On April 19th, FASB Chair Robert Herz submitted a letter to the House Financial Services Committee, explaining the accounting standards that applied to Lehman's repo transactions. In desperate hope that the Committee will also ask whether and how those repo accounting rules could be improved, I decided to follow the FASB's letter to the Committee with one of my own. I haven't sent it yet, but the gist of the latest draft is here in this post. I hope you will send me your comments, suggestions, hisses, groans, etc.
The purpose of this letter is to supplement the information provided to you by Robert Herz, FASB chair, in his letter of April 19th regarding, among other things, the FASB's accounting requirements applicable to repurchase (repo) agreements. As I will describe further below, I believe the committee should be aware that FASB rules addressing the accounting for repo transactions are based on needlessly complex and subjective criteria, which apparently gave license to the machinations that Lehman Brother Holdings Inc. (Lehman) allegedly engaged in for the purpose of removing liabilities off period-end balance sheets.
I would also like the Committee to be aware of the fact that the accounting rules governing repo agreements need not be based on criteria that invite exploitation by managers who care little about fair presentation of financial information to investors. On the contrary, it would be a straightforward matter for the FASB to promulgate rules governing the accounting for repo agreements that are simple, transparent, representationally faithful, relevant to investors, useful to prudential regulators, and would not provide an open invitation for abuse.
The FASB Should Amend Its Repo Accounting Rules
I am proposing for the Committee's consideration a different approach to repo accounting, the first requirement of which is that transferred securities would be measured at fair value. [Note 1] In fact, the FASB has recently announced its intention to require that virtually all financial assets should be measured at fair value.
Second, the following procedures would apply to securities for which ownership has transferred:
At the inception of the agreement, a transferor would recognize an asset for the cash received and derecognize the securities transferred. Any difference between these two amounts would be reflected on the balance sheet as a change in shareholders' equity through net income. [Note 2]
- To recognize the commitment to repurchase the transferred securities, a receivable for the future return of the transferred securities would be recognized at its fair value; and a payable would be recognized at its fair value for the price to be paid for the return of the transferred securities. In contrast to existing accounting rules, these two amounts must be presented "gross"— i.e., they may not be offset. And again, any difference betwee these two amounts would be reflected on the balance sheet as a change in shareholders' equity through net income.
If ownership of the securities does not change per the terms of the repo agreement, then the initial transaction would again recognize the cash receipt, and also a liability to pay it back. The transferred securities would be unaffected. Ultimately the difference between the amount initially recorded as the liability and the cash paid to the counterparty in the repo transaction will be reflected as an increase or decrease to shareholders' equity through net income.
Comparing My Proposal to Existing Accounting Rules
I hope that the Committee will consider whether the standards of accounting that I have proposed are reasonable and would prevent abusive financial reporting practices. In my opinion, they are.
First, unlike the current rules, my proposal is principles-based. The accounting for a repo agreement should reflect without undue effort, given the sophistication of the parties involved, reflect the fair value of each party's obligations and rights.
Second, it appears that the complexity of the Lehman Repo 105 and 108 transactions were not driven by financial considerations, but only by an intent to qualify them for sale accounting treatment. One may debate whether or not Lehman's accounting for its repo agreements complied with existing accounting rules, and like Mr. Herz, I am unable to express an opinion on that without additional information. However, it is inarguable that Lehman's machinations, which were consistently timed to take place near the end of each fiscal quarter, had no other business purpose except for obtaining a particular accounting result. If the accounting rules I am proposing had been in effect, such machinations would have been ineffective for meeting Lehman's apparent financial reporting objectives.
Third, my proposal adds transparency through the requirement to separately report the fair values of assets and liabilities. As a matter of accounting policy, gross presentation should be required when net presentation would be misleading. For example, existing lease accounting rules require that some leases (so-called "capital leases") must be accounted for by the lessee by recognizing representing a right of use of the leased asset, and an obligation for future payments to the lessor. For reasons very similar to the issues raised by Lehman's accounting for repo agreements, the FASB has expressed its intention to require that all leases should be presented on a gross basis, even though the receivable and the liability are with the same counterparty. [Note 3]
Fourth, as Mr. Herz has explained in his letter, the accounting for repo agreements hinges on whether the transferor of securities has maintained "effective control," a condition which is difficult to describe, much less objectively determine. An "ownership" criteria, on the other hand refers to a legal standard, and use of that standard would have thwarted the alleged abuses of repo accounting by Lehman and any other reporting entity.
The Committee Should Investigate Whether the FASB is Responsible for Economic Damages Caused by Its Inadequate Repo Accounting Rules
As Mr. Herz explained, Lehman construed (and their auditor apparently agreed) existing repo accounting rules to permit them to apply sale accounting treatment to its Repo 105 and 108 transactions. As a result, Lehman was able to reduce its on-balance sheet liabilities; because sale accounting treatment calls for the transferred securities to be derecognized from Lehman's balance sheet, and the cash proceeds from transferring the securities was used to settle other liabilities. Under the accounting rules I have proposed, the liability shifting that Lehman had engaged in would not have been possible. This is because the net balance sheet effect, which is to increase assets for the cash received, and to increase liabilities for the obligation to pay cash to the counterparty, does not depend on whether the repo arrangement results in a change in ownership of the transferred securities.
More generally, the Committee should consider whether the existing FASB rules are appropriate for any repo arrangement. In my opinion, they are not. The FASB's rules are based on the simplistic assumption that any repo can be classified, and consequently accounted for, as either a secured borrowing, or a sale of financial instruments; and that a series of subjective criteria will reliably distinguish between these two species of repos. The result of the FASB's approach has predictably been that a small variation in contract language could tip the scales one way or the other toward radically different accounting treatments and portrayals of financial risk and solvency.
Moreover, the FASB should have known that its rules-based approach to accounting for repo agreements would be abused by some issuers to defeat both fair presentation to investors and to corrupt the inputs to capital adequacy calculations relied on by prudential regulators.
I hope that the Committee will see fit to investigate the issue of the FASB's responsibility further. While Mr. Herz did state in his letter that most repo agreements called for treatment as secured borrowings, the Lehman case has made the general public aware that the availability of sales accounting treatment may have contributed in a significant way to the instability of financial institutions, which in turn led to government bailouts of those deemed "too-big-to-fail."
The Committee should ask Mr. Herz whether the abuses of repo accounting that have occurred should have been foreseen by the FASB, and whether he believes that the FASB shares responsibility for the financial crisis that plunged the federal government into further debt, and the economy into recession.
Note 1: Defining and measuring "fair value" are matters of considerable controversy. For the purpose of these comments, however, it is not necessary to consider this issue beyond acknowledgement that "fair value" connotes any one of various approaches for reporting a current economic value for an asset.
Note 2: Other treatments of the difference are possible, and I do not recommend that the Committee focus on that issue at this time.
Note 3: There is also a strong argument to be made for gross presentation of many other financial arrangements. For example, if interest rate or credit default swaps had been presented on a gross basis by financial institutions, their prudential regulators as well as investors would have been provided with a much clearer picture of the overall risk exposures of those entities. The added transparency provided by gross presentation, might have even discouraged many of the derivatives transaction that are widely believed to have been the root cause of the recent financial crisis.