14Federal Funds and Repurchase Agreements – Audit and Accounting Guide Depository and Lending Institutions, 2nd Edition

Chapter 14
Federal Funds and Repurchase Agreements

Introduction

14.01 This chapter addresses two types of transactions—federal funds and repurchase agreements (repos)—that can be either investing or financing transactions, depending on which side of the transaction the financial institution participates. Federal funds transactions can be an important tool for managing liquidity. Repos also can provide a cost-effective source of funds and may provide a means for the institution to leverage its securities portfolio for liquidity and funding needs.

Federal Funds Purchased

14.02 Federal funds are funds that commercial banks deposit at Federal Reserve Banks. Banks must meet legal reserve requirements on a daily basis by maintaining a specified total amount of deposits at Federal Reserve Banks and vault cash. A bank with excess reserves on a particular day may lend the excess, at an agreed-rate of interest (the federal funds rate), to another bank needing funds to meet its reserve requirements that day. The federal funds market does not increase or decrease total reserves in the Federal Reserve System, but merely redistributes them to facilitate efficient use of bank reserves and resources. However, by setting reserve requirements, the Federal Reserve System may increase or decrease total reserves in the system. No physical transfer of funds takes place; the Federal Reserve Bank charges the seller's reserve balance and credits the buyer's reserve balance. In addition to buying and selling funds to meet their own needs, banks with correspondent banking relationships absorb or provide funds as a service or accommodation to their correspondents. Accordingly, banks may operate on both sides of the federal funds market on the same day.

14.03 Two types of transactions involving federal funds are commonly used. In an unsecured transaction, the selling bank sells federal funds on one day and is repaid with interest at maturity (usually the next day). In a collateralized transaction, other than by a repo, a bank purchasing federal funds places U.S. government securities in a custody account for the seller until the funds are repaid. A borrowing bank records a liability (federal funds purchased) and a selling bank records an asset (federal funds sold).

Repos

14.04 A repurchase agreement, as stated in the FASB Accounting Standards Codification (ASC) glossary, refers to an agreement under which the transferor (repo party) transfers a financial asset to a transferee (repo counterparty or reverse party) in exchange for cash and concurrently agrees to reacquire that financial asset at a future date for an amount equal to the cash exchanged plus or minus a stipulated interest factor. Instead of cash, other securities or letters of credit sometimes are exchanged. Some repos call for repurchase of financial assets that need not be identical to the financial assets transferred. A repo may be accounted for either as a collateralized borrowing or a sale, depending on the terms of the contract. See discussion beginning in paragraph 14.27 for further details.

14.05 A repurchase agreement accounted for as a collateralized borrowing, as stated in the FASB ASC glossary, refers to a transaction in which a seller-borrower of securities sells those securities to a buyer-lender with an agreement to repurchase them at a stated price plus interest at a specified date or in specified circumstances.1 A repo accounted for as a collateralized borrowing is a repo that does not qualify for sale accounting under FASB ASC 860, Transfers and Servicing. The payable under a repo accounted for as a collateralized borrowing refers to the amount of the seller-borrower's obligation recognized for the future repurchase of the securities from the buyer-lender. In certain industries, the terminology is reversed; that is, entities in those industries refer to this type of agreement as a reverse repo. A reverse repurchase agreement accounted for as a collateralized borrowing, per the FASB ASC glossary, refers to a transaction that is accounted for as a collateralized lending in which a buyer-lender buys securities with an agreement to resell them to the seller-borrower at a stated price plus interest at a specified date or in specified circumstances. The receivable under a reverse repo accounted for as a collateralized borrowing refers to the amount due from the seller-borrower for the repurchase of the securities from the buyer-lender. In certain industries, the terminology is reversed; that is, entities in those industries refer to this type of agreement as a repo.2

14.06 The FASB ASC glossary defines a repurchase-to-maturity transaction as a repo in which the settlement date of the agreement to repurchase a transferred financial asset is at the maturity date of that financial asset and the agreement would not require the transferor to reacquire the financial asset.

14.07 Most repos involve obligations of the federal government or its agencies, but other financial instruments, such as commercial paper, banker's acceptances, negotiable certificates of deposit, and non-agency mortgage-backed securities (MBSs) are sometimes used in repos. Repos are similar to the seller-borrower's borrowing funds equal to the sales price of the related securities with the securities as collateral. The difference in the price at which the institution sells its securities and repurchases them represents interest for the use of the funds. Most repo transactions occur with other depository institutions, dealers in securities, state and local governments, insurance companies, investment funds, and customers (retail repo). Maturities of such agreements are flexible and generally vary from 1 day to 270 days.

14.08 Dollar-roll repurchase agreements, as defined in the FASB ASC glossary, are agreements to sell and repurchase similar but not identical securities. The securities sold and repurchased are usually of the same issuer. Dollar-rolls differ from regular repos in that the securities sold and repurchased have all of the following characteristics:

  • They are represented by different certificates.
  • They are collateralized by different but similar mortgage pools (for example, conforming single-family residential mortgages).
  • They generally have different principal amounts.

Fixed coupon and yield maintenance dollar-roll agreements comprise the most common agreement variations. In a fixed coupon agreement, the seller and buyer agree that delivery will be made with securities having the same stated interest rate as the interest rate stated on the securities sold. In a yield maintenance agreement, the parties agree that delivery will be made with securities that will provide the seller a yield that is specified in the agreement.

14.09 The dollar roll transactions are typically found in the To Be Announced section of the primary issuance markets for agency MBSs.

14.10 In a fixed coupon dollar-roll, the securities repurchased are generally priced to result in substantially the same yield. In addition, the seller-borrower retains control over the future economic benefits of the securities sold and assumes no additional market risk.

