revenue . . . . . 95 Cumulative Revenue and Net Income Percentage Variations . . . . . . . . . . . . . . . 97 Unearned Finance Charges as Per Cent of Gross Instalment Receivables Outstanding . 99 Income Statement Form . . . . . . . . . . 121 Composite Income Statement of Small Loan Licensees in Michigan for Year Ending December 31, 1962 . . . . . . . . . . . 129 Allocation of Precomputed Finance Charges in Accordance with Proposed Approach . . . . 145 vii ", - ‘0 'podo l v.,.' .. g o .“.a:...' O- “. .A—‘A‘ ._ I A. Q. ‘ D U . - o. . .p - ‘_’V‘\. a to v... . ‘ p. " -‘ . d" 'M' 14 on. c _.., ' T s 0"- ~ 3. 5" v -- n dA.,,. _ u s. .— ‘1 0‘1.-.‘ . I ‘ '3'.“ ca “‘ c. d;"”“ :- ." ' ‘ooAv L ‘- A4990 .4 , vi'- - q 'a'-cr~o on.."._4' ‘ V’s-v Lh't" _ V- q .4 ... cl ’HVMQ .~"-'.4A' Ifnvyo" 41 '-- u‘ fifl‘ofl u a" '- ..U'H.‘-‘H 'v -. (H 1 V ‘- .- y,‘ ~ Vv -.U J‘ .4 h “ a. v... {d 9. 10. 11. 12. 13. LIST OF ILLUSTRATIONS Monthly Revenue~~Reaching Steady State . . . . Cumulative Revenue~_Reaching Steady State . . . . Unearned Finance Chargesu-Reaching Steady State Revenue Variations Level-aIncreased Revenue Variations LevelwmIncreased Revenue Variations Levelumlncreased Revenue Variations Level-mlncreased Revenue Variations LevelumDecreased Revenue Variations LevelamDecreased Revenue Variations Levelm-Deoreased Revenue Variations Level-nDecreased from Steady State Loan Principal . from Steady State Finance Rate . from Steady State Loan Volume . from Steady State Loan Maturity from Steady State Loan Principal from Steady State Finance Rate . from Steady State Loan Volume . from Steady State Loan Maturity Consumer Finance Company Functional Cost Components Functional Costs-wMonthly Pattern viii Page 74 76 78 82 82 84 86 9O 92 93 131 141 ‘flllll’ I‘ll. LIST OF APPENDICES Appendix Page A. Sum-ofmthe-Digits Apportionment Percentages O O O O O O O O O O 160 B. Sum-of-the-Digits Method Monthly Spread System . . . . . . . . 161 Sum-of-the-Digits Method Maturity Control System . . . . 163 C. Straight Line Method Maturity Control System . . . . . . . . . 165 D. Revenue Apportionment Procedure under Proposed Approach . . . . 167 ix CHAPTER I INTRODUCTION Accounting ig information. The many definitions of accounting emphasizing the functions of recording, classifying, and summarizing financial data1 tend to ob- scure the primary purpose of engaging in these activities --namely, the provision of pertinent information to inter- ested parties. Given this as the primary objective of accounting, it follows that one of the more important func- tional activities of the accountant involves communication. The accumulation of financial data is useless unless it is effectively communicated to those for whom it is gathered. The users of financial data are many and varied. Stockholders, creditors, financial analysts, governmental agencies, employees, unions, customers, and potential in- vestors are among the parties interested in the financial statements of a business enterprise. The existence of such diversity is significant to the accountant concerned with 1Three such definitions, those of Maurice Moonitz, F. Sewell Bray, and the committee on terminology of the American Institute of Certified Public Accountants, are found in Maurice Moonitz, The Basic Postulates gf_Accounting, Accounting Research Study No. 14INew York: American Institute of Certified Public Accountants, 1961), p. 23. 2 the preparation of an entity's accounting reports. He can— not operate under the assumption that accounting is domi- nated by any one group. All groups in total are best served by reports reflecting the accountant's objective determina— tion of their contents. Acquiesence to the desires of any one group which leads to a deviation from an objective determination can only result in a lessening of the re- liance of all other users on the statements. At the present time, an enterprisets published fi- nancial statements usually consist of a balance sheet re- flecting financial position, an income statement providing the results of operations, and a statement of retained earn- ings analyzing changes in the retained earnings account. The articulation of these statements with each other re- sults from their reliance upon the same underlying data. Their interrelatedness, however, does not prevent one state- ment from receiving greater emphasis than the others. For many years the balance sheet received the great- est prominence. This was due in large part to the empha- sis given to the examination of balance sheet data by nine- teenth century British auditing practice. Early American accounting and auditing practices drew upon these British roots. Statutory provisions and court decisions also in- fluenced the prominence of the balance sheet. Bankruptcy cases and dividend suits turned on the issue of solvency and thus relied heavily on balance sheet data for their solutions. The income statement currently is receiving the greatest emphasis. Explanations for its increased promi- nence are numerous. The growth of the corporate system, with its separation of ownership from the management of entities, is a contributing factor since it created widen spread interest in the measurement of enterprise perform- ances. Tax laws focusing on business and personal income are also partially responsible for the central position now given income measurement. To one prominent writer, it is only a natural and inevitable phenomenon. In his view, the income statement is, and always has been, accounting's "center of gravity."2 Although the reasons are varied, the outcome is the semen—the income statement occupies the prime position among published accounting reports. The determination of net income for an accounting period is a result of the allocation of revenues and ex- pired costs to that period. The emphasis on income meas- urement, then, focuses attention on the determination of these periodic positive and negative elements~~revenues 2A. C. Littleton, Structure 9;.Accountin Theor , Monograph No. 5 (Urbana, Illinois: American ccounting Association, 1953). pp. 18n35. Littleton devotes an en- tire chapter to the development of his hypothesis "that the extensive need for dependable determinations of peri- odic net income makes the income statement the most im- portant product of enterprise accounting." and expired costs. Many of the problem areas of account- ing, such as depreciation accounting, are concerned with ascertaining appropriate methods for the allocation of in- curred costs to accounting periods. Of equal importance are problems dealing with revenues. "The ascertainment of the revenue figure is a problem in itself, . . . . Indeed, the development of methods by which the amount of gross earnings may be determined on a rational basis is one of the most serious tasks facing the accountant."3 The complexity of the situation is due to the new cessity of determining income for periods typically shorter than the life span of the enterprise. The indefinite lives of most businesses today make it impractical to await their termination points before undertaking income computations. The demands of the informationmusers for regular and peri- odic reports is an overriding consideration. The nature of the resultant reports is well put by William Paton: There is no more difficult problem of quantitative measurement and interpretation than that of deter- mining the earnings of a complex business institution for a given period of time, especially when the period is short. The typical enterprise is a continuing en— tity, and setting up the report of operations and re- sulting earnings for a particular month, quarter, or year, . . . means that many living fibers of activity must be cut, more or less artificially, that estimate and judgment must be relied upon at numerous points. 3William A. Paton, Accountin Theor (Chicago: Accounting Studies Press, Ltd., 1962;, pp. £43~444. This work was originally written in 1922 as a doctoral disser- tation at the University of Michigan. On the other hand, the amount and trend of profits as shown by a series of such reports, carefully and con- sistently prepared, are reasonably dependable facts, of real iervice in guiding the actions of interested parties. The breakinguup of economic events into arbitrary time periods means the operational results for a period are tentative in nature. The timeliness of such reports, though, offsets their inconclusiveness. One of the elements necessary for effective com- munication, regardless of the setting, is that the set of symbols and assumptions used by the message encoder, or preparer, correspond to the set employed by the message decoder, or receiver.5 And the accounting situation, with its very existence centered on the provision of financial information, is no exception. In fact, the need for wide- spread congruency of symbols and assumptions between en- coders and decoders is particularly evident in the area of financial information since many of the decisions of vari- ous informationuusers are based upon comparisons of the re- ports of numerous entities, particularly those within the same industry. Of course, before there can be such a con- gruency between accountants and the users of their informa- tion, it is necessary for accountants (the encoders) to 4William A. Paton, Advanced Accounting (New York: The Macmillan Company, 19415, p. 19. 5Wilbur Schramm (ed.), The Procegg and Effects gf_ Ma C mmunicat on (Urbana, Illinois: The University of I inois ess, 1954), pp. 4-7. achieve uniformity among themselves. Precisely the opposite situation prevails. A con- sequence of having to cut artificially the "many living fi- bers of activity" is that a wide diversity of accounting Practices applicable to similar situations has arisen. These variations receive an aura of respectability through be ing deemed "generally accepted" by the accounting pro- fession. The question of uniformity versus flexibility of In:‘a-cztices is a much debated issue in accounting. There is 111: ‘tle doubt, however, that the informational value of accounting reports is inhibited so long as the present leVel of flexibility enables methods to be selected prin- ciPally with an eye toward their effects on the minimiza- tion, maximization, or stabilization of income. Samuel He:pworth enumerates, for example, many techniques which are available to smooth periodic income.6 The smoothing may be accomplished by taking advantage of the wide lati- tude allowed in accounting for deferred charges, invento- I‘l'Les, intangible assets, property acquisitions, depreci- able assets, non-recurring charges and credits, and re- 8e:rves. Such a broad band of "accepted" practices in- c‘Ji‘eases the likelihood of a report presenting an "accepted" a~<>counting picture more favorable to a particular interest ‘ 6Samuel R. Hepworth, "Smoothing Periodic Income," %W Reyliew, XXVIII (January, 1953). pp. 32-39. grrnlp than would a report prepared within more uniform Luxrauneters. The outcome, as previously noted, can only ‘be discreased confidence in the reports by other interested P<'5t3:“t::i_es.7 There is strong agitation for the introduction of Hfllizkl greater uniformity in accounting practices. Leonard Spacek writes "the accounting profession must . . . pre- 3951ITEa reports that every one can use without adjustment for alt ernative accounting methods."8 The general purpose of 'tllei relatively new research program of the American Institute 035' Certified Public Accountants is the continuation of the ‘ 7Consider the following quote from "Goodyear Widens jIts; Iead," Forbes Business and Finance, LXXXVI (August 1, 1 960), p. 18: "There is also another symptom of Goodyear's new order of efficiency, but it is perhaps more suggestive than conclusive. In every year since 1955. whether or not its sales volume was temporarily trending up or down, Goodyear has been able to increase its earnings. There are so many ways of accomplishing this by mere book- keeping tricks that financial specialists are wont these days to view any such performances skeptically. So many costs can at option legitimately be anticipated or deferred, expensed or capitalized, that no corpo- rate earnings figure is now regarded by sophisticates as . . . objective." gillnilarly, Steven S. Anreder, "Pitfalls for the Unwary," Ea--::‘ron's National Business and Financial Weekly, XXXXII, :Paiirt 2 (December 24, 19625, p. 3 notes: Accounting varies fl‘Qm industry to industry. In fact, even among companies 113. the same field practices are so diverse as to make com- I’Ellflsons of earnings less than meaningful." '3 8Leonard Spacek, "The Need for an Accounting Court," ~QAccounting Review, XXXIII (July, 1958), p. 371. "effort to determine appropriate practice and to narrow arwnas of difference and inconsistency in practice."9 The breadth of uniform practices within the eco- nrnny' is an important consideration. This writer believes tkuat uniformity of practices on the industry level is es- sential. Arthur M. Cannon is of the same opinion: Nevertheless, the circumstances of a particular :1ndustry are likely to be such that reasonable uni- :formity may be attained and, therefore, the useful- Iiess of their resulting statements enhanced by the ‘W'er to prescribe methods to be followed "has been and cCnatinues to be in the public interest and in the interest investors." It is within this broad setting of the contempo- rary accounting scene that the following proposal concern- ing the recognition of revenue in the consumer finance in- dustry is presented. Nature 93 the Problem In recent years the small loan laws of many states have been changed to allow the use of "precomputation" in the lending practices of consumer finance companies. Em- Ployment of this concept permits consumer finance personnel to determine total loan charges at the time a loan is made I‘a‘ther than calculating charges as each monthly instalment is paid. The predetermined finance charge is addedto the loan principal and this sum is divided by the number of con- tract instalments to get a series of even monthly payments for the borrower. The result is a new accounting problem for the consumer finance industry. The accounting problem which presents itself is how to allocate the precomputed finance charge (i.e., rev- ehue) over the life of an instalment loan contract. At the time a loan is made, the predetermined charge is en- tered in an "unearned finance charges" account.12 The apportionment problem involves differentiating between (a) \ 12Other titles used for this account in statements are unearned interest charges, unearned discount, deferred ncome, and unearned income. 