Answered You can hire a professional tutor to get the answer.

QUESTION

Lehman on the Brink of Bankruptcy: A Case about Aggressive Application of Accounting Standards Dennis H. Caplan, Saurav K. Dutta, and David J....

Lehman on the Brink of Bankruptcy:

A Case about Aggressive Application of

Accounting Standards

Dennis H. Caplan, Saurav K. Dutta, and David J. Marcinko

ABSTRACT:

In September 2008, Lehman became the largest company in U.S. history

to file for bankruptcy. Nine months earlier, Lehman had reported record revenue and

earnings for 2007, and had started the year with a market capitalization of over $30

billion. Lehman's precipitous fall has been attributed to a high-risk business strategy and

to aggressive interpretation of accounting rules. Lehman was both a victim of—and an

important contributor to—the worst U.S. economic recession since the Great

Depression, and the firm's accounting choices warrant scrutiny.

This case is structured around collateralized short-term borrowings, commonly used

by financial institutions, called repurchase agreements. Lehman modified the terms of

the standard agreement and used an aggressive interpretation of SFAS No. 140 to

account for these modified agreements as a sale of the collateral. These transactions,

called Repo 105s, affected the firm's reported financial position. The case requires

students to evaluate those effects, interpret financial ratios, critically read authoritative

accounting literature, and consider important questions about auditors' responsibilities.

Key issues include the relative merits of principles-based versus rules-based accounting

standards, corporate governance, ethics, materiality, and whistleblowing.

Keywords:

Lehman; Repo 105; collateralized borrowings; SFAS No. 140; financial

leverage.

INTRODUCTION

L

ehman Brothers was founded in the mid-19th century as a cotton trading company. The

latest entity (Lehman Brothers Holdings Inc.) emerged from a spin-off from American

Express in 1994. This company grew quickly, and for fiscal year 2007, the company

reported record income of over $4 billion on revenue of over $60 billion. In early 2008, Lehman's

stock was trading in the mid-sixties with a market capitalization of over $30 billion. Over the next

eight months, Lehman's stock lost 95 percent of its value and was trading around $4 by September

Dennis H. Caplan is an Assistant Professor and Saurav K. Dutta is an Associate Professor, both at the

University at Albany, SUNY; David J. Marcinko is an Associate Professor at Skidmore College

.

We thank the editor, associate editor, and two reviewers for their helpful insights, comments, and suggestions. We also

acknowledge Wesley R. Bricker for his helpful comments, and our accounting students, who completed the case and

provided us valuable feedback.

Published Online: January 2012

441

12, 2008. Three days later, Lehman filed for bankruptcy protection. By some measures, Lehman

was the largest company to fail in U.S. history.

In March 2010, Lehman's bankruptcy examiner, Anton Valukas, issued a 2,200-page report

that outlined the reasons for the Lehman bankruptcy (

Valukas 2010

). The Examiner's Report also

provides insight into how Lehman's deteriorating financial position led to allegedly misleading

financial reporting practices, including a type of collateralized short-term borrowing arrangement

that Lehman dubbed

''

Repo 105.

''

The Examiner's Report includes interviews with key Lehman

personnel and provides accounting students a rare

''

inside

''

look at the mechanics and dynamics of

aggressive accounting practices when carried out by a large and sophisticated company. In

December 2010, the Attorney General for the State of New York filed a lawsuit against Lehman's

auditors, Ernst & Young LLP (hereafter, E&Y).

1

In April 2011, Valukas testified before a

subcommittee of the U.S. Senate Committee on Banking, Housing, and Urban Affairs, in a hearing

on the role of the accounting profession in preventing another financial crisis (

Valukas 2011

). This

case summarizes information from these sources and requires students to address questions of fact,

as well as conceptual issues.

