Repo Transactions Securities

Makeup Case ESM-17 Q. During the ESM congressional hearings, the auditor’s of ESM’s major customers were questioned regarding the confirmation procedures they used for their client’s transactions with ESM. What would be the key objective or objectives of an auditor’s confirmation procedures when a client has engaged in (a) repo transactions with a government securities broker and (b) reverse repo transactions with a government securities broker? What types of procedures would be used in auditing repo and reverse repo transactions? A. As an introduction, I would first like to define the term “repo transaction”. A repurchase agreement, or repo, can be described as a contract between a financial institution and an investor in which securities are sold and promised to be repurchased on a later specified date for a specified price. The transaction may be for either investing or financing depending on which side of the transaction is participated in. A repurchase agreement is made when a financial institution (the seller-borrower) that sells the securities to an investor (the buyer-lender) and subsequently agrees to repurchase the securities back at the later specified date at the specified price. A reverse repurchase agreement is exactly the same thing, except from the opposite point of view. A reverse repo would from the buyer’s viewpoint instead of the seller’s. In the preceding example, the investor would be considered to have made a reverse repo agreement, agreeing to purchase and subsequently sell the securities back at the later specified date at the specified price. Most repo agreements involve federal government securities such as Treasury bills and bonds, but may also be corporate or municipal obligations as well. Repo agreements are similar in arrangement to secured loans in that the buyer receives the securities as collateral to protect the buyer from default by the seller.

The difference between the selling price and the repurchase price represents the financial institution’s interest for the use of investor’s capital. Although legal title passes from the seller to the buyer, coupon payments are paid directly to the seller even though the ownership of the securities rests with the buyer. Most repo agreements are between other depository institutions, brokers/dealers of securities, governments and retail customers. Maturities of repo agreements range from one day (overnight), short-term (up to 270 days), long-term (two years) or can be open-ended (no maturity date). The securities involved in the repo agreement can be physically delivered, placed with a third-party custodian, or retained (held) by the seller. When planning an audit of a client involved in repo agreements, the auditor should obtain reasonable assurance that focuses on balance-related audit objectives. When the client enters into a repo agreement, selling the securities and promising to repurchase them, at a later date this creates a liability. The dominant balance-related audit objective in this case would be to check for completeness.

Completeness involves checking that all of the amounts that should be included have in fact been included. The point here is to be sure that the client has recorded (included) all the appropriate amounts for the liability.

The incentive for the client is to leave the liability off of the books. If the client enters into a reverse repo agreement, purchasing the securities and agreeing to resell them at a later date, an asset is created. The dominant balance-related audit objective in this case would be to check for existence. Existence involves checking to see if the amounts should actually be included. Key to this objective would be to be sure the client actually possesses the securities to be resold in their inventory.

The incentive of the client is to create an asset that does not exist. An example of completeness and existence related to repo agreements is to obtain reasonable assurance that the repos and reverse repos are properly identified, described, and disclosed; include all agreements; and are stated at appropriate amounts. Another example of existence is the securities purchased under reverse repos exist and are either on hand or are held in custody for the institution. Accuracy should also be considered by the auditor. Accuracy involves making sure that all included amounts are arithmetically correct. An example involving repo agreements would be to obtain reasonable assurance that interest expense or income and related balance sheet accounts are properly measured and recorded. Another example of accuracy would be the values at which the securities are reported are appropriate. Another balance-related audit objective that the auditor must consider is classification. Classification involves determining whether the accounts contain the correct items so that they can be appropriately presented and disclosed. An example related to repo agreements would be to obtain reasonable assurance that repos accounted for as secured borrowings meet the criteria for secured borrowings, including the condition that the assets to be repurchased are the same as sold. Rights and obligations should be considered by the auditor.

Rights involve making sure that the assets are legally owned before they can be included. Obligations deal with liabilities and must belong to the institution. An example related to repo agreements would be to obtain reasonable assurance that the institution has legal title or other rights to ownership for all recorded securities. In addition to balance-related audit objectives, the auditor should also consider presentation and disclosure-related audit objectives. Occurrence and rights and obligations involves whether disclosed events have occurred and are the rights and obligations of the institution. Whether all required disclosures have been included deals with completeness.

Accuracy and valuation refers to whether the financial information is fairly presented and at appropriate amounts. Whether the financial statements and footnotes contain amounts that are appropriately classified, and whether the balance descriptions and related disclosures are understandable involves classification and understandability. Examples of these presentation and disclosure-related audit objectives are that repo agreements have been executed and are obligations of the institution, assets pledged as collateral for repo agreements are properly disclosed in the financial statements, recorded amounts include assets owned by the institution and the financial statements include all transactions for the period, and securities involved in repo agreements are properly described and related footnote disclosures are accurate. In determining the auditing procedures to be used in auditing repo agreements, the auditor should accumulate the appropriate audit evidence. The auditor should examine any repo agreement documentation. Documents should be reviewed and the respective recording of the liability should be agreed to. The securities put up as collateral should be tested to determine if they are adequately identified and properly disclosed, and the descriptions and amounts match those in the subsidiary ledger. The auditor should seek confirmations regarding the amount and terms of all repo agreements with the respective securities dealers, investors, and institutions.

The confirmations serve to provide evidence on their occurrence, terms, and the treatment of the securities, whether delivered to the buyer, held by a custodian, or retained by the seller. It should be noted that it is often impractical to determine the existence or location of securities that are delivered to the buyer. This does not indicate that the buyer will not be able to complete the transaction and should not concern the auditor.

The auditor should however consider using addition procedures to assess the ability of the buyer to complete the transaction by reviewing the audited financial statements of the buyer, considering any regulatory requirements, and obtaining a report from the independent accountant of the buyer. The auditor should also review related party transactions. The review should review transactions recorded as sales transactions to determine potential unrecorded transactions. The review may find that a transaction involving a sale and a repurchase was in fact a repo and should be accounted for as financing. The auditor should be aware of transactions that are improperly recorded. The auditor should assess collateral risk.

The reputation, financial condition and market presence of the buyer should be considered. The current market value of the collateral should be reviewed to determine if the collateral is sufficient in relation to the agreement. The auditor should also assess whether the repo agreement fits the criteria for a financing or sales transaction. The auditor should also test fair value disclosures. Quoted market prices or prevailing interest rates of the same or similar securities should be considered to evaluate if the estimates are reasonable. Some additional procedures an auditor could use are a review of the board of director’s minutes, testing whether approved securities dealers were used, and recomputation of gains or losses on reverse repo agreements.  

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