10 the amount of revenue to be recognized as current revenue of a specific month and (b) the amount to be carried for- ward in the "unearned finance charges" account as being applicable to future periods. There are a number of allo- cation methods currently in use in the consumer finance industry. As this writer will demonstrate in Chapter IV, these alternative methods may produce varying results in financial statements ostensibly reporting the same eco- nomic events. Significance g; the Problem The significance of the thesis problem is clearly demonstrable given the general setting established earlier in the introduction. The problem deals specifically with many of the troublesome areas broadly defined earlier. F1:1:‘st, the important area of the ascertainment of revenue is at the core of the problem. Second, the diversity of Ine'thods used to allocate the finance charge is an instance of the existence of a broad range of accepted accounting Practices which serve to distort the informational value or financial statements. In addition to the effect on reported revenues and earnings in the income statement, 11Ilportant balance sheet ratios are influenced. The per- centage relationship of the unearned finance charges ac- c3C1unt to total notes receivable is one such ratio. This I‘atio is significant since it indicates the proportion 11 of future revenue contained in notes already booked. The balance of net notes receivable, that is, total notes re- ceivable less the unearned finance charges, is also afm fected and this, in turn, influences the current ratio. Third, the numbers of parties involved in the preparation and use of financial statements incorporating one or anu- other of the various methods emphasizes the need for greater uniformity of practice in the consumer finance industry. The third point needs elaboration since it demonn strates the increasing significance of the thesis problem in an absolute sense, that is, in terms of the numbers of affected providers and users of financial data. As small loan laws of additional states are changed to permit the pre determination of finance charges, it is evident that a larger number of persons, both accountants and statement u5631‘s, will be involved. There is also another dimension t0 the area of interested users. It concerns developments in the financing of consumer finance companies since World War II. The postwar growth of consumer credit made it new CeSsary for consumer finance companies to construct well:- b8-la.nced financial programs in order to meet their enhanced needs for funds. This led to the establishment of diverm si-‘E‘ied programs of short:- and long-aterm financing, and to the creation of financial connections with an increasing 12 number of lenders.13 The cultivation of these varied sources of‘:funds has more or less paralleled the growth of precom- putation in the consumer finance industry. The importance of the concomitant increase in the number and diversity of parties interested in the financial statements of companies in the consumer finance industry is evident. If decisions based upon the statements by these parties are to be well-founded, the comparability of data. from the various companies is essential. Dissertation Objectives As the preceding discussion suggests, the selection Of an apportionment method is not of such a nature that it should be based solely upon the "personal choice" of each company's accountant from a spectrum of "accepted" prac- tices.” The solution to the problem instead calls for a uniform approach anchored to the bedrock of accounting theory. A primary objective of this dissertation is to eStablish a theoretically sound and feasible approach to the allocation of finance charge revenue over the life of an instalment loan contract. \ h__ 13John M. Chapman and Frederick W. Jones, Finance W: Egg and WEE-E91 Obtain Their Funds, (Columbia nillersity: Graduate School of Business, 19595, p. 37. 14As advocated by Robert R. Marshall, "Accounting ecomputation," Personal Finance Law Quarterly Report, : No. 2 (Spring, 1960,, p. 54. Und XIVer Pr 13 A prerequisite for the fulfillment of the above objective is a knowledge of present practice and its im- pact on financial statements. Consequently, a second ob- jective of this study is to present a description and anal- ysis of current practice. Approach pg the Problem Source material for this study includes the perti- nent literature found in accounting and business periodi- cals, textbooks, reference books, and publications of pro- fessional organizations. Numerous annual reports of finance companies have been examined. The subject files of two national public accounting firms have also contributed much data included in this study. Following this introductory chapter, there are six additional chapters. Chapter II discusses the nature and growth of consumer finance companies and the concept of Precomputation. Such a discussion is necessary, not only bemause the study deals with a particular industry, but also because the nature of particular accounting practices can- not be considered apart from their environmental setting. Chapters III and IV are concerned with current Practice and its possible impact on financial statements. Ch*“lpter III presents the principal methods used to allo- cate the precomputed finance charges. Chapter IV considers the effects of the various methods on the flow of reported 14 revenue and other financial data under selected situations of changes in the characteristics of loans made. Chapter V investigates the accounting thought under- lying the recognition of revenue. From an examination of the various revenue recognition bases and the matching con- cept, a framework for the determination of a proper ap- proach to the allocation of precomputed finance charges is established. Chapter VI applies the framework established in Chapter V to the consumer finance company situation. Con- sideration of the cost structure of the consumer finance entity provides the basis for the delineation of an appro- Priate allocation approach. Chapter VII is a summarization chapter wherein the author restates the significant findings of the preceding chapters. CHAPTER II THE CONSUMER FINANCE INDUSTRY AND PRECOMPU TAT ION The first half of this chapter discusses the na- ture and development of the consumer finance industry and its role in the structure of consumer instalment credit. Familiarity with the industry is desirable because, first, the thesis problem concerns this segment of the economy and, second, the development and setting of a particular industry influences to some extent the accounting prac- tices employed within the industry. The latter half of the chapter examines the phenomenon giving rise to the the s is problem-mpre computation. The Consumer Finance Industry Development The roots of lending reach deep into antiquity. Since even the most primitive human societies had some form of private property, the history of lending probably dates back to these beginnings of civilization. The cus- tom of taking interest on loans also reaches back many centuries. As early as 4000 B.C. there are evidences of 15 16 interest being charged in the Babylonian civilization.1 The consumer finance industry in the United States is of comparatively recent origin. The industry is com- posed of companies engaged in the business of making in- stalment loans to individuals and families under state reg- ulatory and enabling laws, commonly known as small loan laws . The industry is essentially a product of the mass market for personal loans that developed during the time of the industrial revolution. The effects of this economic and social upheaval, such as the mechanization of industry, the urbanization 01' Population, and the growth of the wage system, signifi- cantly changed the way of life for many. Prior to the cre- ation of an industrial society, the economy had been com- Posed of individuals who were predominantly self-sufficient and who provided for their needs through direct production. BY the turn of the twentieth century, however, a large part Of the population could obtain food, clothing, and shelter only by purchases out of their current wages or savings. When the flow of cash wages to a family was interrupted or some other emergency requiring extra cash arose, the need 1Louis N. Robinson and Rolf Nugent, Regulation _o__f; 1151.2 Small Loan Business (New York: Russell Sage Foundation, 1935 9 p. 15 citing H. F. Lutz, Mone __1 sad Lesa: in W gabxlonia ("University of California Chronicle,"-’\701. XXVI, 0. 2; Berkley: University of California Press, April, 1924), pp. 125-142. 17 ;for‘.funds from another source became of the utmost importance. The laws during this period lagged behind reality. Usury statutes carried forward from the colonial days typ- ically limited the rate of interest that could be charged OIl £111.10ans to 5 or 6 per cent a year, 6 per cent being tflie :nmst common.2 These usury laws were originally con- sixrilcted for commercial transactions requiring large loans, usuxailly well-secured, and between parties of fairly equal ‘barwgaining power. The rates, however, would not permit ecxarnomically sound lending of numerous small sums.3 Since tkma (iemand for small loans could not be met legally, the runed. was met primarily by illegal lenders, or "loan sharks." The unregulated loan shark took advantage of his IKusixtion,and used many different subterfuges to get around the tisury laws. Charges in excess of the maximum allowable iniuezrest rate were frequently concealed as fees and costs fOI‘ :paper. The use of "hazard agreements" was another teckuaique. Repayments of an advance were conditioned upon SUCII things as the borrower not losing an arm or leg or bOtll. By including such negligible contingencies in the conixract, it was hoped that the transaction would not be 2Ibid., p. 65. 3This is due to the existence of many expenses which remain.relatively constant regardless of the size 0 Can.granted. For a mathematical demonstration of this point refer to Milan V. Ayres, Instalment Mathematics Handbook (New York: The Ronald Press Company, 19 , Chapter XVII. 18 coqlsidered within the usury statutes since there was ostensibly not "a fixed obligation to pay." A different :mertliod was to sell the borrower a piece of cheap jewelry ad: ‘the time the loan was made; the interest on the loan bexixig at the legal rate, but the sale of the jewelry net- 'tillé; an exorbitant profit. Other devices used included saulairy purchases and payments for alleged quarantees.4 Concern for this situation led to a variety of state legislation during the first decade of the twentieth ceritniry. Some states enacted general prohibitive statutes 'whixehq due to their low rates, would have done away with all small loans had they been enforceable. Other states attempted to fix rates high enough to enable profitable lending in small amounts. However, the net result of these legislative efforts up to 1910 was negligible. The Prollildtive statutes were unenforceable and merely re- sulsteed in the lender increasing his charges to compensate for? 111s additional risk while the permissive statutes were Characterized by inadequacy, either in allowable rates or in suipervisory provisions. In 1911, Massachusetts passed the first effective smaJ;L loan legislation. Five other states-~Oregon, New Jersey, Ohio, Pennsylvania, andtMichigan-mhad passed 4Jackson R. Collins, "Evasion and Avoidance of Usur Laws," Law and Contemporary Problems, VIII (Winter, 1941 , pp. 54-72. 19 similar legislation by the end of 1915. Providing much assistance in some of these legislative battles was the Russell Sage Foundation, a philanthropic institution formed in ‘1 907. With these legislative experiences as background, representatives of the Russell Sage Foundation, remedial Iloeari societies, and commercial lenders drafted a model bill in 1 916. Known as the Uniform Small Loan Law, it served as the pattern for small loan legislation enacted in many states. Since consumer finance companies owe their exist- ence to legislation exempting small-sum lending from the general usury statutes, the drafting of the Uniform Small Loan Law and its subsequent revisions have been significant Steps contributing to their development. The Russell Sage Foundation, to keep up with changing conditions, revised its model law six times before withdrawing from the small loan field in 1945. In 1948, the National Consumer Finance Association, an organization of companies operating under small loan laws, published a Model Consumer Finance Act WhiC-h closely follows the Uniform Small Loan Law. The reg- ulatory features of both models consist of provisions with “33138 ct to: (1) licensing by state supervisory official, (2) supervision by state official having powers to enforce and interpret the law, (3) authorization of adequate charges to Permit a complete service, (4) limitation of charges, (5) regulation of contract provisions, (6) disclosure of 2O terms and status of loan transactions, (7) prohibition of evasions and subterfuges, and (8) penalties and enforcement powers.5 By September 1, 1961 there were thirty-six states having laws similar to the Uniform Small Loan Law. Ten others had laws containing elements of the Uniform Small Loan Law, but were classed as dissimilar by the National Consumer Finance Association.6 Role in the Structure of Consumer Instalment Credit The position of consumer finance companies in the structure of consumer instalment credit can be analyzed on the basis of two classifications: the purpose for which the credit is granted and the type of institution extending the credit. Table 1 integrates these two classifications uSing data as of December 31, 1962. 5Monograph on the Consumer Finance Industry for the Commission on MS'rTef'a'nd Credit (Washington, B.C.: a 1071.11 Consumer Finance Association, 1960), p. 13, footnote. 6Roster 9; Consumer Finance Companies (Washington, B.C.: Nati'SKaT—Consumer Finance Association, 1961), p. 3. 21 TABLE 1* CONSUMER INSTALMENT CREDIT OUTSTANDING BY TYPE OF CREDIT AND INSTITUTION DECEMBER 31 , 1962 (AMOUNTS IN MILLIONS OF DOLLARS) Type of Credit Repair Other Institution Per- and Auto- Cons. Totals sonal Modern. mobile Goods Loans Loans Paper Paper Consumer Finance 3 3,602 $ . . 8 187 3 342 8 4:131 Companies Commercial Banlcs 4,286 2,238 9,574 2,811 18,909 Sales Finance 1,452 170 7,449 3,123 12,194 Companies Other J Financial 3,374 882 1 ,890 427 6.573 Institutions Automobile ealers . . . . 284 o o 284 Retail Outlets . . . . . . 6,152 6.152 Toinals 312,714 83.290 819.384 812.855 848.243 \ “Source: Federal Reserve Board, Federal Reserve W: XXXXIV (March, 1953), Pp. 374-375, and Federal eServe Statistical Release G. 22, "Consumer Credit at Onsumer Finance Companies, December 1962,” (February 5, 1963).» p. 1- 22 Types pf Instalment Credit.--—As Table 1 indicates, the personal loan market is but one of a series of consumer credit markets which encompasses credit extended to buy automobiles, credit granted to purchase other consumer du- rable goods, and credit used for repair and modernization of homes. The personal loan market is a significant credit market, though, since it comprised 26 per cent of the in- stalment credit outstanding as of December 31, 1962. The importance of consumer finance companies in this market is shovnn by the fact that on this same date their loans out- standing constituted 28 per cent of the total personal in- stalment loans outstanding . m o_f_ Credit Institutions.--Consumer finance ComPanies compete with a variety of institutions. Commer- cial banks operate extensively in the field of consumer in- Stalment financing, as evidenced by their prominent position in the four categories of Table 1. Cooperative organiza- tions , such as credit unions, provide a means for accumu- lat111g savings of its members and for loaning such funds to Inemhers at low finance rates. Sales finance companies ex- tend credit primarily through the purchase of dealers' in- Ste.lment paper which arises from the sale of automobiles and other consumer goods. Industrial loan companies, Morris Plan banks, and mutual savings banks provide sources of con— Bu~Iner instalment credit. In addition to the financial in- stitutions, retail outlets are a source of consumer credit. 23 Most of the credit extended for the purchase of consumer goods originates with these outlets. However, rather than holding the contracts to maturity, many retailers sell them to a financial institution. A growing practice is the sale of merchandise by mail order houses, department stores, and other merchants on a "revolving credit" basis at a finance charge usually of 1% per cent per month. Growth The growth of consumer finance companies and the other sources of consumer instalment credit from 1939 to 1962 is presented in Table 2. As this table indicates, the credit outstanding of each of the institutions declined during World War II. This was due in great part to the re- duced production of consumer durable goods. However, since most of the loans obtained at consumer finance companies are not for the purchase of durable goods, their outstand- ings declined by only 11 per cent during this period (1941- 1945) as compared with a decrease of 60 per cent in total mltstandings. The outstandings of each lender has shown a sub- St45Lntial increase since the end of the war. Consumer finance outstandings increased approximately seven and OIlie-half times while the total outstandings increased over eighteen times. A noteworthy aspect of the growth of these institutions HP. millir Il' lull I‘ll!" 1"! 