Repurchase agreement accounting example: Understanding the basics of repos
Repurchase agreements, commonly known as repos, are financial transactions that allow two parties to engage in a short-term borrowing/lending arrangement with a security as collateral. The basic mechanism of a repo involves the sale of a security by one party to another with an agreement to repurchase the same security at a predetermined price and time.
Repos are widely used by dealers, banks, and other financial institutions for short-term liquidity management and investment purposes. As an essential part of the financial market, repo transactions have specific accounting treatment that reflects the nature of the transaction and the risks involved.
In this article, we will explain the basics of repo accounting with an example to help you understand the key concepts.
Example of a repurchase agreement accounting entry
Let`s assume that Company A, a dealer, enters into a repo transaction with Company B, a bank. The terms of the repo are as follows:
– Company A sells $10,000 worth of Treasury bills to Company B with an agreement to repurchase at a price of $10,100 in two weeks.
– Company A pays interest of 3% per annum to Company B on the $10,000 amount for the two-week period.
To record this repo transaction, the following accounting entries will be made:
On the trade date (Day 1):
Company A:
– Debit – Cash $10,000
– Credit – Securities sold under repo $10,000
Company B:
– Debit – Securities purchased under repo $10,000
– Credit – Cash $10,000
On the repurchase date (Day 14):
Company A:
– Debit – Securities sold under repo $10,000
– Credit – Cash $10,100
– Credit – Interest expense $25 ($10,000 x 3% x 14/360)
Company B:
– Debit – Cash $10,100
– Credit – Securities purchased under repo $10,000
– Credit – Interest income $25
Explanation of the accounting entries
On Day 1, the repo transaction is recorded as a sale of Treasury bills by Company A and a purchase of the same securities by Company B. The cash received by Company A is debited and credited to securities sold under repo account, reflecting the economic substance of the transaction. Company B records the securities purchased under repo as an asset and the cash paid as a liability.
On Day 14, when the repo matures, Company A repurchases the Treasury bills from Company B, paying $10,100, which represents the original amount plus interest at 3% per annum for 14 days. The securities sold under repo account is reduced, and the cash and interest expense accounts are credited. Company B records the cash received, securities sold, and interest income.
The interest expense and income are computed using the simple interest formula, where Interest = Principal x Rate x Time. In this example, the interest for the two-week repo is $25 ($10,000 x 3% x 14/360), which is prorated based on the number of days in the repo period.
Conclusion
Repurchase agreements are important financial instruments that help market participants manage their short-term cash needs and investments. Understanding the accounting treatment of repos is crucial for financial reporting and risk management purposes. By following the example presented in this article, you can gain a clear insight into the key concepts of repo accounting and apply them in your business practices.