Repo Accounting: After Lehman, another Debacle was Just a Matter of Time

A critical component of these reforms was to eliminate the previous exemption for so-called “qualifying special purpose entities.” This structure was used for many securitizations. This so-called “scope exception” had grown beyond its original purpose, and the FASB determined to place all securitization structures and other structured entities under a single accounting model. As I mentioned before, investors — and the market as a whole — are best served by financial information that is presented fully and clearly. The objective of financial reporting is served by finding the right balance of information to be included in an issuer’s financial statements. As the agency empowered by the federal securities laws to be the investor’s advocate, the Commission has the authority and responsibility to prescribe the methods to be followed in the preparation of issuer accounts and the form and content of financial statements to be filed under those laws. The federal securities laws also mandate an independent audit by qualified professionals to provide further assurance as to the faithfulness and integrity of the reporting presented. The Valukas report also shows the need for better risk-management assessments by firm’s boards of directors, Herring says.

The term of a repo is relatively flexible (i.e., can be shorter or longer as needed) compared to other short-term financing arrangements, such as commercial paper or certificates of deposit. The legal definition is that a repurchase agreement is the sale, with transfer of title, of a security to a buyer. The seller simultaneously promises to buy the security back from the buyer with a markup. The economic definition sees this markup as the interest component of a loan secured by the instrument. The IASB and FASB, senior bodies responsible for setting accounting standards, met in April 2010 to review the accounting treatment for such repo transactions.

How Sunk Costs Affect Firms’ Investment Decisions

The securities are debited when returned, the option to purchase is removed, and the cash returned to the lender includes an interest payment. 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. Although the accounting standards did not specifically require a legal opinion that a repo agreement was a sale in legal terms, companies usually obtained one to satisfy auditors that the assets were isolated from the transferor and its creditors in the event of bankruptcy. No American law firm would provide Lehman with such a statement; instead, it had to employ Linklaters LLP in London, which stated that the transaction represented a true sale only under English law. Therefore, the transactions had to be executed by Lehman Brothers International in Europe, with European banks as transfer-ees. The consolidated financial statements of Lehman Brothers Holdings Inc. that included these transactions were, however, filed in the United States. In a typical repo transaction, an entity transfers financial assets to a counterparty in exchange for cash with an agreement for the counterparty to return the same or equivalent financial assets for a fixed price in the future.

Its trades allowed https://intuit-payroll.org/ to reduce its asset size by about $50 billion each quarter, thus making the bank look less leveraged and better capitalized. There were also criticisms of banks waiting too long to record impaired assets. The FASB has since then written more prescriptive accounting rules to address the problems.

FASB plans to update the repo to maturity rules, but will they go too far and impact liquidation risk?

The Fasb Changes Repo Accounting Rule Used By Lehman received for the securities is less than the fair value of the asset and represents the principal of the loan. The difference between the fair value of the asset transferred and the cash received is referred to as the “haircut” in repo transactions. The securities transferred are the collateral, and the amount paid to repurchase the securities represents payment of the principal plus interest at the agreed-upon rate. If the transferor defaults and does not repur-chase the securities, the transferee can sell them to satisfy the obligation. There have been some criticisms that the FASB has been slow to write meaningful accounting rules that respond to changing times. For example, the board only recently added to its technical agenda accounting for and disclosure of digital assets and accounting for environmental credit programs despite push to do so for some time by some market participants, including investors, audit firms, and companies.