'l. It'll. .mH .a AHomH acmmHEOHz mo h+Hmam>HCD one coammmmm mmOCijm mo :mwpzm .cmmHmon anonpq cad m .oZI .bN .Ho> £|.III I'll =.mmHo5pm mmOCHmam cmmHQOszv mCOHpmHaamm new mCOHHmaoco wo >o5sm m HCHCHrOH: CH mm chmoEoo mommCHm smESmcoo mhmmmm mspamz ocm OHOHLm OHRomo ammHm mmsors pom MANN .o HamooH H>amsanmmv wOHH .c «nommH mCOHHSHHmeH HmHocmch Hampopoov mwmm .Q .AmmmH HHpcdv CHHmHHsm obsmmom Hmampmm pamom m>ammmm Hmhmomn .mmopzom# Hmm.ws mm: H cos.H HHHWH maa.s HHH.NH aca.sH HHHH moH.ma mam m mmm.H mmH.m mmm.g mmo.HH msw.oH HomH was as mHo.m HHH.H oHo.H mma.m HHHM HH NHH.HH oomH st mm Hawtm HQH.H Hmmwm 0mm.m on .oH Hmmme mmmH Has..mm mam.s HHN.H mso.m woa.m moo,w omaJHH wmmH msa.mm ess,: maH.H HHHQH HHH.N as:.a HHHJNH ammH HHH.HH HHH.H aHH.H osa.m sHo.m mso.m HHH,HH HmmH Ham Hm mom.s mHO.H mmo.m HHH.H Hm: m .Hoo.oH mmaH Hem. Hm HHH.H HHH Hmwam HHH.H sHH 0 Has H amaH moo mm mso.s Has HHHJN HHH.H ems m was“ a mmmH moa,mH Nmm.m mas HHH.H Hmm .HHH .s 4mm H NHHH Hmmth QHH.m mom mmm.H mmo Hmo. m Haa.m HmaH mos.aH Haw.m ems Ham H _omm HH..m waa.m ommH cam.HH Hmm.m 0mm owQ H mm: ssm.m mma.: asaH Ham.m HHH.H HHH on Ham HHo.H amm m mamH mmo.o css.H com one mmm mmm.H was. H HHaH NHH.H Hma oaH 0mm HmH Has Ham H osmH HHH.H was amH 0H4 VNOH com. mas msmH mso.o mooWH mam 0mm mmH HHH.H HNH.H HsmH mom.a a HHH.H a HON a om: a mmH a saH.H a mso.H mmmH Hmpoe mHOHpso porpo mchmano mQOHCD moHcmano mxcmm UOHhmm H Hump mm mofimfifih P Hfimho @ OCwCHnw HwHOHmeEOO MO amsamsoo mmem new A9258 .mo mZOHHHHz ZHV *mzHQz¢BmsDo BHDmmo BzmzudstH mmzbmzoo N mamas 25 is shown in the table. From 1955 through 1962, the outstand- ings of the consumer finance companies increased by slightly over 57 per cent. Yet the outstandings of credit unions increased by close to 200 per cent. As a result, consumer finance companies were replaced by credit unions as the third largest type of financial institution supplying con- sumer instalment credit. Borrower and Loan Characteristics The existence of many types of lending institutions in the personal loan market suggests that this market may be broken down further. Each source of loans is, to a con- siderable extent, designed for different groups of people. Commercial banks tend to limit their lending to preferred risks. Credit unions limit their service to members only. Consumer finance companies, as a general rule, specialize in the small personal loan where the risk is greater than some other financial institutions are willing to bear. Borrower Occupation.--The credit market of con- sumer finance companies is differentiated to some extent by the occupational groups of its borrowers. Table 3 Shows the results of a 1959 survey in Michigan. The first lflxree categories in the tabulation--skilled and semi- Skilled workers, laborers, and clerical and sales workers "'fl30nstitute 84 per cent of the borrowers. Employment Statistics for Michigan in 1959 indicate that only 65 per 26 cent of their labor force falls into the first three classes.7 Hence, these three groups appear about one and one-third times more frequently as borrowers at consumer finance companies in Michigan than their numerical impor- tance would suggest. TABLE 3* MICHIGAN BORROWER OCCUPATION Occupation Per Cent Skilled and semiuskilled workers . . . . o 58 Laborers, except farm and mine . . . . . . 15 Clerical and sales workers . . . o . . . . 11 Professional workers and managers . . . . 6 Service workers . . . . . . . . . . . . . 6 Others 0 O 0 0 0 0 O O O O O 0 0 O O O O O 4 Total 100 *Thomas Gies. Cedric Frickes and Martha Seger, QQEf sumer Finance Companies in Michigan, A_Studv g§_0perations and Regulations ("Michigan Business Studies." Vol. XV, No. 3; Ann.Krbor, Michigan: Bureau of Business Research, University of Michigan. 1961), p. 32. Other Borrower Characteristics.--The Michigan sur- ‘vey provides further data on the characteristics of the con- sumer finance company borrower. Such a borrower is likely to fall within the lower half of the state’s income distri~ ‘bution. This is not unexpected since the largest groups 7Thomas Gies, Cedric Frickeg and Martha Segerg Egg- EEEEZQ Finance Companies in_Michigan9 A_Study gf_0perations 2&5; ngulations ("Michigan Business Studies," Vol. XV, No. 3; EUI-Arbor, Michigan: Bureau of Business Research, University Of Michigan. 1961), p. 31. 27 of borrowers are in occupations which have relatively un- stable incomes. The borrower is also likely to be married and between the ages of twenty-one and forty. These persons are relatively heavy users of credit since they are in the precess of establishing homes and raising families. Their demand for goods and services is thus high.8 Loan Purpose.--Another way to segment the market 'is to examine the purpose for which loans are made. As Inentioned earlier, loans are not generally obtained at con- sumer finance companies to purchase durable goods. Table 4 bears this statement out. TABLE 4* PURPOSE OF LOAN Per Cent Purpose in 1958 Consolidate overdue bills . . . . . . . . . . . . 39.5 Travel, vacation, education . . . . . . . . . . . 9.3 Medical, dental, hospital, funeral o o o o o o o o 7.9 Taxes, insurance, payments of real estate loans. . 7.6 Clothing, food, rent, fuel, moving . . . . . . . . 7.2 Automobile purchase or repair . . . . . . . . . . 5.5 HOUSGhOld repairs . o o o 0.0 o o o o o o o o o 5.1 Home furnishings and appliances . . . . . . . . . 4.7 Assist relatives . . . . . . . . . . . . . . . . . 3.5 Miscellaneous and not reported . . . . . . . . . . 2.7 Total 100.0 “Monograph gn_the Consumer Finance Industry for th§_Commission on Money and Credit, 0 . cit., p. 107. Data are for 2,253 offices operated y three consumer finance companies as of June 30, 1959. 8Ib1do , pp. 32-360 28 By far the most common reason given for borrowing is to consolidate existing debts. It is in this area that consumer finance companies feel they render one of their most valuable services. In addition to a loan, the com- panies provide the borrower with constructive counseling in his fiscal affairs. This is done so the loan will help solve a financial problem and not become an additional burden. Loan Size, Maturity, and Security.--The maximum loan that consumer finance companies may make is set by state law. The many drafts of the Uniform Small Loan Law set this maximum at 8300. However, in order to adapt to higher price levels, the legislatures of many states have increased the loan-size ceiling. By the latter part of 1962, twenty-three states had loan limits of $1,000 or more.9 As prices increased and ceiling were raised, the average size of loans made also went up. From 1951 through 1961, the average loan of a representative number of com- panies increased from 8250 to $490.10 The average maturity of loans went up during this 9"Higher Loan Ceilings for Consumer Finance Companies,” Personal Finance Law Quarterly Report, XVII, No. 1 (Winter, 1962), p. 6. 10First National Bank of Chicago, ”Small Loan Com- pany Ratios" (years ending December 31, 1951-December 31, 1956, six months ending June 30, 1957). and ”Consumer Finance (Small Loan) Company Ratios” (years ending December 31, 1955 -December 31, 1961), p. 1. same time period, due in no small part to the increasing size of the loan. This trend may be seen in the experi- ence of one of the largest consumer finance companies. The average maturity of its loans increased from 19.6 months in 1952 to 25.21 months in 1961.11 Loans from consumer finance companies are frequently secured by a chattel mortgage. Data covering the security for loans made in fourteen states during 1954 indicated that about 60 per cent of the loans were so secured. Thirty per cent of the loans were unsecured, with the remaining 10 per cent being endorsed and co-maker notes or secured by wage assignments and other security. The percentage of un- secured loans in this analysis, though, represented a no- ticeable increase as compared with a similar analysis in 1937.12 Precomputation Definitions Per Cent Per Month.~~The 1916 draft of the Uniform Small Loan Law, in dealing with the statement of charges, settled on a single, all-inclusive monthly rate of declining 11Household Finance Corporation, Prospectus, November 14, 1962, p. 9. 12Tynan Smith and Robert Johnson, ”Operating Char- acteristics of Consumer Credit Institutions," Consumer In- stalment Credit, Part I, Vol. 1: Growth and Import (washington, D. C.: Federal Reserve System, 1957). Pp. 48-E9. 30 balances. The pertinent provisions read as follows: Section 2. Every person, co-partnership and corporation licensed hereunder may loan any sum of money, goods or things in action not exceeding in amount or value the sum of three hundred dol- lars (8300) and may charge, contract for and re- ceive thereon interest at the rate not to exceed three and one-half (3%) per cent per month. (2a) Interest shall not be payable in advance or compounded and shall be computed on unpaid bal- ances. In addition to the interest herein provided for, no further or other charge, or amount whatso— ever for any examination, service, brokerage, com- mission or other thing, or otherwise, shall be di- rectly or indirectly charged, contracted for or received. . . . 3 Given the parameters of this section of the law, all charges for costs such as those incurred in verifying the borrower's credit worthiness as well as the lender's re- turn for the use of his funds were included in the all- inclusive rate and referred to as interest. Later drafts corrected the inappropriateness of this terminology by sub- stituting the word "charges" for ”interest,”14 although the :philosophy of the all-inclusive rate was retained. There were basically two reasons for adopting the tall—inclusive monthly rate. In the first place, many of ‘the loan shark's abuses were predicated upon his ability “to collect extra fees and charges. The inclusive rate 13David J. Gallert, Walter S. Hilborn, and Geoffrey l“Lay, Small Loan Legislation (New York: Russell Sage Founda- ‘tion, 1932), p. 92. 14Robert W. Johnson, Methods g§_StatingCon§umer gigance Charges, Studies in Consumer Credit No. 2 (Columbia Uil'liversity: Graduate School of Business, 1961), p. 28. 31 covering all charges was developed to overcome this area of exploitation. Secondly, the overstated rate of charge —-three and one-half per cent per month as compared with the standard six per cent per annum--was designed to ap- pear so high as to discourage borrowing by all but those in grave need of small loan services. This stemmed from the feeling in the early days of industrialization and mass production that consumer loans were a necessary evil to be discouraged as much as possible. A few states, such as Maryland and Rhode Island, have such a flat per cent per month rate applicable to all loans made under their small loan laws. Many other states have what are known as graduated, or split, rate structures. For example, Illinois allows a rate of 3 per cent per month on unpaid balances through 3100, 2 per cent per month on unpaid balances from 8100 through #300, and 1 per cent per month on unpaid balances from 8300 through 8800. Split rate structures vary from state to state on the basis of the number of gradations. the separation points in the structure, and the rates applicable to various gradations. Precomputation fig an Alternative.--Within the last decade a number of states have changed their small loan laws to embody the concept called "precomputation." Under precomputation, at the time a loan is made the charges are calculated from the schedule of rates per month specified 32 in the law as if the contract were to be paid exactly ac- cording to schedule. The precomputed charges are then added to the principal of the loan and this sum is divided by the number of monthly instalments in the contract to arrive at an equal amount for each instalment. The instal- ment payments made thereafter by the borrower are credited to his account without separating principal from the fi- nance charges. The relevant portion of the Illinois law is stated in the following manner: (0) When the loan contract requires repayment in sub- stantially equal and consecutive monthly instalments of principal and interest combined, the interest may be precomputed at the agreed monthly rate, not in ex- cess of that provided for in subsection (a) of this section, on scheduled unpaid principal balances ac- cording to the terms of the contract and added to the principal of the loan. Every payment may be applied to the combined total of principal and precomputed interest until the contract is fully paid. . . .15 For example, a 8300 loan at 3 per cent per month to be repaid in twelve equal monthly instalments of principal and charges combined produces a charge of $61.68. Under precomputation, the 861.68 is added to the $300 and each instalment amounts to 830.14. The concept of uniform monthly payments of principal and charges combined is not really new to the consumer finance business. Loans with uniform repayment schedules have been in existence within the in- dustry for many years. What is distinctive about precomputation 15Smith-Hurd Illinois Annotated Statutes, Chapter 749 seCtion 31o 33 is its method of applying instalment payments. In fact, this difference is cited as one of the major advantages of precomputation. Advantages of Precomputation Operating Efficiency.—-Instalment payments received under precompute loans are credited to the borrower's ac- count without separating the finance charge from the prin— cipal. The result, its adherent1s advance, is greater op- erating efficiency. In the absence of precomputation, the finance charge component of each payment must be segregated from the principal and the borrower must receive the results of this computation. The procedural problems involved in requirements of this type are nicely illustrated by the fol- lowing quote: But this stipulation involves the loan company in a truly frightful amount of fruitless squirming. The borrower must be given a pass book on which the amount he owes is entered together with the date the amount he received in cash . . . was advanced to him. For its own records the loan company sets up a ledger card. And now the squirming becomes painful indeed as the poor loan company teller works her way through monthly payment after monthly payment. She takes the borrower’s pass book and his money. She pulls his ledger card from the files and compares the figures on the card with those in the borrower's pass book. Then she counts the number of days that have elasped since the borrower's previous payment, turns to her inter- est calculator, plugs the borrower's last principal bal- ance into her calculating machine, presses her multi- plier keys and lets the motor rip out the amount of in- terest the borrower owes. She posts this amount to her ledger card--and to the borrower's pass book. Then she counts the money the borrower has passed through her win— dow. She writes the amount on a memo pad, subtracts the interest amount--that's three times she's written the interest amount--and arrives at a remainder. She posts 34 this remainder to the ledger card and to the pass book. Then she subtracts this remainder from the old princi- pal balance and posts the new principal balance to the ledger card and to the pass book. Finally, she enters the date of the payment, returns the pass book to the borrower with thanks, and files the ledger card. And she does that every month for nearly every customer -—few payments come in by mail because borrowers don't know how much interest they owe and can't or won't figure it. The bank, on the other hand, gives the customer a coupon book on which the precise amount of each pay- ment and due dates are clearly stated, sets-up a pre- scheduled ledger card and when the coupon comes in --most of the coupons are mailed in with checks accom- panying them-~they are sorted in the same sequence as the ledger cards, the ledger cards are date stamped with the date of payments-~no figures are needed since the balances due are prescheduled--and the job of ac- counting for the monthly payment is done. . . . No wonder the bank can handle 500 accounts per employee against the loan company's 310 to 335.115 The fewer computations involved in the handling of a precompute loan payment also lessen the chance of an error occurring. This is important for consumer finance com- panies since small loan laws generally provide that a will- ful overcharge voids an entire loan. Thus, the simplified handling of payments under precomputation (whether coupon books are used or not) and the adaptability of such a sys- tem to prescheduled and preprinted loan papers and ledger cards can contribute to reducing a company's operating costs. 160tt0 Lorenz, ”State Laws Hamper Procedural Eco- nomies," Personal Finance Law Quarterly Report, X, No. 1 (Winter, 1957). p. 15, reprinted from American Banker, October 17, 1955. 