Financial Services Insights - June 2011 - Repurchase Agreement Accounting Changes

In April 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2011-03 on Topic 860 Transfers and Servicing – Reconsideration of Effective Control for Repurchase Agreements.

Generally, companies enter into repurchase agreements to satisfy short-term cash needs by transferring the security as collateral to a counterparty for cash. The difference between the cash received at the commencement of the transaction and the cash paid for the repurchase of the security represents interest or the cost of borrowing. The new ASU may result in an increase of repurchase agreement transactions being treated as a secured borrowing instead of a sale; thereby grossing-up the balance sheet. This will affect certain leverage and debt ratios and truly reflect the financial condition of the respective company. Under the old standard, if the company did not have the ability to repurchase the security back from the counterparty to the transaction, the transaction was treated as a sale and not as a secured borrowing.

Under Topic 860, a transfer of financial assets is accounted for as a sale if the transferor surrenders control over the transferred assets. Topic 860 evaluates three elements of control:

  1. Isolation of transferred financial assets (i.e., bankruptcy remote);
  2. If there is continuing involvement, the transferee’s rights to pledge or exchange; and
  3. Effective control.

This ASU focuses on the third element of control, effective control, and removes the following from the assessment of whether the transaction should be treated as a sale or secured borrowing:

  1. The criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee, and
  2. The collateral maintenance implementation guidance related to that criterion.

Essentially, the ASU is focusing on the transferor’s contractual rights with respect to the transferred financial assets, not the transferor’s ability to exercises those rights.

This ASU did not change the other criteria applicable to the assessment of effective control which indicate that the transferor is deemed to have maintained effective control over the financial assets transferred (and thus must account for the transaction as a secured borrowing) for the agreements that both entitle and obligate the transferor to repurchase or redeem the financial assets before their maturity if all of the following conditions are met:

  1. The financial assets to be repurchased or redeemed are the same or substantially the same as those transferred.
  2. The agreement is to repurchase or redeem them before maturity, at a fixed or determinable price.
  3. The agreement is entered into contemporaneously with, or in contemplation of, the transfer.

This ASU is effective for the first interim or annual period beginning on or after December 15, 2011. This should be applied prospectively to transactions or modifications of existing transactions that commence on or after the effective date. Early adoption is not permitted.

Financial Services Insights - June 2011 

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