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

Abstract

In September 2008, Lehman Brothers filed for bankruptcy, marking it as the largest company to do so in U.S. history. Prior to the bankruptcy, the firm reported record earnings and had a substantial market cap. This downfall has been attributed to risky business practices and aggressive accounting interpretations. Notably, Lehman's use of modified repurchase agreements, termed Repo 105s, significantly influenced reported financial results, leading to scrutiny of the firm's accounting practices and the responsibilities of auditors. Key issues explored include the benefits of principles-based vs. rules-based accounting, corporate governance, ethics, materiality, and whistleblowing.

Introduction

Lehman Brothers was established as a cotton trading company in the mid-19th century and evolved into a significant financial institution after its spin-off from American Express in 1994. By FY 2007, Lehman reported an income exceeding $4 billion and revenues over $60 billion. However, by September 2008, Lehman’s stock plummeted, leading to the bankruptcy filing just days later.

The bankruptcy examiner's report published in March 2010 detailed the reasons behind Lehman's collapse, highlighting problematic practices in financial reporting, notably the Repo 105 agreements used to mask financial health through aggressive accounting. The report serves as a learning tool for deepening student comprehension of accounting ethics and practices.

Company Background

Initially serving as a broker and underwriter, Lehman Brothers transitioned to taking on more risks by acquiring long-term investments, particularly in commercial real estate and illiquid private equity. This change was marked by a targeted growth strategy with a 13% revenue growth goal. However, as the subprime crisis unfolded in 2006, Lehman expanded its holdings in high-risk assets, leading to a significant increase in exposure from $87 billion in 2006 to $175 billion by early 2008. As such, Lehman’s financial risk increased due to illiquid assets, which were hard to sell during downturns and often resulted in steep losses.

In late 2007, Lehman maintained assets worth $700 billion against $25 billion in equity and liabilities of $675 billion, necessitating short-term debt borrowing and the perpetual rolling of debt amidst declining market conditions. The ability to sustain operations hinged on maintaining favorable credit ratings, which deteriorated as economic conditions worsened.

Repurchase Agreements

Repurchase agreements (repos) are utilized for financing by transferring assets as collateral to obtain cash. These agreements operate in two phases where a borrower provides securities as collateral for cash loans, which must later be repaid with interest. Typically, repurchase agreements are classified as secured borrowings under GAAP.

Repo 105 Strategy

Lehman Brothers innovatively classified transactions with larger haircuts (risk-reduction measures where collateral slightly exceeds the cash amount) as sales rather than as secured borrowings, thus enhancing reported financial metrics.

1. Repo 105 involved transferring $1.05 million in securities to secure a $1 million loan, marking a deviation from typical practices with an ordinary haircut (approx. 2%) to 5% or 8% for specific securities.

2. As a result, exchanges were recorded under SFAS No. 140 as sales rather than secured borrowings, misleading stakeholders about liquidity and financial health.

Accounting Entries

For Repo 105 transactions, the cash advanced and principal amount were recorded as follows (in thousands):

• Cash: $1,000

• Option to Repurchase: $50

• Investment Securities: $1,050
  Repayment transactions included cash and interest expenses as follows:

• Investment Securities: $1,050

• Interest Expense: $1

• Cash: $1,001
  No earnings impacts were recognized because the losses on sales were offset by gains anticipated under the repurchase agreements, resulting in a misreported financial position.

Materiality and Leverage

Lehman’s leverage ratio, a crucial metric indicating risk taken against equity, was defined as total assets against equity, netting out specific items such as cash and segregated securities. Audit partners noted the significant focus of external auditors on leverage metrics.

Example of Repo 105 Usage and Leverage Impact

The leverage ratio dramatically influenced the reported financial state of Lehman, which experienced variances in the ratio due to the use of Repo 105 transactions extensively at year-end reporting.

Substance Over Form

The notion of substance over form emphasized in auditing standards requires auditors to ensure that the financial statements and disclosures genuinely reflect the company's operational activities. Lehman's unique accounting treatment for Repo 105 transactions was criticized for lacking transparency.

Auditor's Oversight

The New York Attorney General’s lawsuit against Ernst & Young (E&Y), Lehman’s auditors, highlighted failures in recognizing the unusual nature of Repo 105 transactions, lack of scrutiny in auditing processes, and insufficient reporting on Lehman's questionable financial health.

The Whistleblower

Matthew Lee, a Senior Vice President, reported irregularities internally, triggering an investigation that failed to address specific allegations of Repo 105 activities. Despite revealing significant findings in interviews, the lack of communication and follow-up regarding these allegations pointed to systemic issues within auditing and corporate governance processes.

Case Requirements

The case raises several key inquiries:

1. Distinguish between the underwriter/brokerage model and the investment model, identifying inherent risks.

2. Assess the relationship between leverage and risk, emphasizing the need for rapid action during downturns.

3. Compare the accounting between ordinary repos and Repo 105 transactions, redefining implications on financial statements.

4. Analyze Lehman's trends against other financial institutions highlighting risk management and performance.

5. Discuss if Repo 105 transactions fit within GAAP and reveal economic distinctions from ordinary repos.

6. Evaluate the effectiveness of rules-based versus principles-based accounting frameworks in relation to auditor oversight.

7. Propose enhanced regulatory disclosures to prevent misrepresentation and assess costs versus benefits.

8. Discuss reforms in corporate governance to enhance the credibility of financial statements post-whistleblowing.

9. Reflect on whether the uptick in Repo 105 transactions should have informed E&Y's audit risk assessments.

10. Inquire about E&Y's responsibilities beyond numerical verification in financial reporting.

Educational Implementation

The case is designed for advanced accounting students, prioritizing an understanding of the dynamics involved in financial reporting choices, corporate governance roles, and the intricacies of ethical accounting practices. It emphasizes real-world implications through interactive discussions based on students' analyses of Lehman's case, urging them to engage critically with financial data and business ethics.