35 Prepayment Refunds.--Precomputation of the monthly charge rate benefits the lender in cases where the loan is prepaid in full, either in cash or by refinancing. Refunds in these cases are lower than those which would result if the finance charge for the shortened period was computed by the simple interest per month method. The reason for this is that refunds under precomputation are computed by the ”rule of 78ths,"17 whereby more of the total charge is retained upon prepayment than if simple interest is used. Table 5 presents a comparison of the two methods. The additional charge retained by the rule of 78ths as successive months pass exceeds those collected by the simple interest method during the early months of a loan contract while the opposite situation exists in the latter months. The last column of Table 5 demonstrates this. In the example, the differential between the two methods in- creases during the first five months, while the contrary circumstances prevail during the last seven months. As Table 5 also shows, the finance charge under either method is the same if the contract is carried to maturity. 17The rule of 78ths is a sum-of-the-digits method for computing refunds. It acquires its name from the fact that 78 is the sum of the digits 1 through 12. As an example of its use, if a twelve month contract were paid in full after one month, 66/78 of the finance charge would be refunded to the borrower. On a twenty-four month loan the denominator is 300 (the sum of 1 through 24) and 276/300 of the total finance charge would be refunded if the loan was paid in full after one month. 36 TABLE 5* COMPARISON OF FINANCE CHARGES RETAINED UPON PREPAYMENT UNDER SIMPLE INTEREST AND THE RULE OF 78THS A! Finance Charge Retained Prepaid Simple Rule of Month-end Interest 78ths Difference 1 3 18.00 3 22.73 8 4.73 2 35.22 43.57 8.35 3 51.66 62.51 10.85 4 67.31 79.56 12.25 5 82.16 94.71 12.55 6 96.20 107.97 11.77 7 109.42 119.33 9.91 8 121.22 128.80 7.58 9 131.34 136.38 5.04 10 139.46 142.06 2.60 11 144.95 145.85 .90 12 147.74 147.74 0 ”Example: 81000 loan; rates 3%/2%/1%/3300/3500/ $1000; twelve monthly instalments of 895.645; total fi- nance charge, 8147.74. The significance of this benefit is, of course, a function of the number and timing of loans that are prepaid. In general, it can be said that a large number of loans are prepaid, although it is usually by refinancing. As an il- lustration, one of the findings of fact by the Massachusetts Small Loan Regulatory Board in 1957 was that 60 to 66 per cent of all loans made by the consumer finance industry in the state were refinanced and new loan contracts entered into after about 37 per cent of the contract life of the 37 original loan had elasped.18 Since the sample loan used in Table 5 is under a split rate structure, the differences shown between the two methods are greater than if one rate was applicable to the entire loan. The reason for the increased difference is that under a graduated structure the monthly finance rate of charge starts out lowest in the first month and gradually increases each subsequent month until the loan balance is reduced to that amount bearing the highest rate. 0n the other hand, application of the rule of 78ths produces the same charge rate each month when applied to the scheduled unpaid balances of principal and charges combined.19 The existence of these differences in the rates of charge leads to another advantage which is cited for precomputation. Logicalness.--Split rate structures have been in existence since around 1928. Taking legal cognizance of the many costs not related to size of loan, their purpose is to give a lower rate on larger loans. To accomplish the objective, different rates are applied to different portions of the unpaid loan balances. As just noted, though, under simple interest per month, this results in the lowest charge 18James C. Gahan, Jr., "Massachusetts Board Issues Small Loan Rate Order," Personal Finance Law QuarterLy Report, XII, No. 2 (Spring, 1958). p. 35} 19On the loan used in Table 5, for example, the rule of 78ths produces a monthly rate of 1.98% on the un- paid balances of principal and charges combined. 38 rate applying during the first month of the loan and gradually increasing thereafter (assuming, of course, the loan is large enough to be affected by the split rate.) Proponents of precomputation, contrasting the vari- ableness of monthly rates derived from simple interest per month with the constant monthly rate produced by precompu- tation, argue strongly for precomputation: There are no other lending agencies having a system of charges which produces a progressively higher rate of charge as the instalment payments reduce the unpaid balance. . . . Where is the justification or logic in giving the borrower who pays off his loan ahead of sched- ule a lower rate than is paid by the borrower who car- ries his loan to maturity? Logically, the one who re- pays should pay at least the same rate, if not a higher rate. Most real estate mortgages provide a penalty for prepayment-~not a lower rate! . . . A constant monthly rate or a variable, pro- gressively higher monthly rate--can there be any ques- tion as to which is the more logical?20 Competitiveness.-—The borrower, under precomputa- tion, knows the dollar cost of the loan at the time the agreement is signed. If he makes his payments regularly, that is, on the due dates or within the allowed grace pe- riods, he will not pay any more or less than this precom- puted dollar amount. From a competitive standpoint, con- sumer finance company personnel consider this an advantage. The practice of most other lending institutions is to com- bine the interest and expense charges into a dollar amount 20J. Miller Redfield, "Precomputation--Plain and Fancy," Personal Finance Law QuarterlyReport, XII, No. 1 (Winter. 1957)» P- 5- 39 which is either added to, or discounted from, the amount of the loan. Personnel of consumer finance companies often feel their borrowers are confused by the per cent per month charge statement, particularly where a split rate structure is in effect. The hope, then, is to improve the "product package" and overcome borrower confusion as to loan costs by precomputing the loan charges. Objections to Precomputation Statement pf_Charges.--A principal objection to pre- computation relates not so much to the concept itself, that is, to the predetermining of the dollar cost of a loan, but to the fact that these computations are determined by ref- erence to a per cent per month rate structure. The objec- tions come from those who wish to eliminate the per cent per month rate structures from the statutes entirely and replace them with a form of dollar cost charge statement, whether it be an add-on method, a discount method, or a statement of a certain number of dollars for each 8100 bor- rowed for a year.’21 For persons so inclined, precomputation’s "only purpose . . . is to gradually educate those lenders who have not had the advantage of experience in the various 21A concise discussion of the various proposals for the statement of finance charges is found in Carl A. Dauten, The Consumer Finance Industry in a D namic Economy, Consumer Credit Monograph No. (St. Louis: Afierican Investment Company of Illinois, 1959). pp. 60 63. 40 types of lending operations, to realize and appreciate the advantages of the add-on or dollar-cost system."22 The disenchantment with the per cent per month stat— utes stems from their misinterpretation by borrowers and others. Consumer finance employees often find much time and effort is needed to convince a borrower that three per cent per month on a $100 loan repayable in twelve monthly instalments does not result in a $36 finance charge. The image of the consumer finance industry suffers from such misinterpretation: It is so easy, for example, to multiply 3% per month by twelve and contrast this 36% per annum with conventional interest rates of 8% to 12% per annum, that there is a constant stream of abuse against this business and its so-called "outrageous charges.” This "percent per month" lends itself as a perfect target for demagogues, politicians and many well-intentioned but uninformed public-spirited citizens--even many expe- rienced loan personnel can't understand it sufficiently well to give a satisfactory explanation.23 Adjustments.--The fact that the finance charge under precomputation is determined on the basis of a scheduled contract means that provision must be made for cases where deviations from the contract occur. Adjustments for such variances are usually classified as extension charges, where the due date of the first instalment is extended; default 22L. J. Holroyd, Jr., "Precomputation--Is It Really Progress?" Personal Finance Law Quarterly Report, XII, No. 1 (Winter,'1957), p0 16. 23L. J. Holroyd, Jr., "A Critical Analysis of Com- puting and Stating Rates of Charges of Consumer Instalment Loans,” Ibid., XI, No. 3 (Summer, 1957). p. 126. 41 charges, where there is a delay in the payment of the full amount of any scheduled instalment; deferment charges, where all wholly unpaid instalments are deferred one or more full months and the maturity of the contract so extended; and re- funds for prepayments. The criticism is sometimes leveled at precomputation that these adjustments are themselves complex, confusing, and time-consuming. And since precom- putation is only an alternative to simple interest, employees must be trained to operate under either method. Further, the existence of two methods creates problems in the de- signing of loan forms, particularly for those cases where a constant delinquency under precompute switches to a simple interest basis.24 It is likely that some of these criticisms of the adjustments result from their newness to the system rather than from any inherent complexity. For example, refunds under the rule of 78ths can be easily taken from tables with few, if any, paper and pencil calculations needed-~except if the loan is prepaid very early in a few states whereupon a recalculation of charges is required on a per cent per month basis. Nevertheless, there is little doubt that pre- computation provides the maximum benefit when all payments are made on schedule. This has led one authority to esti- mate that unless 60 per cent of an office's accounts 24Dan J. Griffen, "Precomputational Considerations in Loan Forms," Consumer Finance News, XLV, No. 7 (January, 1961), pp. 3-50 42 consistently make full payments according to schedule, pre- computation should not be adopted.25 Borrower Cost.--An increase in the cost to the bor- rower is an objection frequently mentioned regarding pre- computation. This, of course, is merely the converse of the advantage presented earlier dealing with refunds in pre- payment cases. To illustrate the increased costs, the same sort of comparison is made between charges computed by sim- ple interest and by the rule of 78ths in case of prepayments in full. One author is quite dogmatic about the criticism. Noting that both methods charge the same amount if the bor- rower lives up to his contract, his attitude is that "con- tracts are made to be observed, not breached." When a bor- rower breaches, through prepayment, delinquency, or other— wise, there is no reason why there should not be differences in the charges.26 A different type of reply is used by another writer-—his opinion being that the only sure way to eliminate the criticism is to eliminate the comparisons. To accomplish this, precomputation must be given up as an 25J. Miller Redfield, "Why Precomputation?" Personal Finance Law Quarterly Report, XIV, No. 2 (Spring, 1960)] p. 59. 26James B. Harper, "A Draftsman Looks at Precom- putation," Personal Finance Law Quarterly Report, XII, No. 1 (Winter, 1957). Pg 12. 43 alternate under a per cent per month law and a dollar-cost method of stating charges must replace it.27 The Personal Holding Company Tax and Precomputation Present tax laws impose a special tax of from 75 to 85 per cent on undistributed personal holding company in- come. The purpose of this tax is to prevent an individual, or a group of individuals, from escaping high individual taxes by collecting and retaining income as an "incorporated pocketbook" rather than distributing it to stockholders. In general, a corporation is a personal holding company if less than six individuals own more than 50 per cent of the value of the outstanding stock and if at least 80 per cent of the corporation income is personal holding company in- come. Personal holding company income essentially consists of ”passive" income, which includes such things as interest, dividends, rents, annuities, and gains from the sale of securities. The law does exclude certain types of companies from the definition of a personal holding company. The exemp- tions are allowed because the companies are engaged in an active trade or business despite the nature of their income. Banks, life insurance companies, and surety companies are examples. Consumer finance companies are also excepted 27Red£ield, loo. cit. 44 under certain conditions. The development of precomputation created some prob- lems for the smaller, independent consumer finance compa- nies seeking exemption from the personal holding company tax. Although the problems have since been neutralized, a brief recapitulation of the situation is necessary since it affected the acceptability of precomputation to a segment of the consumer finance industry. There are two exceptions which can be applied to consumer finance companies. The first exception is a re- sult of the Revenue Act of 1938 and is intended to exempt those companies Operating under statutes similar to the Uniform Small Loan Law. The relevant provision reads that the term "personal holding company" does not include: (6) a licensed personal finance company under State supervision, 80 percent or more of the gross income of which is lawful interest received from loans made to individuals in accordance with the provisions of appli- cable State law if at least 60 percent of such gross income is lawful interest-- (B) not payable ig advance and computed only on unpaid balances, . . . .2 It has already been demonstrated that under precom- putation it is possible, in the case of prepayments, for the lender to receive charges greater than if they were com- puted by the use of simple interest on unpaid balances. 28:. R. c. 542 (c) (o). 45 Part (B) of the above tax provision, however, indicates that charges should be computed only on unpaid balances. WCuld a lender thereby lose his exemption if he used pre- computation and the corresponding adjustments based upon the rule of 78ths? An Illinois licensee applied for an income tax ruling and got the following response: A small loan company will not lose its exempt status under Section 542 (c) (6) . . . solely by reason of adopting the method of precomputing in- terest on loans authorized by the Small Loans Act of the State of Illinois, as amended. However, in determining whether such company is excepted from the definition of a personal holding company, that portion of interest charged by the company in ex- cess of interest computed only on unpaid balances, although includable in gross income as interest, may not be taken into account in determining whether such company satisfies the percentage of gross income re- quirements prescribed. . . . 9 Since the taxpayer has the burden of proof in claiming an exemption, the above ruling meant that each affected consumer finance company had to find some means of measuring the difference between the charges received under precomputation and what it might have received under the simple interest method so the excess could be excluded in determining whether the company met the 60 per cent test in the tax law. If the taxpayer recomputed all loans on a simple interest basis to get a figure to compare with the charges received under precomputation, a major reason for using precomputation--efficiency--would be 29Rev. Rul. 60-194, C. B. 1960-1, p. 206. 