SEC ‘Repo Probe’ May Hinge on Weak GAAP

Companies that transfer assets on or off the balance sheet using repurchase agreements should take a close look at their accounting practices in light of a growing probe into how Lehman Brothers used “repo agreements”—with disastrous results.

The Securities and Exchange Commission published one of its occasional “Dear CFO” letters last week, warning that it has launched an inquiry into how companies (primarily banks and insurance companies) treat asset transfers involving financing or some obligation to repurchase the assets. The SEC is looking for where companies have treated transfers as sales, which reduces leverage by removing them from the balance sheet, even when the company still had a legitimate obligation to repurchase the assets and put them back on the balance sheet.

Hanson

“Dear CFO” letters to the financial reporting community are common fare for the SEC, but they are usually intended to telegraph the Commission’s views on some reporting question. This time, says Jay Hanson, national director of accounting for McGladrey & Pullen, the SEC is asking companies to step forward with information about how they use repo agreements.

“This one says, ‘Please tell us,’” Hanson says. “It’s asking for affirmative response, fishing for information to see what’s out there.”

The letter tells CFOs that the SEC is reviewing Form 10-Ks with an eye toward how filers have accounted for repurchase agreements, securities lending transactions, and other transactions involving the transfer of financial assets with an obligation to repurchase the transferred assets. Where a company has treated such agreements as asset sales rather than as financings, the SEC is studying the scope and the reasoning behind such accounting.

Pounder

Although the inquiry never mentions Lehman Brothers, the connection is obvious, says Bruce Pounder, president of accounting firm Leveraged Logic. The massive report from Lehman’s bankruptcy examiner published last month says Lehman management exploited accounting rules to keep as much as $50 billion in debt off the balance sheet, before the bank finally collapsed in September 2008. The report describes Lehman’s longstanding practice of using “Repo 105” and “Repo 108” transactions, and in apparently record high amounts as management tried to keep the bank open.

“I can’t imagine the SEC coming up with this for any reason other than the Lehman bankruptcy examiner’s report,” Pounder says. “It appears that the SEC is attempting to assess the extent among its registrants of accounting practices similar to Lehman’s reported accounting for Repo 105 transactions.”

CFO LETTER SAMPLE

Below is the sample SEC letter published last month asking for companies to report how they use repurchase agreements in financial reporting.

Dear Chief Financial Officer:

We are currently reviewing your Form 10-K for fiscal year ended ______. In our effort to better understand the decisions you made in determining the accounting for certain of your repurchase agreements, securities lending transactions, or other transactions involving the transfer of financial assets with an obligation to repurchase the transferred assets, we ask that you provide us with information relating to those decisions and your disclosure.

With regard to your repurchase agreements, please tell us whether you account for any of those agreements as sales for accounting purposes in your financial statements. If you do, we ask that you:

Quantify the amount of repurchase agreements qualifying for sales accounting at each quarterly balance sheet date for each of the past three years.

Quantify the average quarterly balance of repurchase agreements qualifying for sales accounting for each of the past three years.

Describe all the differences in transaction terms that result in certain of your repurchase agreements qualifying as sales versus collateralized financings.

Provide a detailed analysis supporting your use of sales accounting for your repurchase agreements.

Describe the business reasons for structuring the repurchase agreements as sales transactions versus collateralized financings. To the extent the amounts accounted for as sales transactions have varied over the past three years, discuss the reasons for quarterly changes in the amounts qualifying for sales accounting.

Describe how your 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.

Tell us whether the repurchase agreements qualifying for sales accounting are concentrated with certain counterparties and/or concentrated within certain countries. If you have any such concentrations, please discuss the reasons for them.

Tell us whether you have changed your original accounting on any repurchase agreements during the last three years. If you have, explain specifically how you determined the original accounting as either a sales transaction or as a collateralized financing transaction noting the specific facts and circumstances leading to this determination. Describe the factors, events or changes which resulted in your changing your accounting and describe how the change impacted your financial statements.

For those repurchase agreements you account for as collateralized financings, please quantify the average quarterly balance for each of the past three years. In addition, quantify the period end balance for each of those quarters and the maximum balance at any month-end. Explain the causes and business reasons for significant variances among these amounts.

In addition, please tell us:

Whether you have any securities lending transactions that you account for as sales pursuant to the guidance in ASC 860-10. If you do, quantify the amount of these transactions at each quarterly balance sheet date for each of the past three years. Provide a detailed analysis supporting your decision to account for these securities lending transactions as sales.

Whether you have any other transactions involving the transfer of financial assets with an obligation to repurchase the transferred assets, similar to repurchase or securities lending transactions that you account for as sales pursuant to the guidance in ASC 860. If you do, describe the key terms and nature of these transactions and quantify the amount of the transactions at each quarterly balance sheet date for the past three years.

