A first response to dereg in the 80’s for US financial institutions was investing in speculative commercial building. Developer projects were undertaken without buyers, on lender financing. The borrower was speculating that a buyer would arrive once they saw committed construction and gained an understanding of the project’s value. The lender’s decision was whether to fund the speculation.

A reporting practice of the period helped them over the hump and accelerated the S&L washout. Borrowers used construction loan proceeds to service the underlying debt during construction (rather than as bridge money until buyer draws) and financial institutions reported it as income. The more money you lent, the more interest income grew, earning at prime rates, which were double digit in the period.

There was no concern for asset risk, yet there is no assurance an asset will be sold in speculative building. Deferral of interest until sale was not practiced or enforced. This incentivized transaction volume and speculative properties moved out of loans and into REO (real estate owned) on balance sheets.

Contemporary lender reporting for option ARM loans also passed off unrealized income as earned. Borrowers could pay less than the minimum carrying cost of the loan for the period (annual interest), substantially less, and roll the shortfall into the principal balance (with ceiling of 115% of loan value). But the banker could take the full contractual value of the interest to income, no matter they didn’t receive it and there was no assurance it would be earned.

On the way up, there was plenty of kool-aid and nobody minded. The perceived inevitable annual equity build of the asset at 20% would secure the unearned interest. Further, the asset would likely be sold and repaid in three years or less, as the borrower cashed out their easy money. As secured asset values deflate and the option ARMs reset, previously recognized income is taken out in loss reserves and REO balances build.

There are twenty years and a library’s worth of new reporting rules between the times these reporting practices were popular. Yet, their footprint is the same and the core principle of revenue recognition that was framed as far back as the US ARB issuances of the 50’s would have been sufficient to curtail the practice in both periods.

Revenue isn’t recognized until earned, where earning culminates in the transfer of risk and reward in exchange for cash or an equivalent assurance of its collectibility. With that yardstick, revenue wasn’t earned in either case and there was no need for more than the elder principles of revenue recognition to discern it.