46 eliminated. To claim exemption under Section 542 (c) (6), then, an alternative method acceptable to the Internal Revenue Service was needed.30 Recourse to Section (c) (7) was another possibility. Section 542 (c) (7) was added to the Internal Rev- enue Code in 1950 to exempt lending companies making small loans in states which allowed interest charges to be deter- mined by the "dollar add-on" method. Ostensibly applicable to precompute loans also, the pertinent part of this exemp- tion did read: (0) The term "personal holding company” does not include-- 0 O O O O O O O O O O O O 0 0 O O O O O O O O O O O O O (7) a lending company, not otherwise excepted by this subsection, authorized to engage in the small loan business under one or more State statutes pro- viding for the direct regulation of such business, 80 percent or more of the gross income of which is lawful interest, discount or other authorized charges-- (B) which do not, in the case of any individual loan, exceed in the aggregate an amount equal to simple interest at the rate of 3 percent per month not payable in advance and computed only on unpaid balances, . . . . 1 30Three suggested methods are summarized by L. J. Styskal and J. E. Newton, "Small Loan Companies Ask New Handling of Precomputation and PHC Exemption," The Journal of Taxation, XIV (May, 1961), p. 301. 31H. S. Congress, House, Committee on ways and Means, Exception of Certain Consumer Finance Companies From Per- sonal Holding Company Tax, 87th Cong., 2nd Sess., H. Rept. 1811 to accompany H. Rept. 8824, p. 6. 47 The problem of claiming exemption under this section was quite similar to that encountered under Section 542 (c) (6), --each affected lender had to measure the difference between the charges received under precomputation and what it would have received under a 5 per cent simple interest method. The burden of recomputing interest on a simple interest basis or drawing up additional refund charts was placed on the small consumer finance company.32 Thus, either exemption open to a firm using precomputation created record-keeping problems. Congress, recognizing the fact that the personal holding company tax was intended to tax passive investments and not to regulate active lending companies, rectified the situation in 1962. An amendment changing Section 542 (c) (7) was signed into law on October 9, 1962. Among other changes, the amendment removed the 3 per cent per month restriction from the books.33 The removal of this restriction thus cor- rected a competitive disequilibrium within the consumer fi- nance industry created by the tax law and eliminated a basis for opposition to the use of precomputation. 32As an example, one author estimated that a $260 loan for 20 months (a $202.67 cash advance) at 2%%/2%/32oo would require recomputation at a 3 per cent rate through all or some part of each instalment period through 5 months and 3 days, William A. Kline, Jr., "Precomputation from Standpoint of a Personal Holding Company, Advertising and Customer Relations," Personal Finance Law Quarterly Report, XIV, No. 2 (Spring, 1960), pp. 66-67. 33A detailed discussion of all changes is found in House Committee on ways and Means, o . cit.. 9 PP. 48 Acceptance of Precomputation California was the first state to enact a precompu- tation provision as an alternate under a per cent per month law. However, before its final passage in 1949, an amend- ment was added which effectively killed the use of precompu- tation. The amendment provided that regardless of the pro- visions for adjustments under precomputation, total charges collected by a lender could not exceed those which would have resulted from simple interest on unpaid balances.34 Missouri enacted the first effective precomputation statute in 1951. Since then fifteen additional states have revised their statutes to permit precomputation. Table 6 lists the states permitting precomputation and the respective adoption dates. TABLE 6* STATES PERMITTING PRECOMPUTATION Adoption Adoption State Date State Date Alabama. . . . . 1960 Minnesota. . . . 1959 Arizona. . . . . 1956 Missouri . . . . 1951 California . . . 1959 New Mexico . . . 1959 Colorado . . . . 1953 New York . . . . 1960 Idaho. . . . . . 1957 North Dakota . . 1960 Illinois . . . . 1957 South Dakota . . 1961 Kansas . . . . . 1955 Vermont . . . . 1959 Massachusetts. . 1956 washington . . . 1959 and 1960 *Source: "Precomputation and Dollar Add-0n Laws," Consumer Finance Law Bulletin, XV, No. 3 (September 25, 1961), p. 50, except for North Dakota. 34Redfield, 92, g;3,. p. 59. 49 Summary The consumer finance industry developed in response to the need (if a wage-earning society for a source of small loans. The industry's subsequent growth to its present po- sition of over 84,000,000,000 of credit outstanding and a consideration of its borrower and loan characteristics dem- onstrate the continued existence of such a market. The state regulation of the industry is designed to permit prof- itable Operations be allowing charges in excess of the usury rate. By the same token, it operates to prevent abuses from arising within the small loan field. The employment of precomputation within the con- sumer finance industry is supported on the grounds that it enables the industry to be more competitive, provides more logical results, creates a favorable situation in prepay- ment cases, and promotes operating efficiencies. Opponents maintain the concept does not go far enough towards elimi- nating per cent per month confusions, increases borrower costs, and creates adjustment complexities. One-third of the states have considered such pros and cons and have adop- ted precomputation. CHAPTER III METHODS OF ALLOCATING UNEARNED FINANCE CHARGES This chapter examines the various approaches to the allocation of precomputed finance charges over the instal- ment contract periods. The methods covered are as follows: 1. Priority 2. Residuary 3. Effective Rate 4. Sum-of-the-Digits 5. Straight Line 6. Liquidation 7. Fixed Percentage The use of an acquisition cost factor in connection with these allocations is also discussed. Priority and Residuary_Methods Priority1 The entire precomputed finance charge is recognized as revenue at the time a loan is made when the priority method is employed. To illustrate, consider a loan of $109.08 with a precomputed finance charge of $10.92, to be repaid in twelve monthly instalments of $10.00. Table 7 indicates the treatment of this finance charge under the priority approach. 1Also known as the yield minimum method. 50 51 TABLE 7 DISTRIBUTION OF FINANCE CHARGES BY PRIORITY METHOD .4 - l J Monthly End of Note Revenue Unearned Finance Month Balance Recognized Charges Balance L $120.00 $10.92 $ 110.00 . 100.00 90.00 80.00 70.00 60.00 50.00 40.00 30.00 20.00 10.00 m—‘OQm'flmm-pkflmfl 000000000000 0 o o o c o o o o o o o o o o o o o o o o o o o o o $10.92 The justification offered for the priority method is that it is convenient and eliminates the annoyance of dealing with the unearned finance charges account. Ignor- ing an apportionment problem, however, is not the most de- fensible approach. The method is basically unsound since it views the loan transaction as closed and all revenue rec- ognized at a time when the full term of the instalment con- tract still remains. Residuary2 The opposite extreme of the priority method is the residuary approach. Using this technique, no part of 2Also known as the yield maximum method. 52 the finance charge is recognized as revenue until after the entire original principal has been repaid. This technique is ultra-conservative in nature and it, too, ignores the reality of the situation by not recognizing any revenue in the early parts of the transaction. Table 8 illustrates the handling of a precomputed finance charge by the resid- uary method. The same loan conditions as in the previous example are used. TABLE 8 DISTRIBUTION OF FINANCE CHARGE BY RESIDUARY METHOD Monthly End of , Note Revenue Unearned Finance Month Balance Recognized Charges Balance $120.00 3 . . 810.92 1 110.00 . . 10.92 2 100.00 . . 10.92 3 90.00 . . 10.92 4 80.00 . . 10.92 5 70.00 . . 10.92 6 60.00 . . 10.92 7 50.00 . . 10.92 8 40.00 . . 10.92 9 30.00 . . 10.92 10. 20.00 . . 10.92 11 10.00 .92 10.00 12 O O 10.00 0 0 $10.92 The priority and residuary techniques are not within the realm of methods considered to be generally ac- cepted by the accounting profession. Consequently, they are not widely used within the consumer finance industry. 53 Their exposition here serves the purpose, however, of delin- eating the boundaries between which all generally accepted methods fall. The fact that the priority and residuary approaches are in use at all, even when not considered generally ac- cepted, is worthy of note. A firm may use one of these methods and still receive an unqualified audit opinion from a public accounting firm. The auditor, in these circum- stances, makes a comparison between the results for the period involved derived from the system in use and the re- sults that would have been provided by a generally accepted technique. If the difference is immaterial, no exception is taken in the audit report. The expediency of the above procedure, given the audit situation, is recognized. Yet this use of the mate- riality concept means that practices can be perpetuated which are even outside the present broad band of accept- ability. The complexity of the task of reducing divergen- cies in practice is thus increased. Further, a short-run view, such as an accounting period, using the concept of materiality as justification for approval of a technique overlooks the possibility that a series of short-run im- material dollar variances may produce a material long-run variance. Even more importantly, there are other aspects to materiality than just the quantitative side. Qualita- tively, the mere divergence of a practice from what is viewed as "generally accepted" is material. 54 Effective Rate} In theory, the effective rate method requires the actuarial computation of the effective interest rate on the instalment contract. The portion of the finance charge recognized as revenue each month is then determined by multiplying the balance of the investment by the effective rate. Since the monthly collections reduce the finance company's investment in the receivable, the revenue recog- nized decreases each month. This approach interprets literally those small loan laws which label the finance charges as interest. The sec- tion of the Illinois law quoted in the previous chapter, for example, uses the terminology ”interest” and ”precom- puted interest” in its discussion of precomputation. Con- sidering the revenues as pure interest, then, this method distributes the finance charge in accordance with the ef- fective interest rate on the loan transaction. Reference to a table of present values of annuities indicates that the effective interest rate on the loan used as an example in the previous two tables is 1% per cent per month. Table 9 shows how the precomputed finance charge would be allocated using the effective rate method. As previously noted, in theory this method entails the computation of the effective interest rate for the 3Also known as the actuarial method. 55 TABLE 9 ALLOCATION OF PRECOMPUTED FINANCE CHARGE BY EFFECTIVE RATE METHOD Unearned Column 5 Monthly Finance as % End of Note Principal Revenue Charges of Note Month Balance Balance Recognized Balance Balance $120.00 $109.08 3 . . 310.92 9.100% 1 110.00 100.72 1.64 9.28 8.436 2 100.00 92.23 1.51 7.77 7.770 3 90.00 83.61 1.38 6.39 7.100 4 80.00 74.86 1.25 5.14 6.425 5 70.00 65.98 1.12 4.02 5.743 6 60.00 56.97 .99 3.03 5.050 7 50.00 47.82 .85 2.18 4.360 8 40.00 38.54 .72 1.46 3.650 9 30.00 29.12 .58 .88 2.933 10 20.00 19.56 .44 .44 2.200 11 10.00 9.85 .29 .15 1.500 12 . . . . .15 . . $10.92 instalment contract and the application of the effective rate to the declining contract investment to determine the monthly revenue. A similarly exact computation involves the calculation of what the balance in the unearned finance charges account should be at the various stages of the con- tract. The difference between the balance so determined and the balance actually in the account represents the rev- enue for the period. The formula to determine this "cor- rect" balance in the unearned finance charges account isznx (t-atli). where m equals the monthly contractual pay- ment, t equals the number of payments yet due, afli equals the present value of an annuity of one per period for t periods valued at the effective monthly rate of interest on 56 the contract.4 These two techniques of calculating the monthly revenue under the effective rate philosophy necessitate individual contract valuation in each case. The large num- ber of instalment contracts carried by the typical consumer finance company makes such monthly individual contract cal- culations extremely burdensome and impractical. Conse- quently, simplified embodiments of the effective rate ap- proach are found in practice. The determination of an over-all rate applicable to the investment in all contracts is one such embodiment. When first instigated, the calculation of the over-all rate requires extensive work. It necessitates the finding of the effective interest rate on instalment contracts of var- ious sizes and maturities. These rates are determined for loans that are paid in full according to schedule and loans paid in full at various times prior to maturity. A standard often used for the elapsed time of a loan paid in full be- fore maturity is one-half of the full contract term. In 4From a formula in B. J. Hill and M. F. Desmarchelier, "Some Problems for Financiers,” The Chartered Accountant in Australia, XXXII (October, 1961), p. 219. To illustrate, consider the determination of the unearned finance charges balance after six payments have been received. At this point, m:10, t:6, 3f] :5.697. The account balance equals 810 x (6.000 - 5.697 = 310:: .303 = $3.03. The revenue for the period of the sixth payment then equals 34.02 - 3.03 = 8 .99. This is the same amount as that reached by multiplying in- vestment for the period by the effective rate. 57 figuring the rate for the loans paid in full at one-half the contract term, effect is given to the fact that refunds are made under the rule of 78ths. Having secured the ef- fective rates for various loan sizes and maturities, these rates are then evaluated into one average rate for the con~ sumer finance firm. Weight is given to the number of its accounts that pay in full at one-half the term, as well as to the frequency of loan sizes. The average rate so deter— mined is the over-all effective rate for the firm on its loans. The firmis monthly revenue is then figured by mul- tiplying the average rate by the net cash invested in loans at the beginning of the month, that is, the gross loans outstanding less the unearned finance charges balance.5 Another simplified approach maintains the balance of the unearned finance charges account in a predetermined relationship with total note balances. Any amount in ex- cess of this balance represents the revenue for the period. For example, referring to the last column of Table 9, if it is assumed that all of a firm's loans are similar to the one illustrated and that on the average they are all oneehalf paid, the balance of the unearned finance charges account is maintained at 5.05 per cent of the gross notes receivable. Again, the difficulty of implementing a per- centage approach such as this is the determination of the ti " P5John C. Wetzel, "Earned Income Under Precomputa- on, ersonal Finance Law Quarterly Report XII No. 1 (Winter, 1957), pp. 8-9. , , 58 proper relationship given many loans of various sizes and maturities.6 Sum-of-the-Digits7 The sum-of-the-digits technique of allocating un- earned charges is commonly used in the consumer finance industry. Its basic justification is the same as that of the effective rate method, namely, that the amount of rev- enue recognized ought to be related to the amount of the investment in the loans. The popularity of the sum-of- the-digits approach stems from the fact that its results approximate those of the effective rate approach without the necessity of employing any actuarial computations. If a loan is to be repaid in twelve equal monthly instalments, the consumer finance company's investment during the first month is approximately twelve times as much as its investment during the last month. Use of the sumwof-the-digits approach results in twelve times as much revenue being recognized at the completion of one month's time as is recognized in the final month. On a twelve month loan, the method works in the following manner. 