SEC opens broad inquiry into accounting for repurchase transactions

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Chief financial officers from 24 financial institutions received a Dear CFO letter from the chief accountant of the Securities and Exchange Commission (SEC) last week asking for detailed information about their accounting for repurchase agreements classified as sales, and their disclosures of these arrangements.

SEC Chairman Mary Schapiro said, in a recent interview on CNBC, that the commission will be probing the “Repo 105” issues with “every major financial institution very thoroughly” in the coming months.” Repo 105 transactions were allegedly used by Lehman Brothers to hide short-term borrowing that made Lehman look less leveraged than it actually was.

Lehman claimed that the Repo 105 transactions were in compliance with U.S. Generally Accepted Accounting Principles under SFAS 140,Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,” issued by the Financial Accounting Standards Board in 2000.

In a recent conversation with AccountingWEB, Randy Oberdiek, partner at BKD, LLP in Kansas City, Missouri, provided some perspective on the complexity of FAS 140 accounting, and commented on what the SEC might be looking for in their letter.

“FAS 140 was designed to provide guidance about when the transfer of a financial asset is a sale or a secured borrowing. In general, the transfer is a borrowing unless you can jump through all the hoops for derecognition of the asset,” Oberdiek said.

“The first two criteria are isolation and the transferee’s ability to pledge or exchange the assets.” For example, Oberdiek said, “In a plain vanilla repurchase agreement, the asset is held by a trustee and the transferee really can’t do anything with the asset. These transactions are accounted for as borrowings.”

The third criteria requires that the transferor does not maintain effective control over the transferred assets through either (1) an agreement that both entitles and obligates the transferor to repurchase or redeem them before their maturity, or (2) the ability to unilaterally cause the holder to return specific assets, other than through a cleanup call.

Media coverage has repeatedly used the term loophole to describe repurchase accounting under FAS 140. “Like many things,” Oberdiek said, “when there appears to be a bad outcome, people will conclude there is something wrong with the accounting. FAS 140 is a very complicated standard, one of the most complex standards, and it is also very rules based. With a rules-based standard – and lease accounting is a good example of this – you can construct a transaction so that it meets the rules and you get result A. If you don’t, you get result B, so then you change the terms. You can enter into agreements that meet specific rules to achieve a specific outcome. Of course, there are economic risks associated with changing the terms.

“The SEC letter is rather broad,” Oberdiek said. “They are trying to gather information. It is hard to tell what they will do with it. They may be trying to understand what is going on in practice. Are people in compliance? Or they may just be trying to determine a level of compliance. Ultimately, there may also be the intent to examine specific issues for enforcement.”

The SEC letter asks chief financial officers to provide the number and amount of repurchase agreements that qualify for sales accounting, and detailed analysis supporting a firm’s use of sales accounting for the repurchase agreements and the business reasons for this accounting. It asks the recipient to describe all the differences in transaction terms that result in certain of their repurchase agreements to qualify as sales versus collateralized financings.

One question which asks for information about how a company’s “use of sales accounting for certain of your repurchase agreements impacts any ratios or metrics you use publicly, provide to analysts and credit rating agencies, disclose in your filings with the SEC, or provide to other regulatory agencies,” seems to reflect concerns about Lehman’s leverage ratios that were expressed in the Bankruptcy Court Examiner’s report. Another very broad question asks whether the repurchase agreements qualifying for sales accounting are concentrated with certain counterparties and/or concentrated within certain countries.

The SEC letter asks whether recipients have changed their original accounting on any repurchase agreements during the last three years and for an explanation of the reasons for these changes.

Companies receiving the letters are required to respond within 10 business days.

SEC enforcement actions could entail sending additional letters of inquiry, followed by subpoenas. Where the commission sees wrongdoing, it can bring civil suits alleging violations of securities laws. Firms often agree to pay fines, without admitting to any wrongdoing, to resolve their disputes with the SEC. The SEC cannot file criminal charges, but may cooperate with the Department of Justice in criminal cases.

Late in 2009, after a five-year investigation by the SEC, Ernst & Young agreed to pay a fine of $8.5 million for its role in an accounting fraud at Bally Total Fitness Holding Corp. The firm and six former and current partners agreed to settle with the SEC without admitting or denying the charges against them.

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