Banks, repos and transparency in accounting

by Linda Beale

Banks, repos and transparency in accounting

A repo transaction is essentially a collateralized financing. For tax purposes, everybody knows that it will be treated as a loan, no matter that it is called a “sale” with an agreement for a repurchase later. For accounting purposes, though, some repo transactions have been able to slide by and look like a “real” sale rather than debt on the financial statement. That’s a perfect example of the fact that tax theory pays attention to economic substance, whereas accounting somehow sets up rather arbitrary categories that may end up letting a repo count as a sale instead of a loan on an entity’s financial statement.

As most everybody is aware by now, the 2000+ page report on the Lehman breakup found that the firm had engaged in repo transactions to make its capital position look better than it actually was by reducing the leverage showing on its books. It concluded that the Lehman executives and the company’s outside auditor (Ernst & YOung) had improperly allowed the repos to temporarily reduce leverage on the firm’s books, which contributed to the company’s ultimate downfall.

Now the SEC is asking 24 large financial institutions and insurance companies to provide information about their accounting and disclosure practices in connection with their use of repos. The sample SEC letter is available here.

Financial institution reform needs to deal with a myriad of factors–over-leverage is one of them. Transparency in accounting, and focus on economic substance rather than form, should be high on the list of reforms needed.

crossposted with ataxingmatter