14.11 In a yield-maintenance agreement, the securities repurchased may have a different stated interest rate from that of the securities sold and are generally priced to result in different yields as specified in the agreement.3 The seller-borrower surrenders control over the future economic benefits of the securities sold and assumes additional market risk. Yield-maintenance agreements may contain par cap4 provisions that could significantly alter the economics of the transactions.

14.12 The terms of the agreements often provide criteria to determine whether the securities are similar enough to make the transaction, in substance, a borrowing and lending of funds or whether the securities are so dissimilar that the transaction is a sale and separate forward purchase of securities. For agreements involving existing securities collateralized by dissimilar pools, those transactions are accounted for as sales and forward purchases of securities.

14.13 Rollovers and extensions. Occasionally, securities involved in repos are not delivered on the settlement date of the agreement and the contract may be rolled over or extended upon mutual agreement of the buyer-lender and seller-borrower. Overnight repos are often used as a source of short-term financing, and rolled over on a daily basis by agreement between the counterparties.

14.14 Breakage. Securities repurchased under repos commonly have a principal amount that differs from the principal amount of the security originally sold under the agreement. This is particularly common to dollar rolls, which involve MBSs. That difference is referred to as breakage and occurs because the principal amounts of MBSs generally differ as a result of the monthly amortization of principal balances of mortgages collateralizing the MBSs. The amount of the breakage is a factor in determining whether substantially the same security is reacquired in the repo transaction, that is, whether good delivery (one in accordance with the agreement terms) has been met on repurchase of the MBSs.

14.15 Business risk. Business risks associated with repos arise from the contractual and economic complexities inherent in certain of these transactions and the degree to which the institution's management understands the terms of the agreements and the economics of the transactions. Misunderstandings may result in incorrect pricing of the agreements or an incorrect assessment of the risks that are being assumed, the return that is anticipated to be earned, or the financing costs that are being incurred. Misunderstandings of a contract’s terms may also result in improper accounting treatment of the transaction (that is, as a sale and forward purchase or as a secured borrowing).

14.16 Market risk. The prices of government securities vary inversely with changes in interest rates. Price changes may be small, but they can result in significant changes in the market values of government securities due to the large dollar amounts often involved in government securities transactions. This is generally referred to as market risk. Price changes may affect the ability of the seller-borrower under repos to continue the financing without providing additional collateral. Changes in market price of nongovernment securities can also be caused by changes in credit spreads and liquidity in the market. Price changes affect the margin in a transaction and may create a need for the seller-borrower to transfer additional securities or return cash.

14.17 The excess of the fair value of the securities transferred by the seller-borrower over the amount of cash transferred by the buyer-lender is called a haircut. A haircut represents a margin of safety required by the buyer-lender to guard against a decline in the value of the collateral as a result of rising interest rates during the term of the agreement. Whether an agreement provides for a haircut depends on competition among buyer-lenders and seller-borrowers and their relative bargaining strengths. Haircuts generally range from a fraction of 1 percent to 4 percent or 5 percent but may be higher in certain instances.

14.18 All of the following factors are considered in determining the haircut for a particular transaction:

  1. a. The term of the agreement
  2. b. The creditworthiness of the institution
  3. c. The type of securities underlying the agreement, the length of time to maturity, and the creditworthiness of the issuer of the securities
  4. d. The volatility of the market value of the underlying securities
  5. e. The differential between the interest rate specified in the agreement and the interest rate on the securities

14.19 Credit risk. A repo or reverse repo can be considered a loan of cash by one party and a loan of securities by another. When the agreement is completed, both loans are repaid. Parties to repo and reverse repo transactions are subject to credit risk, that is, the risk that the transaction counterparty will not perform under the terms of the agreement. For example, a seller-borrower is at risk that changes in market prices and resulting economic losses may prevent the buyer-lender from returning the securities at the maturity of the agreement.

14.20 Credit risk also exists to the extent that the issuer of the underlying securities may default. However, such risk may be negligible for securities issued or guaranteed by the U.S. government or its agencies. If the issuer of the underlying securities defaults, both participants in the repo are obligated to complete the transaction. This aspect of credit risk is affected by the extent to which the institution's repo position is concentrated in any one type of underlying security or with any one counterparty.

14.21 The extent of credit risk faced by a seller-borrower also depends on the buyer-lender's business policies and practices for control and use of collateral (including re-hypothecations), the extent of the haircut on securities serving as collateral, the extent to which the buyer-lender offsets transactions (that is, maintains a matched book), and the buyer-lender's extent of capitalization.

14.22 Analyzing credit risk requires an understanding of how securities dealers and other counterparties to repos manage their businesses and of the steps that can be and are taken to reduce their exposure to market risk. Securities dealers are typically highly leveraged, with securities positions that represent large multiples of their net capital and that can quickly be eroded by adverse market changes. Many securities dealers entering into repos frequently employ matched-book transactions. In a matched-book transaction, the securities dealer effects both a repo and a reverse repo with the same underlying securities for the same period of time but usually at slightly different rates. By running a matched book, a dealer can reduce its exposure to market changes, and a seller-borrower may face less credit risk by entering into agreements with a dealer that has a matched book and employs adequate procedures to control credit risk. Even if the dealer runs a matched book, the seller-borrower still faces credit risk associated with the dealer's credit risk, that is, the risk that a customer of the dealer might not be able to complete its agreement with the dealer.

