Accounting for Repurchase Agreements (Repos)

Repurchase agreements are transactions between two parties where they exchange financial security and cash. These agreements can be arranged in different ways.

The transfer of financial security means both parties should consider the transfer of control with the transaction among other important considerations. The tax and accounting treatment for both parties depends largely on that.

Let us discuss what are repurchase agreements and their accounting treatment.

Repurchase Agreements – Repos

A repurchase agreement is a form of short-term financing where one party transfers a financial asset to another party in exchange for cash.

The first party agrees to repurchase the financial asset on a specific date and at a set price. The arrangement enters into a formal agreement between two parties. Sometimes, a third-party acts as a custodian.

For the first party that transfers the financial asset, the arrangement is called a repurchase agreement (repo). For the second party that buys the financial asset and provides cash, it is called a reverse repurchase agreement.

How Do Repurchase Agreements Work?

Repurchase agreements are also referred to as money-market instruments. These arrangements work as collateralized and interest-bearing loans. However, unlike collateralized loans, repos actually involve a sale and a repurchase of the financial security.

Often the arrangement is made for the short term. The seller of the financial security acts as a short-term borrower, and the buyer acts as a short-term lender.

Both parties arrange the repurchase agreement by setting the terms of the contract. The important points include the tenor of the contract, interest rate, and discount price of the financial security.

At the inception, the transferor (acting as the first party) transfers the financial security to the transferee that acts as the second party in the contract. The transferee then provides the cash to the transferor.

A common repo arrangement involves a third-party such as an investment bank that acts as the custodian of the financial security. This way, both parties try to reduce the credit risk involved in the transaction.

The first party needs to repurchase the financial security at maturity. It also has to pay interest to the second party on the borrowed amount.

At maturity, the first party repurchases the financial security. The completed transaction provides the lender with cash and interest income. The borrower receives the cash initially (same as a short-term financing arrangement) and incurs interest expense.

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Repos are often flexible with renewal terms and both parties can rollover the contract without actually repurchasing the financial security and exchanging cash.

Types of Repurchase Agreements

Repurchase agreements are designed to minimize the counterparty credit risk. Any changes to the market value of the financial security may lead to a margin call or margin excess.

That in turn would mean the exchange of cash from the transferor to the transferee or vice versa depending on the change in the value of financial security.

Repos can be arranged in different ways. Common agreement types include:

Open Repos

These repurchase agreements do not come with any maturity date. However, these repos can be terminated at a short notice by either party.

Term Repos

These repurchase agreements come with a specific maturity date and hence the term. The maturity period ranges from overnight to several months that can be rolled over with mutual consent of both parties.

Tri-Party Repos

These are the most commonly used type of repos where an investment bank acts as the custodian of financial security. The transfer of financial security and cash takes place through the third party in this arrangement.

Accounting for Repurchase Agreements (Repos)

The accounting treatment of repurchase agreements is based on the guiding principles of ASC 860- Transfer and Services of GAAP rules.

The main point is to determine whether the contract resulted in a sale of the financial security or not. The contract is evaluated to judge whether the contract resulted in the loss of control for the transferor.

Transfer of Control

The transferor needs to determine the transfer of control first. The derecognition of the financial security will depend on judging whether the transferor relinquished the control.

Relinquishment of control can be judged based on:

  • Surrender of legal control
  • Surrender of actual control
  • Surrender of effective control

When the transferor fulfills all of these conditions, it accounts for as the forward repurchase agreement. However, if it does not fulfill any of these conditions, the arrangement will be accounted for as a secured borrowing.

The most important aspect in the transfer of control is the judgment on effective control transfer. Effective control occurs when the arrangement entitles and obligates the transferor to repurchase the financial security before the maturity date of the contract.

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The following conditions should be fulfilled in a repo arrangement to evaluate the effective control aspect:

  • The transferor repurchases the same or substantially the same assets from the second party.
  • The repurchase of transferred financial security takes place before the maturity date at a determinable or fixed price.
  • The agreement is entered into concurrently with the transfer.

