Cleaning Up Balance Sheets, One Repo at a Time

 A new accounting proposal could clear up CFOs’ uncertainty about where to book repurchase agreements.

By Kathleen Hoffelder

A new proposal by the Financial Accounting Standards Board (FASB) should eliminate the accounting allowances that made it easy for Lehman Brothers and MF Global to mislabel short-term loans, otherwise referred to as repurchase agreements, or “repos.”

FASB’s policing could thwart other firms from performing similar accounting shenanigans and should reduce the headaches CFOs face in reporting their company’s loans. That’s because, in contrast to current practice, FASB’s new proposal would clarify that repo securities — agreements to exchange financial assets for cash and to buy back the asset at a later date — should be treated mainly as “borrowings,” not “sales” on corporate balance sheets.

Current repo accounting rules have been criticized for being overly complex and subject to loose interpretations. CFOs and their staffs have been understandably stumped over what exactly constitutes a sale or a borrowing.

But Lehman and MF Global took ample advantage of that uncertainty. Both firms used repo transactions to make their balance sheets and financial reporting look less indebted than they actually were. Lehman used what became known as “Repo 105,” a technique named for the firm’s practice of selling a bond it owns at a lower price (typically $100) compared with what it was worth (say, $105).

The firm recorded the transaction as a true sale of a bond, since there was a much larger gap between the price of the bond and what it was actually worth compared with what is typical for a repo transaction, enabling the firm to reduce its amount of debt right at the reporting time. This maneuver helped the firm move billions of debt from its balance sheet before it eventually bought the assets back in a transaction that more closely resembled a repo transaction.

For its part, MF Global used repo-to-maturity transactions (in which the termination date of the repo transaction itself is the same as the maturity of the underlying security). That enabled it to count the agreements as sales and thus keep them off the balance sheet. This technique helped the firm to finance billions of dollars worth of European sovereign debt, which helped to mask the extent of MF Global’s indebtedness.

Indeed, some of FASB’s motivation for proposing the new guidelines was that financial firms have increasingly used repos, which involve asset types (such as sovereign debt) outside the scope of traditional, U.S. Treasury, and other government-agency securities that previously represented most of the collateral for the transactions. The newer asset types are, of course, harder to track and regulate.

Robert Rostan, CFO and Principal of Training The Street, an executive-training firm that specializes in accounting courses, says repo agreements are the perfect tool for such balance-sheet tricks. Firms can easily tailor their repo agreements in a way that skirts quarterly and annual reports, he says. That’s because the transactions, as in Lehman’s case, often have open-ended questions about their maturities and when the transactions close. Both Lehman and MF Global’s accounting techniques were simply “dressing up the balance sheet,” he adds.

The accounting methods Lehman and MF Global used, he notes, created just the right amount of accounting complexity, since some of the tactics were compliant with U.S. generally accepted accounting principles. “If you show somebody a rule, they’re going to go right up to that rule. They can even use that rule as a safe harbor,” he explains.

To improve financial-reporting transparency, FASB is proposing to eliminate the current distinction between agreements that settle before an asset’s maturity and those that settle at the same time the asset matures. Currently, if an asset matures and the participant does not recover the transferred asset at the end of the agreement, it would be considered a sale. FASB also clarifies what kinds of assets are to be repurchased in the transactions, such as if they are “substantially the same” when they are bought as when they are sold.

The new proposal could affect the accounting for many securities. Countless insurance companies, investment funds, and small and large banks routinely use repos for short-term borrowing and to make money on the securities while they are sitting idle on their books. As of September 30, 2011, the insurance industry alone had an aggregate of about $13.1 billion reported as repurchase, dollar-repurchase, and reverse-repurchase agreement securities, according to the National Association of Insurance Commissioners.

FASB has made several improvements to the financial reporting of repos over the years. For example, its current efforts date back to a July 2010 board meeting, where the standard setter put on its agenda a project that would obligate a participant entering into a repo transaction to repurchase or redeem financial assets before their maturity. This attempted to address the gap that often exists between when firms borrow the securities and buy them back.

FASB is seeking comments on its current repo proposal by March 29.