6American Institute of Certified Public Accountants, Technical Information Service, "Excerpts From Correspondence Regarding Computations of Unearned Income," (n.d.), p. 2. 7Also known as the direct ratio or 78ths method. 59 The sum of the numbers 1 through 12 is 78.8 The portion of the original unearned finance charge recognized as rev- enue the first month is 12/78; the second month, 11/78; the third month, 10/78; and so on down to the twelfth month when 1/78 of the original unearned finance charge is recog- nized. The same procedure is used for loans of other matu- rities. Thus, on a six month loan, the denominator is 21 (the sum of 1 through 6) and 6/21 of the unearned finance charge is recognized the first month, 5/21 the second month, and so on for the duration of the loan. On a twenty-four month loan, the denominator is 300 (the sum of 1 through 24) and 24/300 of the original charge is recognized the first month. Tables are available which reduce these fractions to percentages for ease of application.9 Table 10 demonstrates the allocation of precomputed finance charges by the sum-of-the-digits method, using the same loan example presented in the previous tables. To indicate the similarity of results, a comparison of the allocations produced by the effective rate method and the sum—of-the-digits method is presented in Table 11. Slightly more revenue is recognized in the early months under the sum-of-the-digits method. This is because the 8The formula to determine the denominator is n(n+1)/2, where n equals the number of months in the original term of the loan. 9See Appendix A. 60 TABLE 10 ALLOCATION OF PRECOMPUTED FINANCE CHARGES BY SUM-OF-THE-DIGITS METHOD Monthly End of Note Revenue Unearned Finance Month Balance Recognized Charges Balance $120.00 . . 310.92 1 110.00 $ 1.68 9.24 2 100.00 1.54 7.70 3 90.00 1.40 6.30 4 80.00 1.26 5.04 5 70.00 1.12 3.92 6 60.00 .98 2.94 7 50.00 .84 2.10 8 40.00 .70 1.40 9 30.00 .56 .84 10 20.00 .42 .42 11 10.00 .28 .14 12 O 0 .14 O 0 $10.92 TABLE 11 COMPARISON OF EFFECTIVE RATE.AND SUM-OF-THE-DIGITS RESULTS Monthly Revenue Month Effective Rate Sum-of-the-Digits m—LOOCDKIQU‘IJ-‘WN‘A $ 1.64 1.51 1.58 1.25 1.12 .99 .85 .72 .58 .44 .29 .15 $10.92 8 1.68 1.54 1.40 1.26 1.12 .98 .84 .70 .56 .42 .28 .14 810.92 61 porportions are calculated on the basis of the face amount of the note rather than the company's investment in the note. Although the total note receivable does diminish in the ratio of 12 to 11 to 10, etc., the company's investment, under the effective rate philosophy, does not since each monthly collection includes a diminishing amount of inter- est and an increasing amount of principal. The fact that the small loan laws require the use of the sumnof-the-digits method to determine the amount of refunds in the case of a loan prepayment provides its adher- ents a source of support for its use as a method of revenue recognition. Persons reasoning in this manner believe it is unnecessary to provide any other balance in the unearned finance charges account than that determined by the sum-of- the-digits approach, since if all borrowers paid off their loans and received their refunds, the firm would be in no worse position than was stated in its balance sheet.10 This type of reasoning, however, runs counter to one of the most basic assumptions underlying accounting thought. The setting just described envisions a liquida- tion situation, whereas the accountant normally takes for granted the continuity of the entity for which he is ac- counting. To assume other than a "going concern" circumstance 10R. H. Lound, "In Defence of the Rule of 78," The Chartered Accountant in Australia, XXXII (December, 1961): P0 3350 62 as the general case is an unreasonable and untenable position.11 The American Institute of Certified Public Account- ants has not taken a position favoring one or another of the various allocation methods. However, authoritative support for the sum-of-the-digits approach has been issued by the Institute of Chartered Accountants in Australia. In June, 1961, its General Council released a pronouncement which stated, in part, as follows: The gross income arising from any form of finance contract should be apportioned over the term of the contract in direct relationship to the amount of the funds invested therein during the relevant accounting periods. It is therefore recommended that members direct attention of their clients concerned to the importance of using one of these methods, or any other method by which the "rule of 78" is applied, for the purpose of apportioning the income yet to mature in hire purchases or similar finance contracts.1 A number of systems are in existence to make the sum-of-the-digits method workable for a consumer finance firm with a large number of instalment contracts. These are the "methods" referred to by the General Council in 11The "going concern" concept is one basic assump- tion of accounting upon which there has long been wide- spread agreement. For instance, refer to Paton, Accounting Theory, pp. 478-480 and Moonitz, o . gi1,, pp. 38-41. 12"Apportionment of Income of Hire Purchase and General Finance Companies," Pronouncement of the General Council of the Institute of Chartered Accountants in Australia, The Chartered Accountant in Australia, XXI (June, 1961), pp. 616-617. 53 the above quote. Two of the more common systems are the monthly spread system and the maturity control system. Examples of these two systems are presented in Appendix B. Straight Line13 Another common method employed is the straight line approach, whereby an equal part of the precomputed finance Charge is recognized each month of the instalment loan. The straight line philosophy pervades many of the transac- tions requiring allocation in accounting and the apportion- ment of the precomputed finance charge is no exception. Table 12 illustrates the results of using this method on the sample loan transaction. TABLE 1 2 ALLOCATION OF PRECOMPUTED FINANCE CHARGE BY STRAIGHT LINE METHOD T -:_v End of Note Monthly Revenue Unearned Finance Month Balance Recognized Charges Balance 8120.00 8 . . $10.92 1 110.00 .91 10.01 2 100.00 .91 9.10 3 90.00 .91 8.19 4 80.00 .91 7.28 5 70.00 .91 6.37 6 60.00 .91 5.46 7 50.00 .91 4.55 8 40.00 .91 3.64 9 30.00 .91 2.73 ‘0 20.00 .91 1.82 ‘1 10.00 .91 .91 12 0 O 091 O 0 310.92 “K 13Also known as the constant ratio or level accrual method. h- i I.’.A~D- I. A fluslvo~-.-J .. . owl-p. \ . 'Ioig’». I a |QVOA‘A F‘ .- —\ .4--.v. . 1 ‘- tun. . ~ 4 H I. Ott‘iv- '2‘ -nyl.‘ .- '-' -Vu . ‘ . "r- e. ' h" u.. inc: _~' on... a... . (I) ) D 1 I m. . .- ‘4 .H a“ “M. . \ ‘I Q‘ “ . 64 Adherents of the effective rate approach and its gllpIDIOleation, the sum-of-the-digits method, criticize the straight line technique because of the variable monthly 9' interest" rate it produces. These persons claim the method is inaccurate since, in the above illustration for instance, the monthly ”interest" rate varies from .76 per cent the first month to 9.1 per cent the last month. On the other Iraaid, the straight line method is pointed out as being much more conservative in relation to the other two techniques.14 5311143 point is illustrated by a comparison of the cumulative revenues recognized on a single contract under the respec- ‘tisvra methods, such as in Table 13 where the straight line Eirld. the sum—of-the-digits accumulations are compared. After ‘t11EB contract has run six months, for example, 50 per cent C1f7 ‘the finance charge has been recognized as revenue under 't11E3 straight line method whereas 73.08 per cent has been rec- 0grlz’Lzed by the sum-of-the-digits procedure. Strong pressure for a conservative treatment of the ifinance charge allocation comes from a not unusual source C’f7 <2onservatism--creditors. Consider the following quote from a banker’s remarks: I am concerned that some companies take in too much income as acquisition cost and, in addition, use too liberal an accounting method in taking in the ,r~ 14American Institute of Certified Public Accountants, 92. Cite, p. 20 65 remaining finance charges. . . . Management should d3: fer a§_much as possible.15 (Emphasis my own.) Management itself, at times, champions the conserva— t ive cause: Many years ago Dial adopted conservative accounting ,practices. These practices remain inviolate. Dial's financial statements are among the most conservative in its industry. . . .1 TABLE 13 CUMULATIVE REVENUE RECOGNIZED BY STRAIGHT LINE AND SUM-OF-THEwDIGITS METHODS Sum-of-the-Digits Straight Line Per Cent Per Cent Month Amount of Total Amount of Total 1 3 1.68 15.37% 3 .91 8.33% 2 3.22 29.49 1.82 16.67 3 4.62 42.31 2.73 25.00 4 5.88 53.85 3.64 33.33 5 7.00 64.10 4.55 41.67 6 7.98 73.08 5.46 50.00 7 8.82 80.77 6.37 58.33 8 9.52 87.18 7.28 66.67 9 10.08 92.31 8.19 75.00 10 10.50 96.15 9.10 83.33 11 10.78 98.72 10.01 91.67 12 10.92 100.00 10.92 100.00 1 The maturity control system for implementing the Straight line approach into a firm with numerous instalment 15Howard Poduska, "Bankers . . . As Creditors . . . As Competitors," The Industrial Banker, XXVIII, No. 12 (December, 1962), p. 16. 15D1a1 Finance Company, Annual Report 126 , p..7.. .- .-y°"'," a .M_._,,. .1. o .‘AUA‘OI -e.-~. IQ - . . -q a....| hoy., *“ .0— v» “. e ’A.“‘ —_ _-I “"4. «w ‘ ~~ ‘ _ h" 'mv u, .' A bl I'. ‘M' . .‘a-A. I u, a.“ - ..; " K n. V Q O . .. .I ‘FA‘ “v \ Va. . \ -.‘ l4 \ ~ g ,. AAA ' e v‘ . 1 66 contracts is described in Appendix C. Liquidation Method Under the liquidation method, the portion of un- earned finance charges recognized as revenue each month is proportionate to the collections on the related receiv- ables. The ratio of collections to the beginning of the month notes receivable balance is computed each month. This ratio is then applied to the beginning of the month unearned finance charges balance to determine the revenue for the month. Table 14 presents a simplified worksheet for the liquidation approach. The distinctiveness claimed for the liquidation method is that it accounts for revenue on the basis of the 8‘-<>'t‘.:1.on of the receivables rather than on a prescheduled b843113.15 The commonly used straight line and sum-of-the- digits methods recognize revenue based upon the presched— u1th payment schedules whereas the philosophy of the liqui- dation technique is to wait until the payment is actually I‘eczeived before recognizing a portion of it as revenue. If the instalment obligations are repaid in an erratic manner, adherents of the liquidation method believe it undesirable to account for the revenue on a prescheduled basis. (In Chapter II, note was taken of one authority's belief that 16Ralph A. Milliman, "A New Look at an Old Subject," Time Sales Financing, XXVI (March—April, 1962), p. 7. 67 Ingrecmmputation should not be adopted unless payments quite .2carisistently followed their scheduling.) TABLE 14 DETERMINATION OF MONTHLY REVENUE BY THE LIQUIDATION METHOD.” Month Bases First Second Third Fourth Receivables at beginning of month (A) $500,000 $600,000 $700,000 $760,000 Loans during the month 200,000 200,000 200,000 240,000 Total 700,000 800,000 900,000 1,000,000 Deduct receivables at monthlend (B) 600,000 700,000 760,000 924,000 Liquidation during month (C) 100,000 100,000 140,000 76,000 an‘ cent of liquidation (0),.(11) (1:) 20% 16.6% 20% 10% Unearned charges at start of month (E) 50,000 60,000 60,000 63,000 Add charges on month's loans (F) 20,000 10,000 15,000 12,000 Total 70,000 70,000 75,000 75,000 Deduct revenue W (I331?) (G) 10,000 10,000 12,000 6,300 Unearned charges at month-end $60,000 $60,000 $63,000 $68,700 k *The pro—rata method expounded by Wetzel, qp, cit., P. 9, is merely a variation in the implementation of this technique. He takes the ratio of unearned charges to re- ceivables times the monthly collections, or in terms of this table, (FD/(A)x (C): (G). The point is not infrequently made that if all the instalments are collected when due the results of the liqui- dation method are the same as those of the straight line 68 nlezthod. This conclusion is not valid in all cases. It re- sults from isolating a single contract and comparing the two nieatflnods. In such a situation, the results would be iden- 1:i.czal. However, when numerous contracts of varying sizes, Insatnirities, and ratios of charges to outstanding balances eazwe involved, the use of the system illustrated in Table 14 produces differences between the two approaches. Table 15 demonstrates the influence of such complexities on the re- sctldzs produced by the liquidation and straight line methods. TABLE 15 (zomeaalsow OF LIQUIDATION AND STRAIGHT LINE METHODS“ Liquidation Straight Line Monthly Cumulative Monthly Cumulative Payment Revenue Revenue Revenue Revenue 1 t 3.25 t 3.25 a 3.60 3 3.60 2 3.25 6.50 3.60 7.20 3 3.25 9.75 3.60 10.80 4 3-25 13-00 3.60 14.40 5 3.25 16.25 3.60 18.00 6 1.95 18.20 1.60 19.60 7 1.95 20.15 1.60 21.20 8 1.95 22.10 1.60 22.80 9 1.95 24.05 1.60 24.40 10 1.95 26.00 1.60 26.00 $26.00 $26.00 “Two loan contracts made on the same day: One-~five months, 8100 total note, 810 precompute finance charge; One -ten months, 8300 total note, 816 precompute finance charge. 69 Fixed Percentage Method The fixed percentage approach cannot be precisely cellzassified as a method in and of itself since its basis InsaDr be found in one of the other methods. This technique employs a fixed percentage relationship to determine the Incarrthly revenues. The revenues may be established by taking a fixed percentage of the net outstanding receiv- alolxas. More commonly, the revenue is a forced figure re- sxllxting from the maintenance of the unearned finance charges 843ccyunt balance at a predetermined percentage of the out- 8 tanding re ceivables . As was pointed out earlier in the chapter the use 01? fixed percentages, such as those just mentioned, may be a. simplified embodiment of the effective rate concept based Ilipon.previous company experience. On the other hand, they Inay'not be based upon a firm's experience at all. It seems that as in most industries, finance com- panies are prone to copy methods and ideas of other finance companies. This is particularly true in the use of fixed percentages for unearned charges, yet these fixed percentages may not apply to the company seeking to use them. They may for instance have been established by larger companies with greater ability and facilities to determine the correctness of the fixed percentage they use.17 The auditing profession has been guilty, on occa- Sion, of employing verification procedures which allow this practice to exist unchecked. One finance firm, as a case 17Ibid., p. 10. 70 3111 point, maintained its unearned charges account balance 211: a fixed percentage of its outstanding receivables. To ,jIJtstify the reasonableness of the selected percentage, the EilléliLOIS resorted not to the company's experience, but in- stead compared the firm's percentage with the composite percentage in the First National Bank of Chicago's list of consumer finance company ratios for the year in question. 1k) 'the auditors, the closeness of the two percentages demon- sixraited the reasonableness of the firm's selection of a fixed percentage . Acquisition Cost Factor As was alluded to in the previously quoted bankeris Iwmnarks, some firms take an amount into the revenue in the nlonth the loan contract is made. This "acquisition cost Ifactor” may be employed in conjunction with any of the gen- erally'accepted methods. The following financial statement footnote indicates its use with the liquidation technique: Net finance charges on discounted receivables are credited to deferred income accounts. A portion of the net finance charges is transferred to income in the month of acquisition as an offset to acquisition costs and loss provisions; the remainder is trans- ferred to income monthly in proportion to receivab liquidation in the case of discounted loans. 18 The basic reasoning behind this acquisition cost factor usage is that the revenue so recognized acts as an 18General Acceptance Corporation, Prospectus, November 5, 1959. p. 26. 