 Hello and welcome to this 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 going to 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 finished yet. Then we have an agreement on the side. I'm going to buy back the same inventory from you for $106. Therefore, what I will do, you will give me back that inventory and I'll give you back $106. So hold on a second. Why are we doing this? Why would I sell you something for $100, 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 to write 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 wasn't really a sale. What that was is a financing transaction. You're borrowing money, but the sky's in 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 2007, 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 on their books, bad investments, specifically bad investments in 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 in other 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 their worth 105, whatever their worth, it doesn't matter. Let's assume the worth 105 dollars, which is we're going to give, give it to you now and we need 100 dollars 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 5% extra for their 100 dollars. Then it looks like a sale because repo is as long as you are within 2%, 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 dollars, 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 dollars 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 Lehman accounted for the transaction. The other party, as far as their concern, they gave them a loan. The loan is collateralized and Lehman's going to buy back the bonds. 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, farhatlectures.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 Becker, 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, 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 Ryan company. This is not a sale. So the key, the trick is for whoever's 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%, which is that's the case you're going to see why. So 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%. Therefore, we're going to debit interest expense, $10,000, credit liability to Ryan, $10,000. Now, keep in mind, now we're going to 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 incur, I'm sorry, not 10, 11,000 and liability to Ryan will increase by 11,000. Why 11,000? Because we started the year with 110,000, then times 10%, that's going to give us 11,000 in interest. And now we're going to add another 10,000 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 four year zero, the interest four year one, 10,000 and 11,000. Thus the transaction is completed. It was a repo transaction. What should you do now? Go to my website, farhatlectures.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.