14.23 Risk of collateral loss. When an institution transfers the securities sold under an agreement to repurchase, there is a risk that the dealer may not be able to reverse the transaction by selling the securities back at the agreed price. If the institution overcollateralizes the agreement by selling the securities at a relatively large discount from the market price, its rights to the overage may be diminished or lost entirely in the event of the dealer's bankruptcy. In that case, the institution may find that neither the securities nor the funds to replace the securities are available for the dealer to complete the transaction and, as a result, may incur an economic loss. If the institution does not have the legal right of setoff, the potential economic loss extends to the full value of the securities, including accrued interest.

14.24 If the institution has the legal right to set off the securities against the borrowed funds, the potential economic loss is limited to the excess of the fair value of the securities, plus accrued interest, at the date of the sale over the amount borrowed, plus or minus any change in that fair value and accrued interest. However, the accounting loss may be greater or less than the economic loss if the book value of the securities is above or below their fair value. (See paragraph 14.39.)

14.25 Securities purchased under agreements to resell (reverse repos) pose risk to buyer-lenders to the extent that they do not take possession of the securities they agreed to resell.5 If the buyer-lender or securities dealer through whom the transaction is made does not perfect a security interest in securities purchased (by having signed an agreement and by taking possession, either directly or through a custodian acting as its agent), the potential economic loss extends to the full value of the securities and the risk assumed—namely, credit risk—becomes that of an unsecured lender. Institutions reduce such risk by

  1. a. making sure that definitive collateral is held by the counterparty's custodian as the counterparty's agent with specific identification of the assignee;
  2. b. settling through the Federal Reserve System, where book-entry collateral is transferred directly or by a notation entry;
  3. c. evaluating the creditworthiness of the other party to the agreement; and
  4. d. overcollateralizing the borrowing.

Regulatory Matters

14.26 On December 18, 2008, the FDIC issued Financial Institution Letter-146-2008, Recordkeeping Requirements for Qualified Financial Contracts, which required institutions in troubled condition to produce position level and counterparty level data and other information that is relevant to the resolution and disposition of qualified financial contracts (QFCs). QFCs include repos among other contracts and agreements.

Accounting and Financial Reporting

14.27 FASB ASC 860 establishes accounting and reporting standards for transfers and servicing of financial assets. As addressed in FASB ASC 860-10-05-6, transfers of financial assets take many forms, including but not limited to, repos. Paragraphs 19–21 of FASB ASC 860-10-05 provide an overview of repos. Paragraphs 51–56B of FASB ASC 860-10-55 provide implementation guidance for accounting for repos.

14.28 If the conditions in FASB ASC 860-10-40-5 are met, FASB ASC 860-10-55-55 states that the transferor should account for the repo as a sale of financial assets and a forward repurchase commitment, and the transferee should account for the agreement as a purchase of financial assets and a forward resale commitment.

14.29 In accordance with FASB ASC 860-10-55-51 repos and securities lending transactions that do not meet all the criteria in FASB ASC 860-10-40-5 should be treated as secured borrowings.

14.30 FASB ASC 860-10-55-51A goes on to state that under certain agreements to repurchase transferred financial assets before their maturity, the transferor maintains effective control over the transferred financial assets. If effective control is maintained or the transaction qualifies for the repurchase-to-maturity transaction exception, the agreement is accounted for as a secured borrowing. If effective control is not maintained or the repurchase-to-maturity transaction exception is not met, the transaction would be assessed under the other derecognition conditions in FASB ASC 860-10-40-5 to determine if the transferred financial asset should be derecognized and accounted for as a sale.

14.31 FASB ASC 860-10-40-24 states that an agreement that both entitles and obligates the transferor to repurchase or redeem transferred financial assets from the transferee maintains the transferor's effective control over those assets under item (c)(1) in FASB ASC 860-10-40-5, if all of the following conditions are met:

  1. a. The financial assets to be repurchased or redeemed are the same or substantially the same as those transferred (see paragraph 14.32).
  2. b. The agreement is to repurchase or redeem the financial assets before maturity, at a fixed or determinable price.
  3. c. The agreement is entered into contemporaneously with, or in contemplation of, the transfer.

14.32 Item (a) in FASB ASC 860-10-40-24 states that, to be substantially the same, the financial asset that was transferred and the financial asset that is to be repurchased or redeemed need to have all of the following characteristics:

  1. a. The same primary obligor (except for debt guaranteed by a sovereign government, central bank, government-sponsored enterprise or agency thereof, in which case the guarantor and the terms of the guarantee must be the same)
  2. b. Identical form and type to provide the same risks and rights
  3. c. The same maturity (or in the case of mortgage-backed pass-through and pay-through securities, similar remaining weighted-average maturities that result in approximately the same market yield)
  4. d. Identical contractual interest rates
  5. e. Similar assets as collateral
  6. f. The same aggregate unpaid principal amount or principal amounts within accepted good delivery standards for the type of security involved

FASB ASC 860-10-55-35 contains implementation guidance related to these conditions.

14.33 In accordance with item (a) in FASB ASC 860-10-55-35, the exchange of pools of single-family loans would not meet the criteria in item (a)(1) in FASB ASC 860-10-40-24 (see item (a) in paragraph 14.32) because the mortgages making up the pool do not have the same primary obligor and would therefore not be considered substantially the same.

14.34 Item (b) in FASB ASC 860-10-55-35 explains that Government National Mortgage Association (Ginnie Mae) I securities for Ginnie Mae II securities, loans to foreign debtors that are otherwise the same except for different U.S. foreign tax credit benefits (because such differences in the tax receipts associated with the loans result in instruments that vary in form and type), and commercial paper for redeemable preferred stock would not meet the identical form and type criterion (see item [b] in paragraph 14.32).