71 cnjifset to the costs of acquiring the loans that are charged aaggadnst revenues as they are incurred. At times, however, ca'tlier considerations may influence the decision to use an aaczqglisition cost factor. Employing it with the straight line method produces results which more nearly approximate 'tllE! sum-of-the-digits approach.20 The same reasoning may ZLiJe behind its use in conjunction with the liquidation ‘teaclinique.21 Motivations of this sort are evidences of the iPCrpillarity of the sum-of-the-digits philosophy. Summary A variety of techniques to apportion precomputed Ifinance charges are available for use by consumer finance firms. Two approaches, the priority and residuary, are not CMDnsidered to be acceptable by the accounting profession. rI‘he priority method recognizes the entire revenue from ‘the instalment loan at the time the loan is made. Under the residuary procedure, no revenue from the transaction is recognized until the entire principal has first been recovered. Of the generally accepted methods, the effective rate technique attempts to spread the finance charges on the basis of the actuarially computed interest rates on the contracts. All revenue is thus viewed as interest under 20Milliman, QB. 0113., p. 6. 21Ibid., p. 7. 72 this procedure. The same reasoning substantiates the sum- ofathe-digits method. Its popularity is due to the fact that its results approximate those of the effective rate technique without the need for actuarial computations. The finance charge is spread equally to each month by the straight line procedure. It advocates point out that it is more con- servative than the sumnof-the-digits or effective rate ap- proaches. The liquidation procedure recognizes as revenue each month a percentage of the unearned finance charges bal- ance. The percentage varies from month to month and is determined by the per cent of the outstanding receivables liquidated each month. Some firms recognize a fixed per- centage of their outstanding receivables as revenue each nmnth or, approaching it in a slightly different manner, maintain their unearned finance charges account balance in a fixed relationship to the outstanding receivables. These fixed percentages may or may not be based upon the company’s own experience. An acquisition cost factor is used by some firms. This means a percentage of the precomputed charge is recog- nized as revenue when the loan contract is signed. Employ- mentof the factor is supported on the grounds that it is necessary to offset the cost of acquiring the contract. CHAPTER IV COMPARATIVE IMPACT ON FINANCIAL RESULTS The previous chapter discussed the principal methods used to allocate precomputed finance charges. This chapter is devoted to a consideration of the impact these methods may produce on the financial results of a consumer finance company. A number of examples designed to portray the tend- encies resulting from the use of the respective methods will be presented. The examples are simplified, but they fulfill their purpose of isolating the influences exerted by the allocation techniques. The priority and residuary methods are included in the examples as indicators of the extremes by which the results may vary. The Steady_State The existence of the diversity in allocation methods is at times justified on the grounds that once a firm reaches 1i stable level with respect to its loans, that is, as old loans mature they are replaced by similar new loans, all of the techniques will produce the same amount of monthly rev- enue. Chart 1 portrays the pattern of monthly revenues determined by the different methods in the achievement of EmOha "steady state." The assumptions underlying the chart 73 74 CHART 1 MONTHLY REVENUE--REACHING STEADY STATE Dollars (0001s) 14.— 13- 5 Priority/ 12- He 10- Residuary——+I /' I /f+-Straight line 1 /' & Liquidation 1 / Effective rate 1 1 1 1 1 1 1 l L 1 L L 12 34 56789101112131415 Month 75 are that a company begins operations and makes 200 loans of twelve months maturity each month. The principal of each loan is 8500.00 and the finance rate is 2 per cent per month. The principal plus the precomputed finance charge thus totals $567.36 on each loan. By the thirteenth month, the six techniques are recognizing equal amounts of revenue-413,472. However, as Chart 1 also illustrates, the monthly revenues determined by the various procedures follow decidedly different pat- terns in reaching the steady state level. The effect of these incongruous patterns on cumulative revenues is shown in Chart 2. By the time the monthly revenues become equal, sub- Stantial differences exist among the total revenues calcu- lated by the various approaches. Revenue recognized under the priority approach exceeds that determined by the resid- ufiry technique by $157,648 at the end of twelve months. E‘ren ignoring the extreme cases, the differences are large. Af—‘ter one year the cumulative revenue under the sum-of-the- C1igits approach is 33 Per cent greater than the straight line and liquidation gross revenue. The absolute differ- enoes among the approaches continue so long as the steady State conditions prevail. In times of high tax rates, the I‘elative deferral of revenue recognition achieved by some methods is thus not an insignificant effect. The total revenues calculated by all approaches 76 CHART 2 CUMULATIVE REVENUE-~REACHING STEADY STATE Dollars (000’s) 180 »— 1'70 - 16R) - 1 5O - 1‘40 - 1 30 r- Priority-———+I‘ 1 20 *' 110L- .' 1 00 — -' Sumwof-the- ' digits———+ x 80 —' /é—Straight line /' & Liquidation '/' / ,./ ././ Residuary———;// ' vJ$resents revenue to be recognized in future periods from 1&321n contracts already on the books. As such, it is a sig- nificant figure used in the financial analysis of a consumer IHillance company. The percentage relationship of the un- eéllened finance charges balance to total instalment receiv- atDJLes is one of the consumer finance company ratios calcu- lEited by the First National Bank of Chicago. The gaps which develop between the balances in Chart 3 rfiifflect, of course, the cumulative effects of the differences ‘bertween the monthly revenues recognized in Chart 1. Un- 3L54ke those differences, however, which eventually disappeared, the gaps between the unearned finance charges accounts con- 1Sinue to widen until they finally stabilize at a maximum. 'The maximum balances are reached in the twelfth month, the Same month in which the balance of total instalments receiv- able also stabilizes. The number of months required to achieve the stabilization point increases as the contract 78 CHART 3 UNEARNED FINANCE CHARGES--REACHING STEADY STATE Dollars (000 1 s) 160 1— 150 - / 140 r— / 1 $13 (0 m H‘ p. :3 111 H <<; \ 130 120 — / 110 - / 100 '- 0 ’. . 80— / ./' 7O 7 / ,/‘ Effective ratey ,/ ./’ ....~——'--°'-'°- / ,/'./,u ' Sum-of-the-digits 50 '_ //. J/' 40 __ 10— 1 2 3 4 5 6 7 8 9 10 11 12 13 79 maturities lengthen. As long as the steady state continues, the relationships which exist at this point carry forward ilItO future balance sheets. The balance in the unearned fi- ;namice charges account resulting from the sum-of-the-digits approach stands at 8.5 per cent of the total instalments Iwec3eivable; under the straight line and liquidation approaches tIIEB relationship is 11.9 per cent--a 40 per cent increase oxrexr the sum-of-the-digits relationship. At the extremes, tIlEB percentages vary from 21.4 per cent under the residuary method to 0 per cent under the priority method. No bal- aIlcze appears in the unearned finance charges account under tklea priority method since it immediately recognizes all the Pre computed finance charges as revenue. The preceding examples indicate that the several aJLILocation methods do lead to differing financial results ulldier steady state conditions. Yet the validity of the S‘teeady state assumption is questionable. The discussion 3111 Chapter II concerning the growth and loan characteristics (Di? the consumer finance industry suggests the steady state 153 not a typical situation. For this reason, the remainder 01? the chapter will consider the influences of the alloca- 1rion.methods on the financial results given selected changes Ifrom the steady state equilibrium. The variables to be Changed are those that affect the total monthly precomputed finance charges. These are the size of the loan principal, the finance rate, the number of loans, and the maturity of 80 the loans. Variations of the monthly revenue from the steady state level will be examined, as well as the dif- ftxrences in total revenue, net income, and unearned finance To make the remaining charts easier to examine, As is charges.1 the effective rate determinations will be omitted. exrjhdent from the charts presented to date, its results fol- lravr closely those of the sum-of-the-digits method. Monthly Revenue Inc reased Loan Principal Chart 4 presents the variations in monthly revenue given an increase in the principal of each loan. An in- crease to $700 from the previous 8500 is assumed. The ntualber of loans made remains at 200 each month, the loan mEl13urities remain at twelve months and the finance rate Stays at 2 per cent per month. The priority method is the quickest to reflect the Glazinge from the steady state equilibrium as it immediately recognizes the entire increase in the total precomputed 3f34nance charges. On the other hand, the residuary approach 1E3 slowest to vary from the former level of monthly reve- Inae. The sum~of-the-digits monthly increments are greater 'than.the increases displayed by the straight line and 1The succeeding examples hypothesize changes after the steady state level just discussed has been reached. eferences to time periods in these examples have as their R base the month in which the first change occurs. 81 liquidation approaches. The rate of increased revenue rec- ognition of the sum-of-the-digits method exceeds that of the straight line and liquidation techniques during the first few months. In the later months it is lower. As a result, the excess differential determined by the sum-of-the-digits method grows to a maximum in the seventh month and dimin- ishes thereafter. Since the entire assumed change in the principal size occurred in the first month, all approaches achieve a new equilibrium level by the thirteenth month and the variations from the previous level are the same under any-method. Increased Finance Rate An increase in the finance rate to 3 per cent per nuanth is the change underlying the variations shown in Cflaart 5. The loan principal is held constant at 8500, the nuaturity of each loan is twelve months, and the number of lxaans is once again 200 each month. The relationships among the revenue changes pro- dliced by the priority, residuary, straight line, and sum- CHf-the-digits methods are similar to those of Chart 4. In Tunis example, however, the results of the liquidation ap- Irroach differ from the straight line variations. Due to 1318 growth of the unearned finance charges balance, the liq- u1d.a.tion.method initially produces greater increases in rec- oSnized revenue than does the straight line technique. The difference reaches a maximum in the fifth month and then 82 CHART 4 REVENUE VARIATIONS FROM STEADY STATE LEVEL-- INCREASED LOAN PRINCIPAL Dollars (000's) 6 5 4- — -d---.---------—--——-' : Priority’/2 ' Sum-of-the-digits4\\’ a /" _, ,/' / . . x’ / _' ,/"‘~Straight line / f & Liquidation / 7 Residuary——_____,// ' 1 1 1 1 1 1 V 1 1 J_ 1 2 3 4 5 6 7 8 9 10 11 12 13 14 Month CHARTS REVENUE VARIATIONS FROM STEADY STATE LEVEL-- INCREASED FINANCE RATE Dollars (0001s) 7 6 Sttd y State eVel -----------—-----—---c----------- — : Priority /r /’ _ 1' ‘ /’//" . Sum-of-the-digits /,.2~' I 1 ‘-/’/ I '— ' / / . /' /x I I / ’/' I 1.... /.’ ’/ ,." ,:>\\Liquidation I _ ,/ ,z’ ’/./F——-Straight line / ’ Residuary-——+I I J 1 1 1 1 1 1” 1 1 1 h 83 diminishes. The monthly change generated by the liquida- tion procedure becomes quite small as the level of monthly collections and gross receivables outstanding near their new equilibriums. Consequently, in the eleventh month the increased revenue calculated by the straight line method exceeds that determined by the liquidation approach. wor— thy of note is the fact that by the thirteenth month all methods, except liquidation, are at a new equilibrium and are recognizing the same monthly increase in revenue. The ratio of monthly collections to gross receivables outstand- ing is constant by this time. The only variable then left to produce a change in the revenue calculated by the liqui dation procedure is the change in the unearned finance Ckuarges account. However, the nearer the monthly revenue Variations come to the new equilibrium, the smaller is the Cfldange in the unearned finance charges. Thus, given the adssumed change in the finance rate, the attainment of the new equilibrium level is a slow process under the liquida- tion method. Ixicreased Loan Volume Chart 6 illustrates the reactions created when an illcrease in the number of loans made each month occurs. II: is assumed that the loan volume increases by fifty in eaCh of the first four months; that is, 250 loans are made 111 the first month under the changed conditions, 300 the SeCond month, 350 the third month, and 400 the fourth and 84 CHART 6 REVENUE VARIATIONS FROM STEADY STATE LEVEL-- INCREASED LOAN VOLUME Dollars (000's) 14 13 i2 11 10 I\) State Level. ,‘“'“”“‘“""“”‘""""‘-"---'-'°,;:r- r } riority”/a / II I] _ , /. / I Sum-ofetheudigitsa /. / /' I /' / ,/ l ./ / / / I ’ I / 1 /' l I+Straight line / & Liquidation , / I I Residuary——1/ I I I I 1 / / 1 1 1 y 1 1 1 1 1 8 9 1C) 11 12 13 14 15 1’ Month 85 subsequent months. Held constant are the loan maturities at twelve months, the loan principal at 8500, and the fi- nance rate at 2 per cent per month. As in the previous two examples the increased rev- enue calculated by the sum-of-the-digits approach exceeds that of the straight line and liquidation methods for all months until a new equilibrium is reached. Also, the var- iations from the former steady state recognized under the priority procedure are much greater than those of all the other approaches, while the opposite is once again true of the residuary technique. Note that in this situation a new stable level is not achieved until the sixteenth month since the assumed changes are spread over a four month period. IIncreased Loan Maturity Chart 7 shows the variations from the steady state 'base when an increase in the loan maturities is postulated. Jill loans made in the first two months of change are as- sumed to have eighteen.month maturities and all loans in succeeding months are assumed to have twenty-four month Inaturities. The finance rate remains constant at 2 per cent per month. The principal of each loan stays at 8500 and the monthly volume of loans is 200. The revenue changes determined by the sum-of-the- <11gits approach are all positive and grow successively Ilarger each month. The straight line calculations, though, f3 no 87 drop slightly below the steady state level for the first thirteen months as the revenue that results from an equal spreading of the finance charges on the eighteen and twenty- four month loans is not enough to offset the revenue dimi- nution as the twelve month loans liquidate. Thereafter the monthly revenue rises above its former level and in- creases steadily to a new equilibrium, pausing in its growth only as the eighteen month loans mature. The liquidation method shows a more variable pattern, indicating the extent to which collection trends influence its revenue calcula- tions. Initially, the liquidation method produces a monthly revenue increase larger than either the sum-of—the-digits or the straight line determinations. This is a reflection of the growth in the unearned finance charges account. Even- tually the continued downward trend in monthly collections offsets the growth in the unearned finance charges balance and the monthly revenue variations begin to decline. When collections reach their minimum level in the thirteenth month, the liquidation technique's monthly revenue falls below both its former equilibrium level and the straight line monthly calculation. From this point, the revenue rec- <3gnized continues to increase monthly until collections drop off after the eighteen month loans mature. .As the collec- tions move upward once again, so does the revenue determined by the liquidation approach. The monthly variations calcu- lated