Accounting and Corporate Governance

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  • Topic: Repurchase agreement, Repo 105, Balance sheet
  • Pages : 6 (1960 words )
  • Download(s) : 68
  • Published : May 13, 2013
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INTRODUCTION

The memo is to address the accounting maneuver of Lehman’s Repo 105 (or 108) from perspectives of accounting and corporate governance.  The memo will illustrate the role of repo transaction in Lehman’s business model, analyze the accounting irregularities regarding repo by Lehman, observe auditors’ role in these irregularities, and discuss the corresponding accounting and corporate governance issues. In addition, the memo will provide recommendations on how to prevent financial institutions from abusing regulatory deficiencies by emphasizing on the importance of accounting regulation, auditors’ role, and business ethics. ROLE OF REPO 105 IN LEHMAN’S BUSINESS MODEL

The major goal of Lehman’s Repo 105 is to temporarily remove troubled securities from its balance sheet while presenting favorable financial statements to its investors, creditors, rating agencies, and the public. By temporarily removing these securities from its balance sheet, Lehman made its leverage ratio much lower. With low leverage ratio, Lehman would keep its credit rating at high level and maintained its customers’ confidence. A repo, or sale and repurchase agreement, is an agreement in which one party transfers to another party as collateral for a short-term borrowing of cash, while simultaneously agreeing to repay the cash and take back the collateral at a specific point in time (SFAS 140). An ordinary repo should be treated as a financing transaction and should be accounted for as a secured borrowing. An ordinary repo is a commonly-used form of secured loan between financial institutions. In fact, repo does not have real economic substance. However, by the Repo 105 transactions, Lehman did the same in an ordinary repo, but because the assets value were 105 percent or more of the cash received, accounting rules permitted the transactions to be treated as sales rather than financing. Lehman aggressively employed Repo 105 transactions before reporting periods at the end of 2007 and the first two quarters of 2008. During the reporting periods, Repo transactions helped Lehman remove assets from balance sheet and use cash received to payback short-term loans. In addition, Lehman did not report any liabilities that reflected the obligation to repay the borrowed funds. After the reporting periods, Lehman would borrow funds to repurchases the transferred assets. Then these assets would be reversed on the balance sheet again. ACCOUNTING IRREGULARITY OF LEHMAN’S REPO 105

The consideration is whether Lehman’s accounting for Repo 105 violated the Generally Accepted Accounting Principal (the GAAP). Statement of Financial Accounting Standards No. 140 (SFAS 140) provides the accounting guidelines on repo transactions. A company is permitted to account for these transactions as sales only if the transferor surrenders control over the assets to transferees. To account for a repo transaction as a sale, all three conditions must be met: 1) the transferred assets must be isolated from the transfer, 2) transferee has right to pledge or exchange the assets, 3) the transferor does not maintain effective control over the transferred assets. A typical repo contract can easily meet the first two conditions. However, in order to take advantage of favorable accounting treatment as sales transaction, Lehman has employed some accounting maneuvers to meet the third condition. SFAS 140 (Paragraph 218) states that the transferor’s right to repurchase is not assured unless the repurchase price is 102 percent or less of the cash received, or the cash received is 98 percent or more of the value of the transferred assets. “The Board believes that other collateral arrangements typical fall well outside that guideline (FASB, 2000, p.91).” The repurchase price of Repo 105 is 105 percent of the cash received, which is higher than the 102 percent guideline. As a result, Lehman could argue that Repo 105 did not meet the third condition of...
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