Amid the consternation and finger wagging over Lehman Brothers Holdings Inc.'s creative use of the now-infamous Repo 105 accounting rule to hide risk on its balance sheet, one wonders: Why is the rule there in the first place?

The question, in fact, reveals fundamental tensions inherent in accounting regulation: Should it be based on specific rules or on broad principles? The Repo 105 controversy suggests too strict an adherence to bright-line rules may have encouraged behavior such as Lehman's, which, while not technically illegal, served only to obscure the reality of the firm's financial situation.

Repo 105 refers to the accounting treatment that allowed Lehman in late 2007 and 2008 to temporarily remove billions of dollars from its balance sheet by using repurchase agreements, a short-term financing technique in which a borrower "sells" collateral to a lender and promises to buy it back later. Repos are normally accounted for as liabilities of the borrower, but Lehman used Repo 105 to characterize its borrowing as a sale. That allowed it to reduce its balance sheet by jettisoning assets on paper and using the money it received to repay short-term debt. All this was done just in time to report earnings and conveniently reversed afterward.

The firm was able to do this by exploiting a loophole in the Financial Accounting Standards Board's Statement 140, passed in September 2000, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities." That rule itself was an updating of FAS 125, passed in 1996, which attempted to codify accounting for repo agreements.

FAS 140 says repo agreements can be counted as sales if the transferrer of collateral cedes control of the assets to the lender. It notes that a borrower relinquishes control when the money it gets in return doesn't equal the value of the assets. The last part of the rule is the key. According to Robert Willens, president of Robert Willens LLC, overcollateralized deals are deemed sales because FASB feels that, past a certain level, the borrower will not have enough money to repurchase "substantially all" of the collateral.

It's similar to a cash-strapped person leaving his camera with a pawnbroker, receiving a pittance in return and trying to buy the camera back at full value. "The deal is not a good deal for the transferrer by any stretch of the imagination," Willens says.

But why set the line at assets worth 105% more than the cash received in return? According to FASB, repo collateralization between 98% and 102% of the borrowed amount allows the borrower a chance to buy back the collateral, taking into account market fluctuations, meaning it retains control over the assets. "The Board believes that other collateral arrangements typically fall well outside that guideline," says paragraph 218 in the 140 rule.

Given that delineation, Lehman decided that a 105% overcollateralization could be counted as a true sale. Says Willlens, "It's an arbitrary rule."

Arguably, the simple fact that FASB set a bright line acted as an invitation to exploit it. Put another way, FAS 140 seems to officially sanction such treatment. "The only reason to have the rule is to give sale treatment to a borrowing," Willens says. He adds that Ernst & Young LLP, the auditor that signed off on Lehman's accounting, was acting "well within the accounting guidelines," which says something about the rule itself.

Willens argues that a better rule would force auditors and regulators to examine facts and context around repo agreements and take into account patterns that suggest a company is trying to dress up its balance sheet. Transparency and accuracy, in other words, should trump a specific rule.

Ironically, both FASB and its overseer, the Securities and Exchange Commission, have already recognized that principles-based accounting may better serve investors. Indeed, the SEC has been moving in that direction since 2003, when it released a report following the Enron Corp. scandal suggesting that rules-based accounting lends itself to abuse. FASB agreed wholeheartedly with that report in 2004, but it seems that the board still has a lot of work left to do to comply with those aspirations.

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