COMPANYBACKGROUND

Originally, Lehman's business model was that of a brokerage firm and underwriter. In that role,

Lehman acted as an agent, marketing securities and acquiring assets on behalf of third parties. In

2006, Lehman's management and Board of Directors decided to increase the firm's risk profile and

pursue a higher growth strategy. Thereafter, Lehman acquired assets for its own investments, hence,

internalizing the risk and returns of those investments. That is, Lehman transformed itself from a

''

moving

''

business, in which it held securities only for a short time period, to a

''

storage

''

business,

in which it managed securities over a much longer period (

Valukas 2010,

Volume 1, p. 43).

According to a senior Lehman executive, the company pursued an aggressive 13 percent

growth rate in revenues (

Valukas 2010,

Volume 1, pp. 61-62). This business strategy was high-risk

in light of Lehman's low equity and high leverage. The increased risk was borne by Lehman's

investment in long-term assets, primarily commercial real estate, leveraged loans, and illiquid

private equity with high growth potential. When the subprime mortgage crisis hit the U.S. in 2006,

Lehman undertook an aggressive strategy of

''

doubling down,

''

rather than pulling back and

diversifying. By doing so, it violated its own internal controls on risk management. Lehman

increased its holdings in these long-term, illiquid, high-risk investments from $87 billion in 2006 to

$175 billion at the end of the first quarter of 2008 (

Valukas 2010,

Volume 1, p. 57). These newer

investments increased Lehman's business risk in several ways. First, these assets were difficult to

liquidate in an economic downturn, primarily because a ready market did not exist and they could

only be sold at steep losses. Second, many lenders steeply discount the collateral value of illiquid

assets, making them less valuable as collateral against borrowings. Finally, there was no feasible

way to hedge these assets.

In order to finance these long-term investments, Lehman needed to borrow billions of dollars.

In late 2007, the company held assets of $700 billion on equity of $25 billion, with $675 billion of

liabilities, most of which were short-term. The mismatch between short-term debt and long-term

illiquid investments required Lehman to continuously roll over its debt, which increased the firm's

business risk. In fact, Lehman borrowed tens of billions of dollars on a daily basis (

Valukas 2010,

Volume 3, p. 751). Market confidence in a company's viability and debt-servicing ability is critical

1

Acopyofthelawsuitisavailableat:

http://www.ag.ny.go

v/media_center/2010/dec/

ErnstYoungComplaint.pdf

E&Y's response to the lawsuit is available at:

htt

p://www.ey.com/US/en/Newsroom/News-releases/

Ernst—Young-Response-to-New-York-Attorney-General-Complaint

442

Caplan, Dutta, and Marcinko

Issues in Accounting Education

Volume 27, No. 2, 2012

for the company to access funds of this magnitude. It was imperative for Lehman to maintain good

credit ratings from agencies such as Moody's and Standard & Poor's.

As economic conditions worsened and markets further declined in 2007-2008, Lehman's

strategy proved to be a failure. Lehman had no choice but to reduce its exposure and leverage. The

more highly leveraged a company is, the more important it is for the company to act quickly when

market conditions turn against it. However, Lehman had difficulty selling its illiquid assets and,

therefore, was unable to reduce its leverage rapidly through market transactions. Lehman could only

offload assets at a steep loss, which would have a double-negative impact. First, recognizing losses

on the sale of these assets would reduce equity. Second, the market's perception of the quality and

value of Lehman's remaining assets would be negatively affected, making it more difficult for

Lehman to borrow needed funds at a feasible cost.

In response to these difficulties, Lehman developed and engaged in repurchase agreement

transactions that the company called

''

Repo 105

''

transactions. These transactions helped Lehman

improve its reported leverage ratios.

REPURCHASEAGREEMENTS

Sale and repurchase agreements (repos) are commonly used by financial companies to finance

their security position by transferring securities as collateral for short-term borrowings of cash. The

transaction is completed in two phases. In the first phase, the borrower receives cash, records a

liability, and transfers custody of securities to the lender as collateral for the loan. In the second

phase, at a date determined up front, the company repays the borrowed amount with interest to the

lender and repossesses the securities. To reduce the risk borne by the lender, the amount of

securities transferred as collateral slightly exceeds the amount borrowed. This slight excess of the

amount of collateral over the amount borrowed is known as the

''

haircut.