14.35 In accordance with item (c) in FASB ASC 860-10-55-35, an example that would not meet the criterion addressed in item c in paragraph 14.32 would be the exchange of a fast-pay Ginnie Mae certificate (that is, a certificate with underlying mortgage loans that have a high prepayment record) for a slow-pay Ginnie Mae certificate because differences in the expected remaining lives of the certificates result in different market yields.

14.36 Related to item f in paragraph 14.32, participants in the MBSs market have established parameters for what is considered acceptable delivery. As stated in item (a)(6) in FASB ASC 860-10-40-24, these specific standards are defined by the Securities Industry and Financial Markets Association (SIFMA) and can be found in Uniform Practices for the Clearance and Settlement of Mortgage-Backed Securities and Other Related Securities, which is published by the SIFMA.

14.37 Repurchase financings. A repurchase financing, as defined in the FASB ASC glossary, is a repo that relates to a previously transferred financial asset between the same counterparties (or consolidated affiliates of either counterparty) that is entered into contemporaneously with, or in contemplation of, the initial transfer. In transactions involving a contemporaneous transfer of a financial asset and a repurchase financing of that transferred financial asset with the same counterparty, FASB ASC 860-10-40-4C states that a transferor and transferee should separately account for the initial transfer of the financial asset and the related repo.

14.38 Paragraphs 17A–17C of FASB ASC 860-10-55 provide implementation guidance related to repurchase financings.

14.39 Offsetting. Financial institutions may operate on both sides of the federal funds and repo markets on the same day. FASB ASC 210-20-05-1 states that it is a general principle of accounting that the offsetting of assets and liabilities in the balance sheet is improper except where a right of setoff exists. The FASB ASC glossary defines right of setoff as the debtor's legal right, by contract or otherwise, to discharge all or a portion of the debt owed to another party by applying against the debt an amount that the other party owes to the debtor and FASB ASC 210-20-45-1 specifies conditions that must be met to permit offsetting. A debtor having a valid right of setoff may offset the related asset and liability and report the net amount, as stated in FASB ASC 210-20-45-2. According to FASB ASC 210-20-45-11, notwithstanding the condition in item (c) in FASB ASC 210-20-45-1, which requires an intent to net-settle the instruments’ cash flows, an entity may, but is not required to, offset amounts recognized as payables under repos accounted for as collateralized borrowings and amounts recognized as receivables under reverse repos accounted for as collateralized borrowings if all the following conditions are met:

  1. a. The repos and reverse repos are executed with the same counterparty.
  2. b. The repos and reverse repos have the same explicit settlement date specified at the inception of the agreement.
  3. c. The repos and reverse repos are executed in accordance with a master netting arrangement.
  4. d. The securities underlying the repos and reverse repos exist in book entry form and can be transferred only by means of entries in the records of the transfer system operator or securities custodian. Book entry securities meeting the criterion in this paragraph exist only as items in accounting records maintained by a transfer system operator. This requirement does not preclude offsetting securities held in book entry form solely because other securities of the same issue exist in other forms.
  5. e. The repos and reverse repos will be settled on a securities transfer system that operates in the manner described in paragraphs 14–17 of FASB ASC 210-20-45, and the entity must have associated banking arrangement in place as described in those paragraphs. Cash settlements for securities transferred should be made under established banking arrangements that provide that the entity will need available cash on deposit only for any net amounts that are due at the end of the business day. It must be probable that the associated banking arrangements will provide sufficient daylight overdraft or other intraday credit at the settlement date for each of the parties. The term probable is used in FASB ASC 210-20 consistent with its use in FASB ASC 450-20-25-1 to mean that a transaction or event is likely to occur.
  6. f. The entity intends to use the same account at the clearing bank or other financial institution at the settlement date in transacting both the cash inflows resulting from the settlement of the reverse repo and the cash outflows in settlement of the offsetting repo.

According to FASB ASC 942-210-45-3, FASB ASC 210, Balance Sheet, permits offsetting in the statement of financial position of only payables and receivables that represent repos and reverse repos and that meet all of the conditions specified therein and does not apply to securities borrowing or lending transactions.

14.40 FASB ASC 210-20-50-1 establishes the scope of the disclosure requirements in FASB ASC 210-20-50. The disclosures apply to both of the following:

  1. a. Recognized derivative instruments accounted for in accordance with FASB ASC 815, Derivatives and Hedging (including bifurcated embedded derivatives), repos accounted for as collateralized borrowings and reverse repos, and securities borrowing and securities lending transactions that are offset in accordance with either FASB ASC 210-20-45 or FASB ASC 815-10-45
  2. b. Recognized derivative instruments accounted for in accordance with FASB ASC 815 (including bifurcated embedded derivatives), repos and reverse repos, and securities borrowing and securities lending transactions that are subject to an enforceable master netting arrangement or similar agreement, irrespective of whether they are offset in accordance with either FASB ASC 210-20-45 or FASB ASC 815-10-45

14.41 Paragraphs 2–3 of FASB ASC 210-20-50 state that an entity should disclose information to enable users of its financial statements to evaluate the effect or potential effect of netting arrangements on its financial position for recognized assets and liabilities within the scope of the preceding paragraph. This includes the effect or potential effect of rights of setoff associated with an entity’s recognized assets and recognized liabilities that are in the scope of FASB ASC 210-20-50 disclosure requirements. To meet these objectives, an entity should disclose at the end of the reporting period the following quantitative information separately for assets and liabilities that are in scope:6

  1. a. The gross amounts of those recognized assets and those recognized liabilities
  2. b. The amounts offset in accordance with the guidance in FASB ASC 210-20-45 and FASB ASC 815-10-45 to determine the net amounts presented in the statement of financial position
  3. c. The net amounts presented in the statement of financial position
  4. d. The amounts subject to an enforceable master netting arrangement or similar agreement7 not otherwise included in item b:

i.  The amounts related to recognized financial instruments and other derivative instruments that either management makes an accounting policy election not to offset or do not meet some or all of the guidance in either FASB ASC 210-20-45 or FASB ASC 815-10-45

ii.  The amounts related to financial collateral (including cash collateral).