by the residuary method follow an extremely erratic 88 pattern. Not until the twenty-fifth month does its recog- nized revenue rise above the former steady state level. The priority method produces revenues in accord with its actions in previous examples, recognizing large increases well before the other techniques. By the twenty—seventh month, the liquidation approach is the only one not at a new equilibrium. The reasons for this are the same as those mentioned in the discussion of Chart 5. Decreased Loan Principal A decrease in the loan principal to $300 is the change underlying the revenue variations from the steady state level shown in Chart 8. The other variables remain constant--the finance rate at 2 per cent per month, the loan maturities at twelve months, and the loan volume at 200 per month. In the month the change occurs, the revenue recog- nized under the priority method drops below the steady state level by the full amount of the decrease in the monthly precomputed finance charges. The residuary tech- nique produces no change from the steady state determina- tions until the twelfth month. The variations of the sum- of-the-digits method from the previous level are greater each month than those of the straight line and liquidation approaches. The maximum differential between these two latter approaches and the sum-of-the-digits method occurs 89 in the seventh month. The differential decreases thereafter. All approaches reach a new stable level by the thirteenth month and at this point all produce the same variation from the former equilibrium amount. Decreased Finance Rate Chart 9 presents the monthly revenue variations given a decrease in the assumed finance rate to 1 per cent per month. The principal of each loan stays at $500 and the other two variables, volume and maturity, also remain constant at 200 per month and twelve months respectively. The deviations produced by the priority, residuary, sum-of-the-digits, and straight line techniques are similar to those of Chart 8. A different pattern is followed by the liquidation revenue calculations. For ten months, it generates greater decreases in recognized revenue than the straight line approach, with the greatest difference occur- ring in the fifth month. The relative positions of the two approaches reverse in the eleventh month. The liqui- dation approach is also the only technique not achieving a new condition of stability by the thirteenth month. Decreased Loan Volume Underlying Chart 10 is an assumption that the loan volume decreases by twenty-five contracts in each of the first four months. In the fourth and succeeding months the volume levels off at 100 per month. The finance rate continues -6 9O CHART 8 REVENUE VARIATIONS FROM STEADY STATE LEVEL-- DECREASED LOAN PRINCIPAL Month 1 2 3 4 5 6 7 8 9 1O 11 12 13 14 . I I I I I 1 F7 1 1 h 1 l l ‘ \ ‘. Residuary-———)\ '1 \ \ \ \ \ _‘ ~\\a———Straight line \ 4 ‘\\‘ & Liquidation \ 1 \\ "’1 \‘ \ 1 \‘ \ — 1‘ Sum-of-the-digits-——+ \ _ )+—-Priority -\‘A L Dollars (000's) 7L CHART 9 REVENUE VARIATIONS FROM STEADY STATE LEVEL-- DECREASED FINANCE RATE Month 8 9 10 11 12 13 14 1 1 1 l 1 1 1 1 I \ 1 1 1 ‘ Residuary-——+\ \. \ \ ~\$,,»Straight line \ \‘ \. \ a ‘ Liquidation \ \-. X 1 \ Sum-of-the-digits————} I \t-Priority Dollars (000’s) 91 to be 2 per cent per month. Each loan is for $500 and ma- tures in twelve months. The residuary method is the slowest to deviate from “the steady state level. At the opposite extreme, the ear- liest decreases occur through the application of the pri- ority technique to the assumed situation. Also, the reve- nue declines determined by the sum-of-the-digits approach continue to exceed those of the straight line and liquida- tion methods. Since the assumed changes in the loan volume occur over a four month span, a new stable level is not reached by all techniques until the sixteenth month. It is significant that in the last three examples the monthly revenue variations calculated by the sum-of- the-digits method exceed those determined by the straight line approach. The larger the downward deviation is from the steady state level, the smaller is the total revenue recognized for the month. Thus, the monthly revenues rec- ognized under the straight line method in these three sit- ‘uations are greater than the sum-of-the-digits monthly rev- enues. For the periods covered by the charts, then, the Stqaight line philosophy can hardly be advanced as the more cNDnservative of the two approaches. The straight line Inethod did produce the more conservative results in the ifour'cases where the total precomputed finance charges in- <3reased. It is now seen that the opposite circumstances c>ccur in those cases where the variables causing a decline izltme total precomputed finance charges are introduced. 92 CHART 10 REVENUE VARIATIONS FROM STEADY STATE LEVEL-- DECREASED LOAN VOLUME St'dy 12345678910111213141516 itat§\.4\111111111\11111 eve ‘\ Residuary-———;\ ..11—\ ‘\ \ \\ ~ \ -2 - ‘. \.‘——Straight line \ \\ \. & Liquidation ”BI- \\ \‘\ \ \\ -4— \ -5 _ \ \ -6a \ \ \ -7 _ Dollars (000's) Decreased Loan Maturity The deviations from the steady state base when a decrease in loan maturities is assumed are presented in Chart 11. All loans made beginning with the first month 0f the changed conditions are assumed to be of six months ms Op UmhhmMmcmsp mmawno mocwCfiH UmpSQEoo imam HmCHmflpo onp mo mmmpcoohom m.£pcoe wasp ww pommhmFCw mafia mnp cam quHoo asp ohmgz .m .Eovpon mnp pm mafia prcouwhos mnp CH hprSme op :9» mm: coca map mnpcos mo Hones: map mpmooq .m. .pMmH egg co :Esaoo Hmoflpnm> map :0 mnpcos :0 cmoa 0:9 mo Shop Hmcwmfiho map 090009 .H "mgmda mHma mmb 09.30m cam mam smog mspcoz mo Hmcssz ma 3H ma ma AH 0H m m N o m a m m H mm. ~0.H om.m mm.m NH.: 00.m m0.m s0.0 00.0 mm.0 NH.0 00.0H m0.0H N0.HH 0m.ma ma mm. 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APPENDIX B J 101 SUM~OF-THE~DIGITS METHOD MONTHLY SPREAD SYSTEM Amount Cumulative Unearned Divisor Final Constant to be put Amounts Finance (Sum—of- Month's In- into the (Previous Total Month Charges Digits) Portion creases Spread MOnths) (EON) 1 8 7.50 1 7.500 116.760 $1,090.38 $1,100.00 $ 2,190.38 2 5.50 3 1.833 109.260 973.59 1,000.00 1,973.59 3 27.38 6 4.563 107.427 864.33 900.00 1,764.33 4 16.13 10 1.613 102.864 756.90 800.00 1,556.90 5 82.71 15 5.514 101.251 654.03 700.00 1,354.03 6 557.23 21 26.535 95.737 552.78 600.00 1,152.78 7 38.32 28 1.369 69.202 457.05 500.00 957.05 8 140.87 36 3.913 67.833 387.84 400.00 787.84 9 110.19 45 2.449 63.920 320.01 400.00 720.01 10 139.49 55 2.536 61.471 256.09 300.00 556.09 11 27.00 66 .409 58.935 194.62 200.00 394.62 12 3,222.05 78 41.308 58.526 135.69 200.00 335.69 13 98.46 91 1.082 17.218 77.16 100.00 177.16 14 91.10 105 .868 16.136 59.94 100.00 159.94 15 288.95 120 2.408 15.268 43.81 100.00 143.81 16 708.69 136 5.210 12.860 28.54 100.00 128.54 17 . . 153 . . 7.650 15.68 100.00 115.68 18 1,243.61 171 7.273 7.650 8.03 50.00 58.03 19 71.67 190 .377 .377 .38 50.00 50.38 $6,876.85 $6,876.85 $7,700.00 $14,576.85 (A) (B) (c) (D) (E) (F) (G) charges for one month. The foregoing is a spread of the unearned finance The unearned finance charges on all loans made during the month are grouped according to the num- ber of months the various loans are to run, and these amounts are entered in Column A. The amounts in Column C represent the items in Column A divided by the related sum-of-the-digits V" . :"'L I 4 162 in Column B. The amounts in Column D are determined by ac- oumulating the items in Column C from the bottom up, being sure to repeat in Column D the accumulated amount on any line where there is no figure in Column C (see line 17). The amounts in Column E are determined by accumulating the figures in Column D from the bottom up; and this is the spread of unearned finance charges on loans made during the month. Column F represents the cumulative spread of un- earned finance charges for previous months. Column G is the sum of Columns E and F, and represents the spread of charges on all loans held at the end of the month. 165 APPENDIX B (cont.) SUM-OFoTHE-DIGITS METHOD MATURITY CONTROL SYSTEM —- ”—— Unearned Unearned Finance Unearned Finance Charges Finance Charges (Current Earnings Charges Month Brt. Fwd. Month) Total Factor Revenue (EON) 1 8 12.00 $ 8.00 $ 20.00 1.0000 $ 20.00 . . 2 18.50 5.50 24.00 .6667 16.00 8.00 3 316.50 33.50 350.00 .5000 175.00 175.00 4 131.00 69.00 200.00 .4000 80.00 120.00 5 288.00 112.00 400 00 .3333 133.33 266.67 6 362.00 638.00 1,000.00 .2857 285.70 714.30 7 36.00 54.00 90.00 .2500 22.50 67.50 8 121.00 79.00 200.00 .2222 44.44 155.56 9 215.00 85.00 300.00 .2000 60.00 240.00 10 814.00 176.00 990.00 .1818 179.98 810.02 11 82.00 ' 18.00 100.00 .1667 16.67 83.33 12 437.00 2,300.00 2,737.00 .1539 421.22 2,315.78 13 114.00 86.00 200.00 .1429 28.58 171.42 14 85.00 95.00 180.00 .1333 23.99 156.01 15 68.00 432.00 500.00 .1250 62.50 437.50 16 204.00 706.00 910.00 .1177 107.11 802.89 17 79.00 511.00 590.00 .1111 65.55 524.45 18 84.00 1,246.00 1,330.00 .1053 140.05 1,189.95 19 53.00 147.00 200.00 .1000 20.00 180.00 20 12.00 88.00 100.00 .0952 9.52 90.48 $3,532.00 $6,889.00 $10,421.00 $1,912.14 $8,508.86 (A) (B) (C) (D) (E) (F) The foregoing is an example of the determination of one month's revenue under the sum-of-the-digits method using a maturity control system. The unearned finance charges on all loans made during the month are grouped according to the number of months the various loans are to run. are entered in Column B. These amounts Column A represents the unearned to: 25.5“:me A“ .x 3:9, awf~ua .. y - 59 f lit-7f. ' . '_ .....- .‘u -.0._.._~" 164 finzznce charges maturity control balances from the prior ‘montheend. Column 0 is the sum of Columns A and B. Each amount in Column C is multiplied by the respective earnings factor in Column D. These factors are the decimal equi- valents of the fraction 2/(n+1), where n equals the num- * The sum of Column E represents ber of months to maturity.’ the monthly revenue recognized. The amounts in Column F are determined by subtracting Column E from Column 0. The announts in Column F, moved up one month, will become Column A ira the next month. *These are the decimal equivalents of the first month’s fraction resulting from the sum~of~the~digits technique discussed in Chapter III; i.e., 12/78 : .1539, 11/66 : .1667, 10/55 = .1818, etc. Applying these fracw tions to the declining balance of a precomputed finance charge produces the same monthly results as applying the successively declining someofuthesdigits fractions to the original precomputed finance charge. gun”..- um»..- .LL "-"-“"-"F' . . ; . . I .Q 3. v .w in”: Il‘vv ._~ ‘ . V .. 1‘ _-_A 165 APP.NDIX C STRAIGHT LINE METHOD MATURITY CONTROL SYSTEM Unearned Unearned Unearned Finance Finance Finance Charges Charges Earnings Charges Month Brt. FWd. Cur. Mo. Total Factor Revenue (ECM) 1 $ 18.00 8 8.00 a 26.00 1.0000 3 26.00 s . . 2 24.50 5.50 30.00 .5000 15.00 15 00 3 336.50 33.50 370.00 .3333 123.32 246.68 4 171.00 69.00 240.00 .2500 60.00 180.00 5 300.00 112.00 412.00 .2000 82.40 329.60 6 412.00 638.00 1,050.00 .1667 175.04 874.96 7 46.00 54.00 100 00 .1429 14.29 85.71 8 141.00 79 00 220.00 .1250 27.50 192.50 9 235.00 85.00 320.00 .1111 35.55 284.45 10 824.00 176.00 1,000.00 .1000 100.00 900.00 11 92.00 18.00 110.00 .0909 10.00 100.00 12 450.00 2,300.00 2,750.00 .0833 229.08 2,520.92 13 129.00 86.00 215.00 .0769 16.53 198.47 14 105.00 95.00 200.00 .0714 14.28 185.72 15 78.00 432.00 510.00 .0667 34.02 475.98 16 209.00 706 00 915.00 .0625 57.19 857.81 17 89.00 511.00 600.00 .0588 35.28 564.72 18 104.00 1,246.00 1,350.00 .0556 75.06 1,274.94 19 83.00 147.00 230.00 .0526 12.10 217.90 20 22.00 88.00 110.00 .0500 5.50 104.50 $3,869.00 $6,889.00 $10,758.00 $1,148.14 $9,609.86 (A) (B) (c) (D) (E) (F) The foregoing is an example of the determination of one month9s revenue under the straight line method using a maturity control system. The system is the same as the maturity control system for the sum~of-the-digits method except that the earnings factors are different. finance charges on all loans made during the month are grouped The unearned 0. CA CA according to the number of months the various loans are to tun. These amounts are entered in Column B. Column A re- presents the maturity control balances from the prior month- end. Column 0 is the sum of Columns A and B. Each amount in Column 0 is multiplied by the respective earnings factor in Column I). These factors are the decimal equivalents of the fraction 1/n, where n equals the number of months to maturity. The sum of Column E is the revenue recognized for the month. Column F is the result of subtracting Column E i from Column 0. The amounts in Column F, moved up one month, rmr.1 "<;___’ L — become the amounts in Column A the succeeding month. 3 Q7 r.iql“!a§l\ c. x a. .10 pi)?” 000 A00 AHV A00 A00 A00 000 Amv 000 A00 A00 00.000.00 00.000.00 00.000.00 00.000.00 00.004.00 00.000.00 00.0H NH.H mmfi.fi 00H.H 00H 00.m0fi 00.00 000.00 ma 00.mmm 00.000 ma 00.00 00.0 000.H 000. 000 00.00 00.00 000.0 00 00.00 00.00 :0 00.00 00.: 000.H 000. H0 00.00 00.00 Hmm.: 0H 00.mm 00.00 0H m0.aflm 00.Hm 000.0H m00.ma 00 00.00m0H Hm.00H 000.00H 00 00.00000 00.00000 0H 0m.000 0H.00 000.00 000. 00 00.00 H:.00H m0H.0 0H mH.m0 40.00 HH Hfl.00m 00.0m 000.00 000. mm 00.20 H4.000 000.0 H 00.00 00.:0H 0H 00.000 Hm.00 000.00 000.0 m: 00.0: 30.000 000.0 0 00.m0 00.00H 0 00.0H0 00.00 0m0.00 m00.H 00 00.0: 00.000 000.00 0 00.00 00.0mH 0 00.030 00.0HH 0H0.Hm 000. 00 00.00 m:.0mm 400.0 0 00.0: 00.00 0 00.00: 0:.Hmfi 0H0.00 000.0H Hm 00.000 00.000 000.00 0 00.000 00.00m 0 00.002 mm.m0fi 000.00 000.0 ma 00.00 00.000 000.0H m 0m.om 00.00 0 00.000 00.000 000.00 000. 00 00.0 00.000 000.0 0 00.00 00.00 0 00.00m 00.000 000.00 000.0 0 00.0H 00.000 000.0H 0 00.00 00.0: 0 00.000 mH.00m 000.00 000.0 0 0H.0 0m.HHO 000.0 m 00.0 00.0 0 00.000 0 00.000 0 000.400 000.0 0 H 00.0 m 00.Hm0 w 000.00 0 H 00.0H w 00.0H 0 H 000900 pczosd mommonnH cowphom pom 00m.000 pcsoE¢ c00ppom how Amm.m0v nowhmzo Sumo: moom>mm msoo>mm pompmcoo m_npsoz sw>wm 0000000 msbo>mm 0.20202 swbwa 0000000 mocmcwm 0.:pcoz 00200 mocmcam 0000 00:0:00 nocpmocb UmnhmoCD wmcpwmcb modommm¢ ammomomm mama: MMDDmoomm BZMEZOHHmommd mbzm>mm Q NHmzmmmd 168 Explanation of Appendix D The illustration on the preceding page is a spread of the unearned finance charges for one month, based on the assumptions of Table 21 in Chapter VI. These assumptions are that 20 per cent of the precomputed charge is recog- nized at the time the loan is made. 50 per cent is allow cated on a straight line basis. and 30 per cent is Spread by a sum-ofwthe~digits method. The unearned finance charges on all loans made during the month are grouped according to the number of months the various loans are to run. and these amounts are entered in Column A. Since 20 per cent of the charge is recognized at acquisition. the amounts in Column A represent 80 per cent of the total precomputed charges. The amounts in Column A are apportioned in the ratio of 5:3 to Columns (B) and (F) respectively. Equal monthly portions of ColumnIBare shown in Column D. the result of dividing Column B by Column C. The amounts in Column E are deterc mined by accumulating the items in Column D from the bottom up and represent the revenue allocated on a straight line basis. The amounts in Column H represent the amounts in Column F divided by the related summofnthe-digits in Column G. The amounts in.Column I are determined by accumulating the items in Column H from the bottom up. The amounts in Column J are determined by accumulating the items in Column I from the bottom up, and represent the allocation of the ‘ 4‘3”.“ .hulfln'Aaa'h‘wh- ..0 4. 14?. ~.\ .;0 g I [m E ‘ ”I. ( T69 portion of the charges on a sumnofmthemdigits basis. The spread of the unearned charges for the month is then shown in Column K. This column represents the cross-addition of Column E (the straight line spread) and Column J (the sum- of-the-digits spread). .0 ‘0, fin. “-5“. . fl WK} .4. ‘01... BIBLIOGRAPHY Books AmermxnlAccounting Association. Accounting and Reporting Standards for Corporate Financial Statements and Preceding Statements and Supplements. Columbus, Ohio: American Accounting Association, 1957. Analyzing_the Cost Factors American Bankers Association. 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