''

Under Statement of

Financial Accounting Standards (SFAS) No. 140, the transaction described above would be

regarded as a secured borrowing primarily because the borrower retains control over the securities

(Financial Accounting Standards Board

[FASB] 2000)

. The transaction would also be regarded as a

collateralized borrowing under International Accounting Standard (IAS) No. 39 (International

Accounting Standards Board

[IASB] 2003

).

2

As an example, if Lehman put up $1.02 million of

collateral to borrow $1 million and incurred $1,000 of interest expense, the journal entry would be

(all amounts in thousands):

Cash

$1,000

Collateralized Financing

$1,000

As a separate transaction, Lehman would use the cash it just borrowed to settle short-term

borrowings from other creditors. This transaction would be recorded as follows:

Short-Term Borrowings

$1,000

Cash

$1,000

The subsequent repayment would be recorded as:

Collateralized Financing

$1,000

Interest Expense

$1

Cash

$1,001

2

See paragraphs 9, 98, and 100 of SFAS No. 140, and paragraphs 20 and 21 of IAS No. 39.

Lehman on the Brink of Bankruptcy: A Case about Aggressive Application of Accounting Standards

443

Issues in Accounting Education

Volume 27, No. 2, 2012

The amount of collateral does not constitute a part of the journal entry, although total securities

pledged as collateral would normally require footnote disclosure.

For a portion of its repo transactions, Lehman modified the terms of a normal repurchase

agreement by taking a bigger haircut (i.e., the excess of securities collateralized over cash received).

While a typical haircut was about 2 percent for the period under discussion (and in the example

above), Lehman created agreements that took haircuts of 5 percent for fixed income securities and 8

percent for equity securities; hence, the terminology that Lehman used for these transactions: Repo

105 and Repo 108 (

Valukas 2010,

Volume 3, p. 732).

3

For example, if Lehman borrowed $1

million, the company would transfer either $1.05 million of fixed income securities or $1.08 million

of equity securities to the lender. By taking this larger haircut, Lehman characterized these

transactions as sales of securities in accordance with Lehman's interpretation of SFAS No. 140.

4

Instead of classifying these transferred securities as collateral for the loan, to be returned upon the

settlement of the loan, Lehman would record the transfer as a sale with an agreement to repurchase

on a specified date. As a separate transaction, Lehman would use the cash it just borrowed to settle

other liabilities. The borrowing phase of the Repo 105 transaction would be recorded as follows (all

amounts in thousands):

Cash

$1,000

Option to Repurchase

$50

Investment Securities

$1,050

Similar to the previous example, Lehman would use the cash it just received to settle short-term

borrowings from other creditors. This transaction would be recorded as follows:

Short-Term Borrowings

$1,000

Cash

$1,000

The repayment transaction would be recorded as:

Investment Securities

$1,050

Interest Expense

$1

Option to Repurchase

$50

Cash

$1,001

Lehman had vetted its interpretation of how to account for repurchase agreements under SFAS

No. 140 with E&Y prior to adopting a formal Repo 105 accounting policy (

Valukas 2010,

Volume

3, p. 765). Additionally, Lehman acquired an opinion letter supporting its accounting treatment of

Repo 105 transactions from Linklaters, a British law firm.

5

There were many similarities between a Repo 105 transaction and an ordinary repurchase

agreement. For instance, in ordinary repo transactions, the borrower typically continues to receive

3

In the Examiner's Report, the business press, and in this paper the term

''

Repo 105

''

often denotes Lehman's

combined Repo 105 and Repo 108 activity.

4

The relevant section of SFAS No. 140 includes paragraph 218.