  1. e. The net amount after deducting the amounts in item d from the amounts in item c.

14.42 Disclosures. FASB ASC 860 requires certain disclosures about transfers and servicing of financial assets. See chapter 10, “Transfers and Servicing and Variable Interest Entities,” of this guide for additional information regarding the particular disclosures.

14.43 Item (a) in FASB ASC 860-30-50-1A requires an entity that has entered into repos or securities lending transactions to disclose its policy for requiring collateral or other security.

14.44 To provide an understanding of the nature and risks of short-term collateralized financing obtained through repos, securities lending transactions, and repurchase-to-maturity transactions, that are accounted for as secured borrowings at the reporting date, FASB ASC 860-30-50-7 states that an entity should disclose the following information for each interim and annual period about the collateral pledged and the associated risks to which the transferor continues to be exposed after the transfer:

  1. a. A disaggregation of the gross obligation by the class of collateral pledged. An entity should determine the appropriate level of disaggregation and classes to be presented on the basis of the nature, characteristics, and risks of the collateral pledged. Total borrowings under those agreements should be reconciled to the amount of the gross liability for repos and securities lending transactions disclosed in accordance with item (a) in FASB ASC 210-20-50-3 before any adjustments for offsetting. Any difference between the amount of the gross obligation disclosed under this paragraph and the amount disclosed in accordance with item (a) in FASB ASC 210-20-50-3 should be presented as reconciling item(s).
  2. b. The remaining contractual maturity of the repos, securities lending transactions, and repurchase-to-maturity transactions. An entity should use judgment to determine an appropriate range of maturity intervals that would convey an understanding of the overall maturity profile of the entity’s financing agreements.
  3. c. A discussion of the potential risks associated with the agreements and related collateral pledged, including obligations arising from a decline in the fair value of the collateral pledged and how those risks are managed.

14.45 In addition, FASB ASC 825-10-50-20 states that, except as indicated in FASB ASC 825-10-50-22, an entity should disclose all significant concentrations of credit risk arising from all financial instruments, whether from an individual counterparty or groups of counterparties. The concentrations-of-credit-risk disclosures apply to debt securities and loans.

14.46 The balance sheet classification noncash collateral by the seller-borrower depends on whether the buyer-lender has the right to sell or repledge the collateral under the agreement. If there is a right to sell or repledge the collateral, FASB 860-30-45-1 requires the seller-borrower to classify those assets separately from assets not so encumbered (for example, as security pledged to creditors). See paragraphs 10.66–.69 of this guide for further discussion.

14.47 When a smaller financial institution sells securities to another larger financial institution, under agreements to repurchase, the agreements may have default provisions that should be considered for disclosure in the financial statements. For example, a common default provision is if the selling financial institution drops below well capitalized under prompt corrective action provisions. The defaulting institution may be required to pay amounts in excess of the outstanding balance plus accrued interest.

Auditing8

Objectives

14.48 The primary objectives of audit procedures applied to federal funds and repo transactions are to obtain sufficient appropriate evidence that

  1. a. the reported amounts include all federal funds purchased or sold and that repos and reverse repos are properly identified, described, and disclosed; include all such agreements; and are stated at appropriate amounts;
  2. b. interest expense or income and the related balance sheet accounts are properly measured and reported in the proper periods;
  3. c. repos and dollar rolls are appropriately accounted for as sales or secured borrowings based upon whether the assets to be repurchased or redeemed are the same or substantially the same as those transferred;
  4. d. federal funds and repo transactions have been executed in accordance with management's authorizations and are obligations of the institution;
  5. e. assets pledged as collateral for federal funds and repo transactions are properly disclosed in the financial statements, including classification of collateral on the balance sheet;
  6. f. the federal funds sold and securities purchased under reverse repos exist and are either on hand or are held in safekeeping or custody for the bank;
  7. g. the institution has legal title or similar rights of ownership for all recorded securities;
  8. h. recorded amounts include all securities owned by the institution, and the financial statements include all related transactions during the period;
  9. i. the values at which securities are reported are appropriate;
  10. j. realized and unrealized gains and losses on sales of securities are properly measured, recorded, and disclosed;
  11. k. securities involved in such agreements are properly described and classified in the financial statements and the related footnote disclosures are adequate; and
  12. l. events of default are appropriately disclosed and any related fees are properly accrued; and
  13. m. amounts that have been offset in the statement of financial position meet the criteria for netting set forth in FASB ASC 210.

Planning

14.49 In accordance with AU-C section 315, Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement (AICPA, Professional Standards), the objective of the auditor is to identify and assess the risks of material misstatement, whether due to fraud or error, at the financial statement and relevant assertion levels through understanding the entity and its environment, including the entity’s internal control, thereby providing a basis for designing and implementing responses to the assessed risks of material misstatement (as described in chapter 5, “Audit Considerations and Certain Financial Reporting Matters,” of this guide). Federal funds transactions are fairly routine for most institutions, are generally not complex, and many have matured by the close of the audit; thus, less risk may be associated with this account balance at a specific institution. Normal auditing procedures for borrowed funds could be applied to such obligations. However, certain repo transactions, whether viewed from an accounting, legal, or economic perspective, are extremely complex. Also, the risks involved in repo transactions vary widely, depending on the terms of the agreement, the parties involved, and the legal status of the agreement. The risks faced by an institution entering into a repo are generally reduced if the institution maintains effective controls related to the authorization, processing, and recording of these transactions. The auditing guidance in this chapter focuses on repo transactions.

