Manufactured Homes: Accounting Policies

Manufactured Homes (MH) uses the installment sales method for recognizing revenue. Using this installment sales method assumes that the customer probably will not default and there is little risk for the company. As cash is supposed to come in, revenues are matched with expenses. However, if the customer defaults, then there are many future expenses that cannot be matched with corresponding revenue. The company usually sold its installment contracts to unrelated financial institutions and was responsible for payments to the financial institution if the customer defaulted. Thus, MH bore risk for the houses it sold. MH charged its customers a portion above the market rate, and the financial institution paid MH a portion of the differential between the stated interest rate and the market rate. Therefore, interest income was a fairly important part of MH’s business. MH set up a provision for losses on credit sales account based on historical performance.

The company said that since its customers needed these houses, they would work especially hard because these houses were their primary residences and supported this with repossession rates that were much lower than the industry average. However, this might have been a little short sighted. MH did realize that there was a declining economy looming in the future, but we are not sure if the company realized its full effect. This declining economy might drive interest rates down, allowing people to choose conventional homes instead of mobile homes. Furthermore, a bad economy would signal less money invested in mobile homes from people who wanted a second home used for vacations. This poorer economy could also signal problems for the installment sales method, as some people might lose their jobs and not be able to pay for their homes.

Repossession rates would increase, and Manufactured Homes might be stuck with many houses that it cannot sell because of the economy. These things were evident in Manufactured Homes’ provision of losses, which increased from $793, 497 in 1985 to $3,777,900 in 1986. We think that MH should have looked more closely at its method for selling homes. They might have overestimated their customers’ abilities to keep up with payments in a declining economy. Just because their houses in large part were poorer people’s only residence does not mean that these people can afford payments on the houses if they lose their jobs. This could be a potential problem for MH. This is also something to look at for the future success of the company.

Evaluation during 1986 and first nine months of 1987

At the end of 1986, MH saw an increase in total revenues from 1985 as well as a substantial increase in total costs and expenses. This gave rise to a decrease in overall net earnings for 1986. In terms of growth, total revenues increased at a rate of 51% from 1985 to 1986 while total costs and expenses increased at a rate of 60%. Taking this into account, their net earnings decreased at a substantial rate from approximately $3.2 million in 1985 to $2 million in 1986. In terms of growth for the first nine months of 1987, total revenue again increased while total cost and expenses increased also. It should be noted however that the increases for total revenues and total cost and expenses were closer, at 72% and 73% respectively, giving rise to an overall increase in net earning.

MH’s revenue growth for the first nine months of 1987 can be attributed to the acquisition of 15 retail sales centers (9 from Jeff Brown Homes, Inc. and 6 from Piggy Bank Homes of Alabama, Inc.) and the opening of 24 additional retail centers, which took place in the fourth quarter of 1986 and the first three quarters of 1987. Furthermore, there was a reported growth of 20% in the average number of mobile homes sold per retail sales center.

In the first nine months of 1987 it appeared that MH was back on track, having recovered from the disastrous fourth quarter losses of 1986 that lead the return on sales to decline from 1985 to 1986, from 4.0% to 1.7% respectively. The first three quarters of operation in 1986 and 1987 produced a return on sales to be consistent at 3.9%. Although this profitability ratio was an improvement, it seems as though MH was in danger of repeating losses as produced in the fourth quarter of 1986. The industry that MH was part of was experiencing negative pricing pressures and higher rates of payment defaults. With this in mind, revenues should have been decreasing, as opposed to the increases that it experienced. This demonstrates that MH might be using aggressive accounting tactics in order to increase revenues.

These tactics focus on the fact that MH’s core business is failing while they are able to generate revenue and profit from the financed participation income portion of their business. In the first nine months of 1987 MH’s finance subsidiary sold, with recourse, a portfolio of retail installment sales contracts with a principle balance of approximately $8.3 million to another financial institution. As a result the company recognized finance participation income of $1.7 million in the third quarter of 1987 instead of being forced to recognize it over the entire course of the mortgages.

Additionally, the increase seen throughout 1986 as well as during the first nine months of 1987 stemmed from an increase in debt from their balance sheet. This increase in debt substantially increased MH’s debt-to-equity ratio from 3.6 in 1985 to 4.7 in 1986. Although it dropped to 4.5 in the first nine months of 1987, the fourth quarter remains to be uncertain. MH was increasing cash flow from financing participation income as well as increasing debt. The increase of financing and debt to such an extent that it covers a company’s inability to generate income from operations have typically come back to hurt these companies in the future.

Current Condition

As of September 30th, 1987, MH continues to run a profitable business with strong revenue growth and a business model that has not failed the company to this point. The building of revenues through acquisitions (two in 1987) and the opening additional retail centers in new markets (39 new retail centers opened or acquired in the first 9 months of 1987) has fostered outstanding revenue growth. MH has experienced revenue growth of 120% in 1985. 51% in 1986 and has already experienced 23% growth in 1987 vs 1986 despite only being ¾ of the way through the year. Coupled with MH’s ability to management the costs (costs as a percentage of sales remain fairly steady year over year) by buying in bulk, the net profits and EPS of the firm are at an all-time high.

There is a cause for concern brought to life in the management discussion of the YTD results in 1987. The issue lies in the cost of goods sold and the negative trend that has developed in the most recent three months period. Management noted that the cost of sales has increased as a percentage of sales during this period due to “competitive market conditions”. This was not expanded on in the management discussion. The reason for concern is due to the already existing high costs as a % of sales (consistently around 90% during the past 4 years).

If this competitive market pressure continues MH will be greatly impacted in the bottom line, which is currently only achieved approximately 4% of sales. One of the competitive advantages that MH has is its ability to buy in bulk, negotiate lower prices with manufacturers and pass along the savings to the customers. This advantage pushes out the “mom and pops” and gives MH the market share it has enjoyed to this point. Competitive pressures may not only impact the bottom line by increasing costs, but may also hurt the top line sales as market share is lost. MH may have no choice but to increase prices and open itself up to further competition.

The most significant current concern at MH is the accounting for credit sales and the associated losses on credit sales. Under the FASB rule 77, recognition of sales on the transfer of receivables must be recorded if the amount of bad debt, repossession and prepayment can be reasonably estimated. MH has not shown the ability to do that at this point. Despite the increase in the provision for losses on credit sales to $3 million in 1986, MH again had to increase this provision to $4.85 million (and was hit with a total of $3.2 million on the statement of earnings). This means MH increased the provision by $1.85 million but also incurred $1.35 million in addition. This impact on MH financial statements causes great concern that the condition may spiral out of control as revenues continue to grow to record levels.

Future Potential

The future at MH is open to criticism at every angle. While revenues have continued to growth during 1987, the growth has come from expansion. Expansion is good for a company assuming the market potential is solid. In the economy’s current condition the market is not very good for MH due to low interest rates that are leading to conventional home buying and increased prepayment of loans due to refinancing. MH has not shown the ability to manage repossession and prepayment issues. Increased costs will lead to lower earnings and the amount of credit losses could start to impact the financials in such a way that MH is no longer profitable.

Like many businesses and industries, a change in the economic conditions could turn the prospects of MH around very quickly. Despite their current issues, MH is building a manufacturing home empire that expands with each passing day. However, with the status of the market and a potential overly aggressive business plan, MH is a risk of becoming non-profitable in the very near future.