5

Despite Lehman's sale of $1.05 million of securities

for $1 million cash, no gain or loss was recognized on the

transaction because at the time of the sale, Lehman ent

ered into a binding commitment to buy back those same

securities at a later date for $1 milli

on. Hence, even though Lehman would

''

sell

''

$1.05 million of securities for

$1 million with an apparent loss of

$0.05 million, the loss is offset by an

apparent $0.05 million gain on the

commitment to purch

ase the same $1.05 million of securities for $1

million (a derivative a

sset). Recognizing the

$0.05 million gain from the commitment exactly offs

ets the loss. See Lehman Brothers Holdings Inc.,

Accounting Policy Manual Repo 105 and Repo 108 (Sept. 9, 2006), pp. 7-8 [LBEX-DOCID 3213290], as

referenced in

Valukas (2010,

Volume 3, p. 776, footnote 2990).

444

Caplan, Dutta, and Marcinko

Issues in Accounting Education

Volume 27, No. 2, 2012

the income from coupon payments of the securities that were transferred to the lender as collateral.

Similarly, during the term of a Repo 105 transaction, Lehman continued to receive the stream of

income through coupon payments from the securities it transferred. Additionally, just as in an

ordinary repo transaction, Lehman was obligated to

''

repurchase

''

the transferred securities at a

specified date. Moreover, Lehman used the same documentation to execute both Repo 105 and

ordinary repo transactions, and these transactions were conducted with the same collateral

agreements and substantially with the same counter-parties (

Valukas 2010,

Volume 3, p. 746).

Repo 105 was a more expensive source of financing compared to ordinary repo agreements

because of the opportunity cost of the increased collateral, as well as transaction costs incurred by

channeling these transactions through Lehman's British subsidiary. Consequently, its usage was timed

around the end of reporting periods. The Examiner's Report analyzed the intra-quarter data on the usage

of Repo 105 and concluded that its usage spiked at quarter-ends and fell off on an intra-quarter basis.

The amount of Repo 105 activity at period-end from late 2007 to mid-2008 ranged from $39 billion to

$50 billion. Figure 1 is excerpted from the Examiner's Report (

Valukas 2010,

Volume 3, p. 875).

MATERIALITY AND LEVERAGE

The leverage ratio is a widely accepted measure of the additional risk placed on common

stockholders as a result of the decision to finance operations with debt. Lehman defined its leverage

ratio as assets (net of certain items) divided by equity. The items that were netted out in the

numerator of the leverage ratio were: cash and securities segregated and on deposit for regulatory or

other purposes, securities received as collateral, securities purchased under agreements to resell,

securities borrowed, and identifiable intangible assets and goodwill (

Valukas 2010,

Volume 3, p.

734).

The importance of the leverage ratio in analyzing Lehman's financial statements was widely

recognized. In fact, the Global Treasurer of Lehman remarked to the bankruptcy examiner that

''

ratings agencies were 'most interested and focused on leverage'

''

(as quoted in

Valukas 2011,

FIGURE 1

Repo 105 Usage

Lehman on the Brink of Bankruptcy: A Case about Aggressive Application of Accounting Standards

445

Issues in Accounting Education

Volume 27, No. 2, 2012

3-4). In addition, E&Y identified a separate materiality threshold specifically for leverage, defining

materiality as an amount that

''

moves

''

net leverage by a tenth of 1 percent. Table 1 shows data from

the Examiner's Report on the usage of Repo 105, and Lehman's reported leverage ratio (

Valukas

2010,

Volume 3, p. 748)

Despite their materiality threshold for leverage, E&Y's lead audit partner on the Lehman audit

team, William Schlich, told the bankruptcy examiner that E&Y did not have a

''

hard and fast rule

defining materiality in the balance sheet context

''

(

Valukas 2010,

Volume 3, p. 890). This assertion

is consistent with the independent auditor's professional standards, as promulgated by the Auditing

Standards Board (ASB) and the Public Company Accounting Oversight Board (PCAOB), which

generally avoid providing auditors specific quantitative benchmarks for materiality. Professional

standards state that the

''

auditor's consideration of materiality is a matter of professional judgment

and is influenced by his or her perception of the needs of a reasonable person who will rely on the

financial statements

''

(AU §312.10,

AICPA 2009

). The importance of considering the user's

perspective in determining what is material is underscored in the auditor's professional literature:

''

In all instances, the element or elements selected should reflect, in the auditor's judgment, the

measures most likely to be considered important by the financial statement users

''

(AU §9312.11,

AICPA 2009

). Also, qualitative factors should include the potential effect of the misstatement on

trends, and the potential effect on the entity's compliance with regulatory provisions (AU §9312.17,

AICPA 2009

).