14.50 The auditor inspects the current-year's interim financial statements, board of directors' reports and minutes, supervisory examination reports or related reports, and pertinent financial information and accounting to obtain an understanding of the level of activity in federal funds and repos, types of transactions entered into, accounting treatment (financing versus a sale and repurchase), and compliance with the institution's established investment and asset/liability management policies.

14.51 When an institution concentrates its repos with one dealer or a small group of dealers the evaluation of credit risk and counterparty risk gains significant importance to the auditor. The auditor might

  1. a. obtain an understanding of the institution's controls over evaluating the reputation and financial strength of the dealer;
  2. b. inspect the latest audited financial statements of the dealer;
  3. c. obtain an understanding of the specific entity within an affiliated group with which the institution is doing business; and
  4. d. obtain an understanding of transactions between that entity and its affiliates.

14.52 The audit procedures applied to federal funds purchased and securities sold under agreements to repurchase are also appropriate for federal funds sold and securities purchased under agreements to resell. It is important for the auditor to be aware that, as a buyer-lender, an institution might not take delivery of the securities that serve as collateral in a repo transaction. If it does take delivery, either directly or indirectly through another party acting as its agent, credit risk is less than may otherwise be the case; the auditor could consider confirming the occurrence and terms of the transaction, and the seller-borrower's obligation to repurchase the securities with the seller-borrower, and might consider counting securities in the institution's possession and confirming securities not in its possession with the custodian.

14.53 Whenever a buyer-lender or its agent does not take delivery of the securities, the auditor should consider confirming not only the occurrence and terms of the transaction and the obligation to repurchase the securities but also that they have not been delivered and are being held on the institution's behalf. It is important to note, when delivery is not made, the transaction has many of the attributes of an unsecured loan. Accordingly, the auditor should consider assessing the reputation and financial strength of the seller-borrower and of its custodian. Based on those assessments, the auditor should consider the desirability of obtaining a report from the custodian's auditor on the custodian's internal accounting controls over securities held in safekeeping, about which guidance for user auditors is provided in AU-C section 402, Audit Considerations Relating to an Entity Using a Service Organization (AICPA, Professional Standards), and for service auditors is provided in AT-C section 320, Reporting on an Examination of Controls at a Service Organization Relevant to User Entities’ Internal Control Over Financial Reporting (AICPA, Professional Standards).9 If, in accordance with paragraph .16a of AU-C section 402, the user auditor plans to use a type 2 report as audit evidence that controls at the service organization are operating effectively, paragraph .17 of AU-C section 402 states that the user auditor should determine whether the service auditor’s report provides sufficient appropriate audit evidence about the effectiveness of the controls to support the user auditor’s risk assessment by

  1. a. evaluating whether the type 2 report is for a period that is appropriate for the user auditor’s purposes;
  2. b. determining whether complementary user entity controls identified by the service organization are relevant in addressing the risks of material misstatement relating to the relevant assertions in the user entity’s financial statements and, if so, obtaining an understanding of whether the user entity has designed and implemented such controls and, if so, testing their operating effectiveness;
  3. c. evaluating the adequacy of the time period covered by the tests of controls and the time elapsed since the performance of the tests of controls; and
  4. d. evaluating whether the tests of controls performed by the service auditor and the results thereof, as described in the service auditor's report, are relevant to the assertions in the user entity's financial statements and provide sufficient appropriate audit evidence to support the user auditor's risk assessment.

Internal Control Over Financial Reporting and Possible Tests of Controls

14.54 AU-C section 315 addresses the auditor’s responsibility to identify and assess the risks of material misstatement in the financial statements through understanding the entity and its environment, including the entity’s internal control. Paragraphs .13–.14 of AU-C section 315 state that the auditor should obtain an understanding of internal control relevant to the audit (see examples of controls over financial reporting of federal funds and repo transactions in paragraph 14.55) and, in doing so, should evaluate the design of those controls and determine whether they have been implemented by performing procedures in addition to inquiry of the entity’s personnel. (See chapter 5 of this guide for further discussion of the components of internal control.) To provide a basis for designing and performing further audit procedures, paragraph .26 of AU-C section 315 states that the auditor should identify and assess the risks of material misstatement at the financial statement level and the relevant assertion level for classes of transactions, account balances, and disclosures.

14.55 Examples of controls over financial reporting of federal funds and repo transactions are as follows:

  • The institution has formal, written policies that specify the types of securities that can be sold or repurchased under repos.
  • Formal policies and procedures are in place to provide that repo transactions are executed in accordance with written contracts that describe the rights and obligations of the parties and that offsetting is applied only where appropriate based on the underlying contracts.
  • Master agreements used by the institution should be entered into by authorized personnel and should specify the terms of the transactions and the intent of the parties.
  • Only board-approved securities dealers and other institutions are allowed to enter into transactions with the institution.
  • The institution has policies and procedures to provide that only authorized individuals enter into and approve such transactions and that those individuals are aware of the inherent risks and returns of such agreements. The institution's board of directors sets limits on the amount and terms of agreements with particular securities dealers and other institutions.
  • The institution has policies and procedures for monitoring the reputation, financial stability, and creditworthiness of securities dealers and other institutions with which the institution may enter into an agreement as a basis for evaluating their ability to fulfill their obligation to return the collateral to the institution.
  • The institution has procedures for monitoring communications with securities dealers and other institutions and for reviewing confirmations from securities dealers to detect unrecorded or inappropriately recorded transactions and to determine the reasonableness of interest rates.
  • Initial transactions and rollover agreements are reviewed by a responsible official who determines whether the transactions represent sales or financing transactions.
  • Written policies mandate frequent evaluation of the market value, including accrued interest, of the agreements and necessary collateral levels.
  • The subsidiary ledgers containing information on securities collateralizing agreements are periodically reconciled to the general ledger. The reconciliations are reviewed by supervisory personnel.
  • Policies and procedures exist to monitor the use of hedging techniques, if any, to reduce market risk.
  • Review of the default provisions to ensure that any required disclosures are included in the financial statements.

