In 2014, FASB issued amended accounting rules and disclosures for certain types of repurchase (repo) transactions. Under the new guidance, certain repo transactions previously accounted for as sales must now be accounted for as secured borrowings. The new rules also require increased disclosures. As a result, companies may be required to reduce or eliminate the use of repos as a means of achieving off–balance sheet financing. While more stringent accounting rules are designed to prevent repo runs like those that lead to the failure of Lehman Brothers, decreased use of the repo market could lead to increased short-term interest rate volatility. The repo markets afford readily available financing to institutions such as security dealers and hedge funds. They also allow institutional investors, such as pension funds and municipalities, to earn a rate of return on excess cash. Both their multitrillion-dollar size and their role in providing liquidity are indicative of repo markets’ importance.

How a Repo Works

A repo agreement typically involves the transfer of securities in exchange for cash. The amount of cash remitted depends on the market value of the securities minus a specified percentage to serve as a cushion. This cushion, referred to as a haircut, protects the transferee in the event that the securities must be liquidated for repayment. In addition, the transferor agrees to repurchase the securities for a higher price at a specified later date. The repurchase price is typically higher than the original price paid by the transferee, with the difference representing interest. Because the transferor is contractually obligated to repurchase the securities at an agreed price, it retains much of the risk of ownership.

Changes in Accounting for Repo Transactions

In June 2014, FASB issued Accounting Standards Update (ASU) 2014-11, Transfers and Servicing (Topic 860): Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures. The revised rules require entities to account for repo-to-maturity (RTM) transactions as secured borrowings. An RTM is a repo agreement in which the securities mature on the same date that the repurchase agreement terminates. Prior to the update, FASB made a distinction between an RTM and a repurchase agreement in which the securities had not yet reached maturity when returned to the original party. Under the previous rules for RTM agreements, the transferor was not assumed to have effective control of the transferred assets because it would not recover the assets before they had matured. Under these conditions, RTM agreements were recorded as outright sales (KPMG Defining Issues, “FASB Proposes New Accounting Guidance for Repos”, January 2013, no. 13-6). The obligation to repurchase the securities was not recorded, and thus the underlying risk was not apparent on the balance sheet. Under the new rules, FASB decided that although the securities are not returned to the original party due to the security’s maturity, receiving cash at settlement is essentially the same as receiving the securities. Thus, secured borrowing accounting treatment is now considered appropriate (Ernst & Young, “FASB Changes Accounting for Certain Repurchase Agreements and Requires New Disclosures,” Technical Line, no. 2014-12, June 19, 2014).

ASU 2014-11 also modifies the accounting guidance for repurchase financing transactions. Under these agreements, the first leg is a typical repo where securities are transferred for cash. Then, in the second leg, the transferee sends the asset back to the transferor as collateral in return for cash and agrees to buy the security back for a specified amount of cash at a certain date. Such agreements result in off–balance sheet financing. Under prior rules, the repo leg of the agreement was handled as a sale; now such agreements will likely result in secured borrowing accounting for most repurchase financings.

To explain the difference between sale accounting and secured borrowing, consider the example of Lehman Brothers, which made extensive use of repo programs before it ultimately declared bankruptcy in 2008. Its practices are described in further detail in “How Lehman Brothers and MF Global’s Misuse of Repurchase Agreements Reformed Accounting Standards” on page 44 of this issue. In short, Lehman’s purpose in using repo transactions was to reduce the overall size of its balance sheet and to decrease its leverage ratios, both paramount in maintaining a good credit rating. Secured borrowing accounting does not achieve that purpose and would result in unchanged leverage ratios. Consequently, Lehman engaged in sale accounting with an agreement to repurchase. Under this treatment, no recognition of a contractual obligation to repurchase is evident on the balance sheet. The securities are debited when returned, the option to purchase is removed, and the cash returned to the lender includes an interest payment. Exhibits 1 and 2 illustrate this approach. Overall, repos helped Lehman remove as much as $50 billion of debt from its balance sheet, with very little, if any, impact on the other financial statements.

EXHIBIT 1

Repo Journal Entries ($ millions)

Repo recorded as a secured borrowing
a.;Cash; 10,000
RepoEncumbered Securities; 10,500
InvestmentSecurities; 10,500
RepoRepurchase Obligation; 10,000
b.;Short-term Debt; 10,000
Cash;10,000
c.;Investment Securities; 10,500
RepoRepurchase Obligation; 10,000
InterestExpense; 5
RepoEncumbered Securities; 10,500
Cash;10,005
Reporecorded as a sale with agreement to repurchase
d.;Cash; 10,000
Optionto Repurchase; 500
InvestmentSecurities; 10,500
e.;Short-term Debt; 10,000
Cash;10,000
f.;Investment Securities; 10,500
Interest Expense; 5
Option to Repurchase; 500
Cash; 10,005

EXHIBIT 2

Balance Sheet Analysis ($ millions)