Recognition of Repurchase Agreements

All types of repurchase-to-maturity agreements should be accounted for under ASC 860-10-40-24A.

Most repurchase contracts fulfill the criteria of “effective control” under the guidelines of ASC 860-10-40-24. In particular, these contracts obligate a transferor to repurchase the financial security at a determinable price when the financial is the same or substantially the same as transferred.

In other cases, when a transferee can exercise its resale obligation by transferring a similar financial asset, additional analysis is required. The analysis should further evaluate whether the transferor maintained effective control or not.

In such cases, the transferor should follow the ASC 860-30-25-5 guidelines and record the cash received, record the obligation to repurchase the transferred asset, and apply the secured borrowing accounting model.

Repurchase Agreements as a Sale Transaction

In some arrangements, repos may be accounted for as a sale transaction. If the repurchase contract does not fulfill all the conditions required under ASC 860-10-40-24, it can be accounted for as a sale transaction.

These situations occur when the arrangement does not obligate the transferor to repurchase the financial asset. It means the transferor does not hold the “effective control” clause under ASC 860 guidelines.

In such cases, if the contract fulfills other conditions under ASC 860-10-55-51, the transaction should be derecognized from the financial statements of the transferor. The transferor should then account for the proceeds received and liabilities assumed.

Examples

Let us understand the repurchase agreements with the help of a working example.

Suppose two companies Bob plc and Salt plc enter into a repurchase agreement with the following details.

  • Salt plc sold a financial security of $ 1 million to Bob plc in exchange for $ 980,000 cash
  • The repurchase contract has a maturity of 7 days
  • The repurchase amount of the financial security is $ 984,000, which means the interest cost for Salt plc is $4,000.
  • Salt plc earns a profit of $ 5,000 by investing the borrowed amount
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Suppose the transaction is considered a secured borrowing arrangement. Salt plc will record the contract as a repurchase agreement and Bob plc will recognize it as a reverse repurchase agreement.

Further, we assume that although Bob plc can sell the financial security in the secondary market, it holds it until maturity.

Initial Transfer and Cash Exchange

Salt plc is the seller of the financial security. They will record cash received from Bob plc and recognize a liability with the following journal entry:

AccountDebitCredit
Cash$980,000
Repurchase Agreement$980,000

Similarly, the journal entry for Bob plc will be:

AccountDebitCredit
Repurchase Agreement$980,000
Cash$980,000

Bob plc cannot recognize the financial security received from Salt plc. Thus, it will only provide an explanatory note in its financial statement recognizing the possession of the financial security.

Salt plc will record the security in its account books to reclassify it with the following journal entry.

AccountDebitCredit
Security Pledged to Bob plc$980,000
Securities Account$980,000

And for cash investment transactions:

AccountDebitCredit
Money Market Instrument$980,000
Cash$980,000

Interest Expense and Settlement of Repurchase Agreement

The borrower Salt plc will pay interest on its borrowed amount of $ 1 million to Bob plc. Thus, Salt plc will record an interest expense while Bob plc will record it as interest income in their account books respectively.

To record cash investment return:

AccountDebitCredit
Cash$985,000
Money Market Instrument$980,000
Interest Income$5,000

Bob plc’s journal entry to record repo obligation and interest expense will be:

AccountDebitCredit
Repurchase Agreement$980,000
Interest Expense$4,000
Cash$984,000

In the conclusion, Bob plc will record the following entry to record the settlement of the repurchase agreement that no longer exists now.

AccountDebitCredit
Securities Account$1,000,000
Security Pledged to Salt plc$1,000,000

In the conclusion, Salt plc will record the reverse repo agreement cash and interest income as:

AccountDebitCredit
Cash$984,000
Reverse Repo Agreement$980,000
Interest Income$4,000

Important Considerations

ASC 860-30-25-2 states that both parties in a repurchase agreement should apply the same accounting treatment to the contract. Although both parties may reach different professional conclusions to record the transaction and subsequent interest income.

For instance, when the transferor accounts for the financial security as a borrowed transaction, the transferee should also record the financial security the same way.

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