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hello and welcome to the session in which we will discuss repurchase agreements also known as repo or repo agreements what is a repurchase agreement a repurchase agreement simply put as the definition implies i'm gonna sell you something sell you let's assume a piece of inventory for 100 you're going to give me cash today so in return you're going to give me cash for 100 but the transaction is not is not finished yet then we have an agreement on the side i'm gonna buy back the same inventory from you for 106 dollars therefore what i will do you will i will you will give me back that inventory and i will give you back 106 dollars so hold on a second why are we doing this why would i sell you something for a hundred buy back at 106. well that's not really a sale what you are technically doing is borrowing money this is a finance transaction so why is this important it's important for revenue recognition we want to know whether the company is entering into a repo agreement or is this transaction a sale so the company transfer or sells an asset to a customer but they have an unconditional obligation or a right so they have to buy it back they have the right to buy it back or if they choose or they have an unconditional obligation they have to buy it back the asset at a later date if the amount of the repurchase is greater than or equal to the selling amount then that's not that wasn't really a sale what that was is a financing transaction you're borrowing money but disguising it as a sale so you cannot do that why is this important why this topic is important well if you know anything about the financial crisis of 2008 one of the companies that went bankrupt and basically almost brought the whole market with it is a company called an investment firm called lehman brothers so what did lehman brothers do lehman brothers sold and quote sold their bad investments before they issued their financial statements through repo agreement what does that mean well here's what they did so lehman had hondur books bad investments specifically bad investments and bonds and those bonds that are backed up by mortgage-backed securities so what happened is this right before the end of the year they wanted to make those investment disappear so when the auditor value the company when the auditor you know look at their financial assets those assets don't even exist so what they did they found a counterparty another bank and they told the bank look we're going to give you for example billions worth of those bonds so we're going to give you our bonds as an investment and they're worth 105 whatever they're worth it doesn't matter let's assume they're worth 105 dollars we're just we're going to give give it to you now and we need 100 in cash but what but what lehman did lehman find out if they over collateralize simply put what does that mean it means they are giving them five percent extra for their 100 then it looks like a sale because repo is as long as you are within two percent it's a repo agreement now what they did lehman kind of find this loophole and said okay take our bonds and give us 100. let's assume 105 million give us 100 million now the other party doesn't care because the other party has an agreement that lehman's going to have to give them back 105 or 105 million so as far as this party is concerned the counterparty is that's a loan for them however lehman record this as a sale this this party recorded it as a loan so why did lehman wanted to record it as a sale to get rid of those bonds so they are not valued then what happened two three months later or whatever the agreement is lehman will pay them back to 105 million or the 105 billion whatever that number is and the other party will give them back their bonds the other party doesn't care how even accounted for the transaction the other party as far as they're concerned they gave them a loan the loan is collateralized and lehman's gonna buy back the bond so this is why this is important in the real world because companies will try to disguise repo agreement as sales agreement so the best way to illustrate this from an accounting perspective is to work an example but before we work the example i would like to remind you whether you are an accounting student or a cpa candidate to take a look at my website thorhatlectures.com i don't replace your cpa review course i don't replace your accounting course i'm a useful addition a useful supplement for your accounting courses as well as your cpa this is a list of all my accounting courses organized by chapter topics i provide lectures multiple choice through false exercises for most courses my cpa material is aligned with your backer roger wiley gleam miles or whatever cpa review course you are taking if you have not connected with me on linkedin please do so take a look at my linkedin recommendation like this recording it helps me tremendously share it with other connect with me on instagram facebook twitter and reddit as i said the best way is to look at an example let's assume adam company transfer a piece of equipment that they have that they're not using on january 1st 20x0 to ryan company for 100 000. and adam agrees to repurchase this piece of equipment on december 31st 20x1 for a price of 121 000. we have to be very careful what happened here adam transfers it well but they're going to buy it back for 121 000. that's not really a sale now if adam wants to cook their books they will consider this as a sale but this is not really a sale therefore we're going to debit cash 100 000 credit liability to ryan company 100 000. for now we have a liability to run company this is not a sale so the key the trick is for for whoever's uh whoever's uh cooking the books consider this as a sale which is not a sale now we're going to assume for this transaction the implied interest rate is 10 percent which is that's the case you're going to see why so at the end of at the end of year x0 a year later into the deal well we have a loan and the loan will incur interest and the interest is 10 percent therefore we're going to debit interest expense 10 000 credit liability to ryan ten thousand dollar now keep in mind now we're gonna kind of keep track of this liability it started at 100 000 a year later we added 10 000 to it then at the end of december 31st 20x1 again now we're going to record another interest expense of 11 000 and liability to ryan it's going to inc i'm sorry not 10 11 000 and liability trying will increase by 11 000. why 11 thousand because we started the year with one hundred and ten thousand then times ten percent that's going to give us eleven thousand in interest and now we're going to add another ten 000 to the liability now the liability is worth 121 000 now we are ready to pay off the liability we debit the liability 121 000 to get rid of it and we pay cash 121 000 which is the original amount the interest for year zero the interest for year one ten thousand and eleven thousand thus the transaction is completed it was a repo transaction what should you do now go to my website for hat lectures dot com work additional multiple choice questions look at additional resources as an accounting student you want to invest in your education you want to invest in your professional certification it will pay off dividend down the road good luck study hard and of course stay safe