Whether you have offset financial assets and financial liabilities in the balance sheet where a right of setoff—the general principle for offsetting—does not exist. If you have offset financial assets and financial liabilities in the balance sheet where a right of setoff does not exist, please identify those circumstances, explain the basis for your presentation policy, and quantify the gross amount of the financial assets and financial liabilities that are offset in the balance sheet. For example, please tell us whether you have offset securities owned (long positions) with securities sold, but not yet purchased (short positions), along with any basis for your presentation policy and the related gross amounts that are offset.

Finally, if you accounted for repurchase agreements, securities lending transactions, or other transactions involving the transfer of financial assets with an obligation to repurchase the transferred assets as sales and did not provide disclosure of those transactions in your Management’s Discussion and Analysis, please advise us of the basis for your conclusion that disclosure was not necessary and describe the process you undertook to reach that conclusion. We refer you to paragraphs (a)(1) and (a)(4) of Item 303 of Regulation S-K.

As noted above, we seek to better understand the basis for your decisions and your disclosure. Please provide us with a written response to these questions within ten business days from the date of this letter or tell us when you will respond. Upon our review of your response to these questions, we may have additional comments that we will provide to you with any other comments we may have on your Form 10-K.

Please contact me if you have any questions.

Sincerely,

Senior Assistant Chief Accountant

Source

src="/sites/default/files/data/web2.gif" border="0"

style="margin-top:3px;margin-right:6px;margin-bottom:9px" border="0"

align="left">SEC (March 29, 2010)

Some possible re-assurance: Fred Lipman, a partner at the law firm Blank Rome and president of the Association of Audit Committee Members, says he believes the SEC will not find the Lehman approach to be commonplace. “It was strawberry, not vanilla,” Lipman says. “What’s bothered the SEC is the structuring motivation, I’m sure.”

The bankruptcy examiner report does outline numerous communications among Lehman executives, who described the repo agreements as “another drug” Lehman was on, “window dressing,” and an approach “based on legal technicalities.”

In its letter to CFOs, the SEC asks for information about why companies treated repurchase agreements as sale transactions, if they did so. It wants a list of the differences in transaction terms that would lead to a sale treatment rather than financing treatment, a full explanation for those business reasons, and disclosure of whether the accounting has changed in the last three years. It also wants to know if any such transactions are concentrated with particular counterparties or in particular countries.

Change in Standards

During Lehman’s last days, companies were still following Financial Accounting Standard No. 140, Accounting for Transfers and Servicing of Financial Assets, to decide when an asset transfer qualified as a sale (that could be kept off the balance sheet) or when it had to be treated as a financing (that remained on). Last year, however, the Financial Accounting Standards Board altered FAS 140 with FAS 166, Accounting for Transfers of Financial Assets, to end the sort of manipulations Lehman had been doing. That rule has since been codified into the Accounting Standards Codification under ASC 860-10.

Hanson, however, notes a potentially important loophole: While FAS 166 gave companies new criteria to consider in deciding whether an entity belonged on the balance sheet, it made scant change to how a company would decide if a particular asset belonged on or off the balance sheet.

That means the accounting rules that Lehman followed to structure its repo agreements as sales have remained relatively untouched in the transition from FAS 140 to FAS 166, and ultimately into the ASC 860-10. “It was not addressed,” Hanson says. “It wasn’t even on the radar screen.”

Pounder agrees. “Statement 166 did change some of the language in the paragraph Lehman relied on,” he says. “But my reading of the changes to Statement 166 points me toward a conclusion that it would not have led Lehman to a different conclusion regarding how it did its accounting.”

FASB’s focus when it rewrote FAS 140 into FAS 166 was to eliminate bright-line criteria that companies had been using to keep entire structured entities off corporate balance sheets, even when the company retained significant interest in and control over such entities. FASB issued the FAS 166 changes “for many reasons which had nothing to do with suspecting anyone of doing what Lehman was doing,” Pounder says.

The bankruptcy examiner’s report says actionable claims against Lehman executives and their advisers do exist, although most accounting experts who have read the report say it’s still difficult to pinpoint exactly how Lehman’s accounting was a direct violation of Generally Accepted Accounting Principles. Lehman’s external auditing firm, Ernst & Young, has defended its audit conclusions at least through Lehman’s last full fiscal year, which ended Nov. 30, 2007.

Ultimately, the accounting may have landed within bright-line boundaries but violated the spirit of the rules, Lipman says. “If, in fact, it looks like a lot of other companies are ignoring the spirit of the rule, the SEC may well decide to enforce it and force some restatements,” he says.

Hanson says FASB added some significant disclosure requirements to FAS 140 at the end of 2008, after Lehman had already collapsed, and in the end it may be the disclosure that was lacking under Lehman’s approach. “When all the dust settles and the investigation is complete, the accounting might not pass the smell test but it might pass the FAS 140 test,” he says. “It seems like the bigger concern might be whether or not management properly disclosed everything it needed to disclose.”

Dodd

Senate Banking Chairman Christopher Dodd, D-Conn., has called on the Justice Department to investigate the allegations of accounting manipulation, but the department has not yet given any public response.