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Accounting rules helped Lehman hide its shaky condition

CPA Tom Selling thinks the House Financial Services Committee should examine whether the Financial Accounting Standards Board bears any responsibility for the economic damages caused by accounting rules he says allowed Lehman Brothers to misrepresent its financial condition.

From his April 25, 2010, column:

I believe the committee should be aware that FASB rules addressing the accounting for repo transactions are based on needlessly complex and subjective criteria, which apparently gave license to the machinations that Lehman Brother Holdings Inc. (Lehman) allegedly engaged in for the purpose of removing liabilities off period-end balance sheets.

I would also like the Committee to be aware of the fact that the accounting rules governing repo agreements need not be based on criteria that invite exploitation by managers who care little about fair presentation of financial information to investors. On the contrary, it would be a straightforward matter for the FASB to promulgate rules governing the accounting for repo agreements that are simple, transparent, representationally faithful, relevant to investors, useful to prudential regulators, and would not provide an open invitation for abuse.

Under Selling’s proposals to fix repo accounting, collateral would be measured at market value and transactions would be accounted for this way.

In a sale:

-At the inception of the agreement, a transferor would recognize an asset for the cash received and derecognize the securities transferred. Any difference between these two amounts would be reflected on the balance sheet as a change in shareholders’ equity through net income.

-To recognize the commitment to repurchase the transferred securities, a receivable for the future return of the transferred securities would be recognized at its fair value; and a payable would be recognized at its fair value for the price to be paid for the return of the transferred securities. In contrast to existing accounting rules, these two amounts must be presented “gross”— i.e., they may not be offset. And again, any difference betwee these two amounts would be reflected on the balance sheet as a change in shareholders’ equity through net income.

If no sale:

-The initial transaction would again recognize the cash receipt, and also a liability to pay it back. The transferred securities would be unaffected. Ultimately the difference between the amount initially recorded as the liability and the cash paid to the counterparty in the repo transaction will be reflected as an increase or decrease to shareholders’ equity through net income.

Selling defends his plan:

First, unlike the current rules, my proposal is principles-based. The accounting for a repo agreement should easily, given the sophistication of the parties involved, reflect the fair value of each party’s obligations and rights.

Second … it is inarguable that Lehman’s machinations, which were consistently timed to take place near the end of each fiscal quarter, had no other business purpose except for obtaining a particular accounting result. If the accounting rules I am proposing had been in effect, such machinations would have been ineffective for meeting Lehman’s apparent financial reporting objectives.

Third, my proposal adds transparency through the requirement to separately report the fair values of assets and liabilities. As a matter of accounting policy, gross presentation should be required when net presentation would be misleading.

Fourth, the accounting for repo agreements hinges on whether the transferor of securities has maintained “effective control,” a condition which is difficult to describe, much less objectively determine. An “ownership” criteria, on the other hand refers to a legal standard, and use of that standard would have thwarted the alleged abuses of repo accounting by Lehman and any other reporting entity.

 See Selling’s column for more detail.

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