How Lehman Brothers and MF Global’s Misuse of Repurchase Agreements Reformed Accounting Standards

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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. That enabled it to count the agreements as sales and thus keep them off the balance sheet.

Did the Lehman Brothers violate GAAP?

The judge concluded that Lehman did not violate the accounting rule. But, he added, “the fact that Lehman's accounting for the Repo 105 transactions technically complied” with the rule “does not mean that Lehman's financial statements complied with GAAP.” Although companies hate it, that is the law.

“MF Global structured the repo so that it matured when the bonds matured. The assertion is that the firm doesn’t control the debt instrument during the repo period, and when the repo matures, the firm will not regain control of the instrument because it matures on that date. Nice try. The perceived ambiguity in FAS 140’s language led the SEC to not pursue Lehman or E&Y . In December 2010 New York State Attorney General Andrew Cuomo filed a lawsuit against E&Y to seize $150 million from E&Y; the same amount the firm charged Lehman for seven years of audits.

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As evidenced in recent rule proposals for money market funds and asset-backed securities, among others, the Commission continues to move toward a more comprehensive use of interactive data in its disclosure system in service of users of disclosure data. The Boards are grappling with a long-standing struggle in financial reporting as to the appropriate characterization of complex instruments on the balance sheet.

Lehman’s Demise and Repo 105: No Accounting for Deception – Knowledge@Wharton

Lehman’s Demise and Repo 105: No Accounting for Deception.

Posted: Wed, 31 Mar 2010 07:00:00 GMT [source]

Although the business purpose of most repo transactions is for companies to borrow and lend money, Statement of Financial Accounting Standards 125 permitted the transactions to be recorded as sales or as loans. Repos are arrangements wherein one party transfers securities to another for a specified price, along with an agreement to repurchase the securities at a fixed date and amount with interest. Because the terms are so brief, there is little risk involved, which results in lower interest rates than other types of loans. The following journal entries show the accounting treatment for this arrangement.

The Accounting Onion

https://intuit-payroll.org/ Brothers used the loophole to hide the fact that it was highly leveraged during the financial crisis. Bushee says Repo 105 has its roots in a rule called FAS 140, approved by the Financial Accounting Standards Board in 2000.

  • To explain the difference between sale accounting and secured borrowing, consider the example of Lehman Brothers, which made extensive use of repo programs before it ultimately declared bankruptcy in 2008.
  • The Vakulas report has led some experts to renew calls for reforms in accounting firms, a topic that has not been front-and-center in recent debates over financial regulation.
  • Those transactions, completely hidden from investors while Lehman was heading to disaster, were disclosed last year in a blistering report by Lehman’s bankruptcy trustee.

The U.S. Fasb Changes Repo Accounting Rule Used By Lehman accounting treatment of repurchase agreement generally adopts the economic definition by requiring in SFAS 140 (now ASC 860–10–55–51) that companies recognize these transactions on financial statements as secured borrowing or lending and not as sales or purchases. This accounting treatment is consistent with the FASB’s conceptual framework which states that the financial reporting of instruments such as repurchase agreements should provide information that helps investors “assess the amount, timing, and uncertainty of future net cash flows for an entity” .

Lehman Case Hints at Need to Stiffen Audit Rules

Real-time last sale data for U.S. stock quotes reflect trades reported through Nasdaq only. Securities and Exchange Commission Chairwoman Mary Schapiro told lawmakers Tuesday in testimony that the commission could change disclosure rules connected to repo accounting. As you know, a challenge to the PCAOB’s constitutionality is currently pending before the U.S. We have supported the PCAOB and agree that the claims are without merit due to the Commission’s comprehensive oversight over the PCAOB. Hopefully, the Court will uphold the constitutionality of the PCAOB so that the work of improving audit quality continues unabated. However, the Commission stands ready to issue any interpretive guidance that may be necessary to provide continuity and minimize any disruption in the U.S. capital markets. If Congressional action is determined to be necessary after the Court’s decision, we will promptly provide technical assistance so that any needed legislative changes may be considered as quickly as possible.

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To date, approximately 500 companies have submitted over 1,500 sets of XBRL-encoded financial statements to the Commission’s EDGAR system. The target for the Boards’ joint projects is aggressive, reflecting a commitment on both sides to bring about improvements to financial reporting in the United States and abroad. While both Boards share the same mission, they may not agree on every detail of a standard. Although reasonable differences of opinion may exist, we will continue to encourage the two Boards to work closely together.

PwC comments on ONS’s LCREE report

Lehman Brothers found a loophole in the financial accounting standards, which allowed it to move its repurchase agreements off its balance sheet. The intent of the accounting standard was not to facilitate investor deception, but Lehman Brothers apparently exploited the loophole in that way. As asset quality deterioration began to accelerate during the subprime crisis and the public began to focus their concern on leverage, Lehman Brothers relied on this loophole to decrease leverage and maintain investor confidence . In an RTM, the timing of the settlement matches the maturity of the security, allowing the transferee to either return the security to the transferor or redeem it from the issuer. Because the transferor does not reacquire the asset, accounting standards deem control to be surrendered, and therefore a sale is recorded on the date the trade is initiated.

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It is important that audits of all broker-dealers be conducted by an auditor subject to the oversight regime of the PCAOB. Recent events, including highly publicized accounts of the role of broker-dealer auditors, have highlighted the need for this level of oversight. Clarifying the PCAOB’s oversight authority with respect to auditors who perform audits of broker-dealers will improve the quality of broker-dealer audits and strengthen both investor protection and broker-dealer compliance.

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Although Transferee Corp may sell or repledge the security, it does not do so over the repo’s term. Transferor Corp transfers a security carried at its fair value of $1,000 to Transferee Corp in exchange for $980 in cash.

Nevertheless the judge did not dismiss claims against E&Y relating to the whistleblower, Matthew Lee, and the Audit Committee. Confusingly the article discusses GAAP as if it contained auditing standards and was written by the PCAOB. The third requirement is the most complicated to explain since Lehman had to literally prove that its repurchase agreements did not fit the definition of a repurchase agreement. The seller does not have a repurchase agreement or call option tied to the transferred assets. In response to the report, the auditors said that the transactions were accounted for in line with Generally Accepted Accounting Principles.

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