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In April 2011, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2011-03 Transfers and Servicing (Topic 860), Reconsideration of Effective Control for Repurchase Agreements (the "Update"). ASU 2011-03 amends FASB Accounting Standards Codification Topic 860, specifically the criteria required to determine whether a repurchase agreement (repo) and similar agreements should be accounted for as sales of financial assets or secured borrowings with commitments.
Repurchase Agreements and Accounting Basics
The accounting literature defines a repurchase agreement ("repo") as "an agreement under which the transfer or (repo party) transfers a security to a transferee (repo counterparty or reverse party) in exchange for cash and concurrently agrees to reacquire that security at a future date for an amount equal to the cash exchanged plus a stipulated interest factor..."1. Repos often have collateral maintenance provisions to mitigate credit exposure to the parties.
Repos are typically used as a financing source, generally on a short-term basis. Depending on the structure, repos may be accounted for as a sale or a secured borrowing. Under existing accounting guidance, four conditions must all be met for a repurchase agreement to qualify as a secured borrowing, wherein the transferred assets remain on the repo party's books. If the repo party has surrendered effective control of the transferred asset, the repo would be accounted for as a sale and the transferred asset would be removed from the repo party's balance sheet. In assessing the condition of effective control, determining the repo party's ability to repurchase or redeem the transferred asset is a key consideration. In this regard, the transferor should consider whether there is an exchange of collateral in sufficient amount to fund substantially all of the cost of purchasing identical replacement assets even if the counterparty defaults. Under existing guidance, collateralization between 98%-102% is considered an acceptable range for assessing the repo party's "ability" under such circumstances.
What Are the Main Changes Introduced by ASU 2011-3
The ASU removes from the assessment of effective control (1) the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee, and (2) the collateral maintenance guidance related to that criterion. By eliminating these conditions, the transferor's ability to repurchase or redeem the transferred asset, as well as the amount of available collateral, will be irrelevant in determining if such transactions should be accounted for as sales.
The three other criteria applicable to the assessment of effective control are not changed by the ASU. Existence of those criteria will continue to indicate that the repo party has maintained effective control of the transferred assets and must account for the transaction as a secured borrowing.
Effective Date and Implications to Entities Involved in Repurchase Agreements
The amendments in ASU 2011-3 affect all entities that enter into agreements to transfer financial assets that both entitle and obligate the transferor to repurchase or redeem the financial assets before their maturity. The guidance in the Update is effective for the first interim or annual period beginning on or after December 15, 2011 (2012 for calendar year-end companies; the "Effective Date") and should be applied prospectively to transactions or modifications of existing transactions for both publicly traded and private entities. Early adoption is not permitted.
Because the Update will essentially eliminate from the consideration of effective control, a repo party's ability to repurchase or redeem transferred assets, this amendment will increase the number of transactions accounted for as financings rather than sales and will reduce the derecognition of assets subject to repurchase agreements, as compared to current guidance. For new transactions and modifications of existing agreements executed after the Effective Date, entities that previously accounted for repos as sale transactions based solely on this condition, may now be required to report the underlying transferred assets on their balance sheet as well as the corresponding secured borrowing.
The provision eliminated by the ASU was relied upon by executives and advisors to remove up to $50 billion of inventory (i.e., investments) from Lehman Brothers Holdings Inc.'s ("LBHI") reported quarter-end balance sheets prior to its bankruptcy filing. Removal of inventory was accomplished by structuring certain repos that straddled quarter-end with 105% or more of collateralization, which was more collateral than LBHI's typical repo that was accounted for as a secured borrowing. As a result, the overcollateralization suggested that LBHI did not have effective control of its transferred assets as it did not have the ability to redeem them in the event of default of the transferee. By applying this criterion, LBHI characterized transactions that otherwise were no different than its regular repos as sales rather than secured borrowings. The sales treatment allowed LBHI to use the cash received from these repos to repay other liabilities, which resulted in the appearance that LBHI was less levered than it actually was at the time. Duff & Phelps was the lead financial advisor to Anton Valukas, Chairman of Jenner & Block, in connection with his role as Examiner in the Lehman bankruptcy, the largest such case in U.S. history. Anton Valukas concluded that Lehman failed to disclose that it was using these transactions "to reverse engineer the firm's net leverage ratio for public consumption."
International Financial Reporting Standards (IFRS) Convergence
International Accounting Standards ("IAS") 39 does not require the consideration of a transferor's ability to repurchase or redeem financial assets transferred on substantially agreed terms, even in the event of default by the transferee, in determining the maintenance of effective control over the transferred assets. The amendments in the Update improve convergence by eliminating from U.S. GAAP the need to consider this criterion.
The entire ASU 2011-3 can be found at the following link: ASU 2011-03.
1.ASC 860-10-20 and Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities ("SFAS 140"), paragraph 364. Effective July 1, 2009, all Statements of Financial Accounting Standards have been codified into the Accounting Standards Codification.
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