Professional standards on materiality appear consistent with the prevailing view by the courts.

In 2011, in

Matrixx Initiatives, Inc. v. Siracusano

, 131 S. Ct. 1309, the U.S. Supreme Court

reaffirmed its commitment to a

''

reasonable person

''

standard in the assessment of materiality in the

context of financial reporting and disclosure. Matrixx, a pharmaceutical company, argued

unsuccessfully that evidence of adverse side effects caused by its cold remedy medication was

immaterial by virtue of the fact that the evidence failed to meet tests of statistical significance. The

Court characterized Matrixx's argument as an attempt to apply a

''

bright-line

''

definition of

materiality, and concluded that materiality cannot be reduced to a bright-line rule. The Court

reiterated its position from an earlier case that materiality is satisfied when there is a substantial

likelihood that the disclosure of the omitted fact would have been viewed by a reasonable investor

as significantly altering the

''

total mix

''

of information available.

In his Senate testimony, the Lehman bankruptcy examiner said that

''

existing rules require

analyses of

qualitative

materiality—particularly when management is trying to actively manage the

financial statements—and not just number-crunching, to determine if an issue is material

''

(

Valukas

2011,

13) (emphasis in the original). Valukas recommended that these rules need to be tightened or

enforced more aggressively, and that auditors must avoid the mindset of finding a way to describe

an issue as immaterial.

TABLE 1

Repo 105 Usage and Net Leverage

Date

Amount of

Repo 105 Usage

Reported

Net Leverage

a

Q4, 2007

$38.60 billion

16.1

Q1, 2008

$49.10 billion

15.4

Q2, 2008

$50.38 billion

12.1

a

As an example of the derivation of the net leverage ratio, refer to pp. 29-30 of Lehman Brothers Holdings Inc. Form

10-K for the fiscal year ended November 30, 2007.

446

Caplan, Dutta, and Marcinko

Issues in Accounting Education

Volume 27, No. 2, 2012

SUBSTANCE OVER FORM

According to professional standards, the objective of the independent auditor's report

''

is the

expression of an opinion on the fairness with which [the financial statements] present, in all material

respects, financial position, results of operations, and its cash flows in conformity with generally

accepted accounting principles

''

(AU §110.01,

AICPA 2009

). Generally accepted accounting

principles provide auditors a common, uniform framework with which to judge the

''

fairness

''

of

the audit client's financial statement presentation. Auditing standards adopted by the Public

Company Accounting Oversight Board for public company audits state that the auditor's judgment

should be based on whether, among other considerations, (1) the accounting principles selected and

applied have general acceptance, (2) the accounting principles are appropriate in the circumstances,

and (3) the financial statements, including the related notes, are informative of matters that may

affect their use, understanding, and interpretation (AU §411.04,

AICPA 2009

). Auditing standards

also state:

''

generally accepted accounting principles recognize the importance of reporting

transactions and events in accordance with their substance. The auditor should consider whether the

substance of transactions or events differs materially from their form

''

(AU §411.06,

AICPA 2009

).

Lehman personnel believed that by late 2007, none of Lehman's peer investment banks were

applying the same accounting treatment to Repo 105-type transactions (

Valukas 2010,

Volume 3, p.

739). Further, Lehman used a London law firm for the opinion letter supporting Lehman's Repo

105 accounting, and conducted its Repo 105 activity out of England. Finally, according to

Lehman's former Global Financial Controller, a careful review of Lehman's 10-K and 10-Q filings

would not reveal Lehman's use of Repo 105 transactions (

Valukas 2010,

Volume 3, pp. 734-735).