Before Repo; (Gross Leverage=30, Net Leverage=17)*
Cashand Equivalents; 20,000; Short-term Debt; 178,000
InvestmentSecurities; 310,000; Other Financings; 258,000
CollateralizedAgreements; 301,000; Repo Repurchase Obligation; –
Receivables;43,000; Other Payables; 109,000
RepoEncumbered Securities; –; Long-term Liabilities; 119,000
Fixed;4,000; Equity; 23,000
OtherAssets; 9,000
RepoRepurchase Option; –
687,000;687,000
SecuredBorrowing; (Gross Leverage=30, Net Leverage=17)*
Cashand Equivalents; 20,000; Short-term Debt; 168,000
InvestmentSecurities; 299,500; Other Financings; 258,000
CollateralizedAgreements; 301,000; Repo Repurchase Obligation; 10,000
Receivables;43,000; Other Payables; 109,000
RepoEncumbered Securities; 10,500; Long-term Liabilities; 119,000
Fixed;4,000; Equity; 23,000
OtherAssets; 9,000
RepoRepurchase Option; –
687,000;687,000
SaleAccounting; (Gross Leverage=29, Net Leverage=16)*
Cashand Equivalents; 20,000; Short-term Debt; 168,000
InvestmentSecurities; 299,500; Other Financings; 258,000
CollateralizedAgreements; 301,000; Repo Repurchase Obligation; –
Receivables;43,000; Other Payables; 109,000
RepoEncumbered Securities; –; Long-term Liabilities; 119,000
Fixed;4,000; Equity; 23,000
OtherAssets; 9,000
RepoRepurchase Option; 500
677,000;677,000
Source:Lehman

Lastly, ASU 2014-11 also expands note disclosure requirements for transfers of financial assets accounted for as sales, as well as certain transfers accounted for as secured borrowings (Abhinetri Velanand, Shahid Shah, and Adrian Mills, “FASB Makes Limited Amendments to its Repurchase Accounting Guidance,” Deloitte Heads Up, June 19, 2014). For any repurchase agreements or agreements characterized as sales, disclosures must be made regarding the carrying amounts, amounts received for the securities, ongoing obligations of the agreement, and an explanation of any related amounts reported on the balance sheet. In addition, for all repurchase agreements and agreements accounted for as secured borrowings, notes must include disclosures of collateral pledged, remaining obligations, and an assessment of risk.

Public Response

The new guidance received a surprising amount of support from financial institutions. Exhibit 3 summarizes the responses received by FASB from two exposure draft requests for comments. The first exposure draft, “Reconsideration of Effective Control for Repurchase Agreements” (November 2010), was intended to amend criteria for establishing effective control. It resulted in comment letters which contained proposals that were subsequently incorporated into the final standard (“FASB Proposes New Accounting Guidance for Repos,” KPMG Defining Issues, January 2013, no. 13-6). Of particular note is the overwhelming support for the proposal in 2010. All eight of the public accounting firm responses can be characterized as either favoring or qualifiedly favoring the proposal. Of the 19 total responses, 16 can be characterized as favoring or qualifiedly favoring of the proposal. The second exposure draft, “Effective Control for Transfers with Forward Agreements to Repurchase Assets and Accounting for Repurchase Financings” (January 2013), received more mixed support, however.

EXHIBIT 3

Frequency of Responses to FASB Request for Comment

December 2010 Responses; January 2013 Responses
OrganizationType; Favor; Qualified Favor; Oppose; Favor; Qualified Favor; Oppose
PublicAccounting Firm; 7; 1; 0; 1; 1; 1
FinancialInstitution; 6; 1; 3; 5; 6; 5
Government;1; 0; 0; 1; 0; 3
Total;14; 2; 3; 7; 7; 9
Source:http://www.fasb.org/jsp/FASB/Page/SectionPage&cid=1176157086783

Further Complications

While Lehman is an extreme example of aggressive use of repos for balance sheet management, it is unlikely the 2014 accounting rule changes would have prevented its collapse or the broader financial crisis in September 2008. First, the regulations already in place at the time of the collapse precluded sale accounting in the United States for the repos Lehman was transacting, which prompted the company to skirt the rules by transferring the securities to its U.K. broker-dealer. Second, Lehman’s failure was largely caused by a precipitous plunge in the market value of subprime mortgages, in which the firm was heavily invested. Had Lehman used secured borrowing accounting and provided the note disclosures required by the new rules, the increased usefulness of the balance sheet would likely have alerted market participants to the company’s excessive borrowing more quickly, but it may not have diverted the ensuing problems for Lehman or the market as a whole.

The new accounting rules will make it more difficult for companies to repeat Lehman’s aggressive accounting for repos. The increased transparency afforded by the new rules should provide investors and analysts with more insight into companies that utilize repo transactions. This will not eliminate the risk of repo transactions, but rather emphasizes the need for continued monitoring and oversight to prevent future abuses.

David F. Salerno, PhD, CPA is an assistant professor at the University of Scranton, Scranton, Penn.
John A. Ruddy, CPA, CFA is a faculty specialist at the University of Scranton, Scranton, Penn.
Murliddd Rajan, PhD, CFA is an associate dean at the University of Scranton, Scranton, Penn.