The cost to taxpayers to bail out failed savings and loan (S&L) companies in the late 1980s has been estimated as high as $500 billion. Reasons for the crisis included mismanagement of resources, management fraud, and unfavorable economic conditions. Another factor contributing to the S&L problems was their revenue recognition techniques. When a loan was made, the associated loan origination fee, often as high as 6% of the loan principal, was recognized immediately as revenue. If a financial institution’s objective was to increase income for the short term, one strategy would be to loan as much money as possible and collect large loan fees. The president of one S&L, Western Savings in Texas, elected to follow this strategy. He enticed investors by promising high yields on certificates of deposit that were federally insured. His telephone operations often netted over $20 million in investments per day. Once the money was received from investors, the president would then loan the money to borrowers and collect loan fees as revenue. These fees and other income were the source of a $3 million dividend to the president over a 2-year period. The problem for taxpayers was that the president was making poor-quality loans. Since investors’ deposits were federally insured, the collectibility of loans was not a major issue for Western. Million-dollar loans were made with no required down payment. Loans were made for more than the full purchase price of properties. As an example, $64 million was loaned to purchase land that two years earlier had sold for $17.2 million. On this particular deal, Western, holding a sixth lien on the property, received $2 million in loan fees.
1. How can a savings and loan company justify recognizing immediately the loan origination fee as revenue rather than recognizing it over the life of the loan?
2. From an accounting point of view, what revenue recognition method should be used when dealing with high-risk loans?
3. Why would investors deposit their money in financial institutions that had lending practices like those illustrated in this case?
4. Do external auditors have a responsibility to evaluate the loan practices of the financial institutions that they audit?