Chapter 7, “Investments in Debt and Equity Securities,” and chapter 15, “Debt,” of this guide discuss related control issues for investments and borrowings, respectively.

14.56 AU-C section 330, Performing Audit Procedures in Response to Assessed Risks and Evaluating the Audit Evidence Obtained (AICPA, Professional Standards), addresses the auditor’s responsibility to design and implement responses to the risks of material misstatement identified and assessed by the auditor in accordance with AU-C section 315 and to evaluate the audit evidence obtained in an audit of financial statements.

14.57 In accordance with paragraph .08 of AU-C section 330, the auditor should design and perform tests of controls to obtain sufficient appropriate audit evidence about the operating effectiveness of relevant controls if (a) the auditor’s assessment of risks of material misstatement at the relevant assertion level includes an expectation that the controls are operating effectively or (b) substantive procedures alone do not provide sufficient appropriate audit evidence at the relevant assertion level. Examples of tests of controls the auditor may perform include the following:

  • Obtain and review the institution's written investment and asset/liability management policies (or other applicable policies relating to the management of federal funds and repo transactions), and consider whether such policies have been reviewed and approved by the institution's board of directors.
  • Obtain the institution's approved list of counterparties to agreements, and compare the list with those dealers with whom borrowing transactions were entered into during the current year. Ascertain that counterparty limits set by the board of directors have not been exceeded.
  • Review selected transactions to consider whether all significant terms were specified and documented and whether the amounts and terms were consistent with those established by the institution's formal investment and asset/liability management policies and subject to supervisory review.
  • Review supporting documentation for transactions, and consider whether only authorized individuals entered into or otherwise executed those transactions on behalf of the institution and that these components of the transactions were appropriately reviewed by supervisory personnel.
  • Review management’s control over the appropriateness of the accounting for repo transactions, including the determination of sale or secured borrowing treatment, application of netting, recording the difference between the selling price and repurchase price as interest expense and determining whether interest expense is properly recorded on other borrowings, such as federal funds purchased. Obtain evidence that supervisory personnel reviewed the recording of the transaction.10
  • Review the latest audited financial statements of the counterparties and other available reports, such as reports on internal control or special-purpose reports by the dealer's accountant, to determine whether the dealer has net capital in excess of statutory requirements.

14.58 If there is reason to question the creditworthiness of the counterparty, the auditor might consult with legal counsel regarding whether, in the event of the counterparty's inability to return (sell back) the collateral securities, the institution has the right to set off the loan liability against the collateral.

Substantive Tests

14.59 Irrespective of the assessed risks of material misstatement, paragraph .18 of AU-C section 330 states that the auditor should design and perform substantive procedures for all relevant assertions related to each material class of transactions, account balance, and disclosure. In accordance with paragraph .A45 of AU-C section 330, this requirement reflects the facts that (a) the auditor’s assessment of risk is judgmental and may not identify all risks of material misstatement and (b) inherent limitations to internal control exist, including management override.

14.60 Inspection of repo or other documentation of borrowing. Repos and other source documents may be inspected by the auditor and relevant details may be agreed upon concerning the respective recording of the liability in the subsidiary records. The auditor should test that securities collateralizing the borrowing are adequately identified to ensure proper disclosure and that the amounts and description should agree to the respective subsidiary ledger, and that when such securities are sold or re-hypothecated, a liability to return them is recorded by the original buyer-lender. The auditor should also examine the underlying contracts and (a) assess whether the criteria for offsetting assets and liabilities have been met (in cases where netting has been applied) and (b) identify any default provisions and determine whether any events of default have occurred and whether any liabilities require accrual as a result of the event of default.

14.61 Confirmation. Paragraph .A8 of AU-C section 500, Audit Evidence (AICPA, Professional Standards), states that corroborating information obtained from a source independent of the entity may increase the assurance that the auditor obtains from audit evidence that is generated internally, such as evidence existing within the accounting records, minutes of meetings, or a management representation. The auditor could consider confirming the amount and all significant terms of federal funds transactions and repos with the respective securities dealers, customers, and institutions. Details of any rollovers or extensions of repos should be agreed to brokers' advices. Confirming the repo transactions provides evidence of the occurrence of the transactions, their terms, and the treatment of the underlying securities, for example, evidence that the securities were delivered to the counterparty. Confirmation does not provide evidence about the existence, location, or transferability of the securities or about the counterparty's ability to complete the transactions. It is usually impracticable to confirm the location of the securities delivered to the counterparty as collateral. The counterparty often is not able to determine the exact location of the securities delivered because they are fungible with other securities of the same issue under the dealer's control and are commingled with those securities. In addition, the counterparty may have appropriately used the securities for collateral in another repo or dollar roll in which the counterparty sold the securities to be repurchased at a later date. The seller-borrower and its auditor need not necessarily be concerned, however, about the location of securities transferred to the counterparty as collateral because their location does not necessarily affect the risk that the counterparty may not complete the transactions.

