Definition of Sale and Repurchase Agreement
A Sale and Repurchase Agreement (also known as a repurchase agreement or repo) is a financial arrangement where one party sells an asset to another party with the explicit agreement to repurchase the asset at a later date under specific terms. This type of transaction is commonly used in the financial industry as a means of securing short-term borrowing.
Key Points
- Nature of Transaction: In essence, it can be seen as a type of secured loan, where the seller retains the risks and rewards of ownership while obtaining funds temporarily.
- Accounting Treatment: Under UK accounting standards, if the seller retains the risks and rewards of ownership, the original asset continues to be shown on the balance sheet, along with a liability for the cash received.
- Derecognition Rules: For financial assets, derecognition rules are governed by Section 11 of the Financial Reporting Standard Applicable in the UK and Republic of Ireland as well as International Accounting Standards (IAS 39) and International Financial Reporting Standards (IFRS 9).
- US Accounting Practices: Different rules apply in the USA, where repos are frequently used as a method of off-balance-sheet financing to enhance balance sheet presentation without fully revealing associated liabilities.
Examples
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Government Bonds: A financial institution sells government bonds to an investment firm with the agreement to repurchase them at a premium the following week. The sale provides the institution with liquidity while preserving the bond investment for future returns.
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Corporate Securities: A corporation in need of short-term cash flow sells its corporate securities to another company with the arrangement to buy back the securities after three days, effectively using the agreement as collateralized borrowing.
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Mortgage-Backed Securities: A bank sells mortgage-backed securities to another bank with a repurchase agreement, allowing the first bank to manage its liquidity needs while retaining economic interest in the underlying mortgages.
Frequently Asked Questions (FAQs)
What is the primary purpose of a sale and repurchase agreement?
The primary purpose is to facilitate short-term borrowing against the security of an asset. It allows sellers to access liquidity without permanently parting with the asset.
How is a sale and repurchase agreement accounted for?
In many cases, it is accounted for as a secured loan. The seller retains the asset on the balance sheet and records a liability for the cash received.
What are derecognition rules in context of repos?
Derecognition rules determine whether the financial asset should be removed from the balance sheet when it is sold. IFRS 9 and IAS 39 provide the international standards for such rules.
How do repos work in US accounting practices?
In the USA, different accounting rules may apply, and repos can be used as a method of off-balance-sheet finance. This can affect how liabilities are presented, potentially enhancing the company’s balance sheet appearance without fully revealing the associated obligations.
Can repos involve non-financial assets?
While commonly associated with financial assets such as bonds or securities, in principle, repos can involve any asset agreed upon by the parties involved.
Related Terms
Secured Loan
A loan in which the borrower pledges an asset as collateral for the loan. In a repo, the transferred asset serves as collateral.
Derecognition
This accounting process involves the removal of a financial asset or liability from the balance sheet when specific criteria are met, such as the transfer of risks and rewards of ownership.
Financial Reporting Standard Applicable in the UK and Republic of Ireland
A set of standards for financial reporting and accounting practices in the UK and Republic of Ireland, including rules around derecognition of financial assets.
International Financial Reporting Standard (IFRS 9)
It lays down principles for the recognition, measurement, presentation, and disclosure of financial assets and liabilities.
Off-Balance-Sheet Finance
Financing methods that do not appear on the balance sheet but still represent financial obligations, such as operating leases and certain types of repurchase agreements.
Online Resources
Suggested Books for Further Studies
- “International Financial Reporting Standards (IFRS) 2021” by Ernst & Young LLP
- “Accounting for Investments, Equities, Futures and Options” by R. V. Bayston
- “Financial Statement Analysis and Security Valuation” by Stephen H. Penman
Accounting Basics: “Sale and Repurchase Agreement” Fundamentals Quiz
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