Subject: Accounting Treatment of Repurchase Agreements (Purchase Refinancing)
Background information: Aces Hardwares and building supplies, a national chain of retail home remodelling stores manufacturers paint that it sells to other chain stores and other markets. To help in solving its cash flow problem, Aces sell all fix current paint inventory to Windy city Holdings under a repurchase agreement. Under this repurchase agreement, Aces is required to repurchase the paint (as need) from windy City at a price that cover (1.) the original sales price, (2) all holding cost incurred by Windy city, and (3) a return of 1% per month
Objective: The objective of this report is to show how repurchase agreement should be treated in Aces financial statement.
Definition of Term: Repurchase agreements are defined as agreements under which a reporting entity purchases securities and simultaneously agrees to resell the same or substantially the same securities at a stated price on a specified date.
This occur when a company sells an asset to another on terms that allow that company to repurchase the asset in certain circumstances where the substance of a transaction is a secure loan, for example when the sale price does not equals market value or the is a commitment to repurchase, the seller should continue to recognized the asset and record the proceeds received as a liability. Interest however designated should be accrued on the loan (ACCA Text, 2007/2008)
On February 20, 2008, the Financial Accounting Standard Board (FASB) issues a final authoritative document FASB Staff Position (FSP) 140-3, which deals with the Accounting for Transfers of Financial Assets and Repurchase Financing Transactions.
The substance over form concept from International Accounting Standards (IAS) 1 requires transaction and other events to be accounted for and presented in accordance with their substance and financial reality, not merely with their legal form. Repurchase agreement is an example of a transaction where substance and form differs (ACCA Text, 2007/08)
Analysis of Repurchase Price
The repurchase price may be variable depending on the original price and the period during which the assets has been held by the purchaser, agreed at the time of repurchase or subject to market price movements.
Based in the case application the repurchase price is arranged to cover the following; original sales price, all holding cost incurred by Windy city and a 1% return per month.
Accounting Treatment of Repurchase Agreement
The key question is whether the commercial effect of the repurchase agreement is that of a sale or of a secured loan. For a secured loan to be recognised, the following features are required: (1) the seller will secure access to all future benefits inherent in the assets, often through call options. (2) The buyer would secure adequate return on the purchase (interest on the loan, often through adjustment of the repurchase price) and appropriate protection against loss in value of the asset bought, often through put options.
Therefore, considering the characteristics of the repurchase agreement in the case application, Ace hardwares and building supplies should treat the transaction as a secured loan from Windy city and not as a sales, since the requirement for a secured loan are met. That is, the transaction should be recognised as a liability in the company statement of financial position and not as a sale in its statement of income.
Repurchase agreements that are accounted for as collateralized lending shall not be accounted for as investments owned by the reporting entity. The amount paid for the securities shall be reported as a short-term investment, and the difference between the amount paid and the amount at which the securities will be subsequently resold shall be reported as interest income, calculated on the straight-line method or the scientific interest method, over the term of the agreement (www.naic.org/documents/committees_e_app_sapwg_exposures_0902.doc)
ACCA Textbook (2008/09): Financial Reporting (FR). Kaplan Publishing: United Kingdom