14.62 The auditor should consider the need to assess the counterparty's ability to complete the transaction by performing other procedures, such as testing the subsequent completion of the transaction for transactions that are completed after period-end but before the issuance of the financial statements, reviewing audited financial statements of the counterparty, considering the regulatory requirements applicable to the counterparty, and, if necessary, obtaining a special-purpose report from the counterparty's auditor.

14.63 Auditing interests in trusts held by a third-party trustee and reported at fair value. In circumstances in which the auditor determines that the nature and extent of auditing procedures should include verifying the existence and testing the measurement of investments held by a trust simply receiving a confirmation from the trustee, either in aggregate or on an investment by investment basis, does not in and of itself constitute adequate audit evidence with respect to the requirements for auditing the fair value of the interest in trust under AU-C section 540, Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures (AICPA, Professional Standards). In addition, receiving conformation from the trustee for investments in aggregate does not constitute adequate audit evidence with respect to the existence assertion. Receiving confirmation from the trustee on an investment-by-investment basis, however, typically would constitute adequate audit evidence with respect to the existence assertion. Also, in discussing obtaining an understanding of how management identifies the need for accounting estimates, paragraph .A15 of AU-C section 540 states that the preparation and fair presentation of the financial statements requires management to determine whether a transaction, an event, or a condition gives rise to the need to make an accounting estimate and that all necessary accounting estimates have been recognized, measured, and disclosed in the financial statements in accordance with the applicable financial reporting framework.

14.64 In circumstances in which the auditor is unable to audit the existence or measurement of interests in trusts at the financial statement date, the auditor should consider whether that scope limitation requires the auditor to either qualify his or her opinion or to disclaim an opinion, as discussed in AU-C section 705, Modifications to the Opinion in the Independent Auditor’s Report (AICPA, Professional Standards).

14.65 Review of related-party transactions. The auditor might consider reviewing borrowing transactions involving related parties that have been accounted for as sales transactions to determine whether there are potential unrecorded financing transactions. A review of transaction activity may indicate that an event accounted for as two separate transactions (a sale and subsequent purchase) is in fact a repo that should be accounted for as a financing. The auditor might consider the possibility of related party transactions that are improperly accounted for, possibly to avoid recognizing losses on sales.

14.66 Assess collateral risk. The auditor may assess the collateral risk through consideration of the counterparty's reputation, financial position, and market presence. The auditor may consider reviewing the fair values, including accrued interest, of securities serving as collateral and consider whether the collateral is sufficient or excessive in relation to the requirements of the agreement. The auditor might assess whether those securities repurchased under repos meet the substantially-the-same criteria for financing transactions or whether a gain or loss should have been recorded under a sales transaction. The auditor may test whether collateral held is properly recognized on the balance sheet in accordance with FASB ASC 860. Under FASB ASC 860-30-25-5(c), if the obligor (transferor) defaults under the terms of the secured contract and is no longer entitled to redeem the pledged asset, it should derecognize the pledged asset as required by FASB ASC 860-30-40-1 and the secured party (transferee) should recognize the collateral as its asset.

14.67 Analytical procedures. Chapters 7 and 15 of this guide discuss analytical procedures that may also be applied in this area.

14.68 Tests of fair value disclosures. AU-C section 540 addresses the auditor’s responsibilities relating to accounting estimates, including fair value accounting estimates and related disclosures, in an audit of financial statements. Specifically, it expands on how AU-C section 315, AU-C section 330, and other relevant AU-C sections are to be applied with regard to accounting estimates. It also includes requirements and guidance related to misstatements of individual accounting estimates and indicators of possible management bias. AU-C section 501, Audit Evidence—Specific Considerations for Selected Items (AICPA, Professional Standards), addresses specific considerations by the auditor in obtaining sufficient appropriate audit evidence, in accordance with AU-C sections 330, AU-C section 500, and other relevant AU-C sections, regarding certain aspects of (a) investments in securities and derivative instruments; (b) inventory; (c) litigation, claims, and assessments involving the entity; and (d) segment information in an audit of financial statements.

Considerations for Audits Performed in Accordance With PCAOB Standards

The second note to paragraph .A5 of AS 2201, An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements (AICPA, PCAOB Standards and Related Rules), discusses the inherent limitations of internal control. Because fair value determinations often involve subjective judgments by management, this may affect the nature of controls that are capable of being implemented, including the possibility of management override of controls. The auditor considers the inherent limitations of internal control in such circumstances in assessing control risk.

Paragraph .47 of AS 2502, Auditing Fair Value Measurements and Disclosures (AICPA, PCAOB Standards and Related Rules), states that the auditor should evaluate the sufficiency and competence of the audit evidence obtained from auditing fair value measurements and disclosures as well as the consistency of that evidence with other audit evidence obtained and evaluated during the audit. The auditor’s evaluation of whether the fair value measurements and disclosures in the financial statements are in conformity with U.S. generally accepted accounting principles is performed in the context of the financial statements taken as a whole (see paragraphs .12–.18 and .24–.27 of AS 2810, Evaluating Audit Results [AICPA, PCAOB Standards and Related Rules]).

14.69 Other procedures. Other audit procedures related to repos that the auditor may consider performing are as follows:

  • Read the board of directors' minutes to determine whether financing transactions have been authorized.
  • Test whether approved securities dealers are used, and whether financing arrangements comply with the institution's established policies.
  • Recompute gains or losses on reverse repos that are accounted for as sales on a test basis.

Notes

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