The lawsuit that the New York Attorney General filed against E&Y in December 2010 stresses

the role of substance over form in financial reporting, and also the auditor's responsibilities in

connection with financial statement audits. The lawsuit is premised on E&Y's implicit approval of

Lehman's accounting for Repo 105 transactions. It alleges that E&Y failed to meet Generally

Accepted Auditing Standards in their audits of Lehman's financial statements because:

E&Y failed to treat Repo 105 transactions as sufficiently unusual to warrant informing

Lehman's audit committee.

E&Y failed to conduct a

bona fide

investigation of Lehman's accounting for Repo 105

transactions, even though it was aware, or should have been aware, that Lehman's intended

use of its Repo 105 accounting policies was to manage balance sheet metrics without

changing the economic substance of the underlying repurchase agreements.

E&Y did not object when Lehman's management made false and misleading assertions

regarding Lehman's liquidity position in press releases, earnings calls, and in management's

discussion and analysis (MD&A) in Lehman's Form 10-K and Form 10-Q filings from 2001

through 2008.

THE WHISTLEBLOWER

In May 2008, Matthew Lee, a Senior Vice President in Lehman's Finance Division, submitted

a letter to senior Lehman management in which he alleged various financial reporting practices that

potentially violated Lehman's own code of ethics (

Valukas 2010,

Volume 3, p. 956). Section 301

of the Sarbanes-Oxley Act requires audit committees to establish procedures for the receipt,

retention, and treatment of complaints received by the company regarding accounting, internal

accounting controls, or auditing matters. Consequently, Lehman's audit committee identified and

treated Lee as a whistleblower. The audit committee instructed Lehman's internal audit group and

external auditors to investigate Lee's concerns.

Lehman on the Brink of Bankruptcy: A Case about Aggressive Application of Accounting Standards

447

Issues in Accounting Education

Volume 27, No. 2, 2012

Lee's letter contained six allegations, but did not refer to Lehman's Repo 105 activity. On June

12, E&Y's engagement partner and another member of the audit team interviewed Lee. The

auditor's notes of the interview indicate that Lee verbally informed E&Y that Lehman had used

Repo 105 transactions to remove $50 billion of inventory from its balance sheet for the quarter just

ended (the second quarter, ending May 31), and returned the inventory to its balance sheet

approximately one week later (

Valukas 2010,

Volume 3, p. 957). Lee could not have included this

specific allegation in his letter, because his letter preceded the quarter-end. However, the Repo 105

activity had been almost as high at the end of the prior quarter, and Lee could have, but chose not

to, include that matter in his letter.

On the day following this interview, E&Y met with Lehman's audit committee, but did not

inform the committee of Lee's allegations regarding the Repo 105 activity, even though the

chairman of the audit committee specifically instructed that every allegation by Lee, whether

contained in his letter or not, should be investigated (

Valukas 2010,

Volume 3, p. 959), and even

though Section 301 of the Sarbanes-Oxley Act imposes a general requirement that the external

auditors report directly to the audit committee. Also, E&Y did not discuss Lee's allegation about

the Repo 105 activity with Lehman's internal audit director, nor did E&Y discuss the Repo 105

activity with the audit committee when the auditors met with the committee in July to review

Lehman's second-quarter results. In his Senate testimony, the bankruptcy examiner commented that

''

Auditors must take seriously and fully analyze allegations of financial impropriety

''

(

Valukas

2011,

13). Valukas went on to comment that auditors

''

face intense pressures to conclude their

analyses quickly in order to allow financial statements to be released on time but have an important

responsibility to follow the facts wherever they may lead

''

(

Valukas 2011,

13).

CASE REQUIREMENTS

8. Lehman's senior management, internal auditors, and external auditors were alerted to the

use of Repo 105 transactions by a whistleblower. The resulting investigation does not

appear to have led to a serious reconsideration of the appropriateness of Lehman's

accounting for these transactions. What corporate governance measures can be instituted to

help prevent the issuance of misleading financial statements?

Show more
LEARN MORE EFFECTIVELY AND GET BETTER GRADES!
Ask a Question