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Lehman Brothers Holdings, Inc Accounting 6355 Seminar in Auditing Standards and Application

Written Case Analysis

Synopsis

The story of Lehman Brothers starts back to 1844 when a 23 year old Henry Lehman immigrated to the United States from Bavaria. He decided to settle in Montgomery Alabama where he opened a retail store. In 1847 another of three brothers arrived and by 1850 the third one came. King Cotton had a high market value and seeing a market for this; the 3 brothers started to accept payment in cotton for goods and also created a secondary market for trading in cotton. Seeing the need to be closer to the liquid market of cotton in New York the firm relocated to New York in 1858. In 1870, the Lehman brothers made the New York City office the headquarters of their business. Later in nineteenth century, Lehman brothers expanded their business to include trading of other commodities, and joined the Coffee Exchange and also the New York Stock Exchange. In early years of twentieth century, Lehman brothers focused on investment banking. During the same time frame, the firm started underwriting some bigger public companies. The names of Sears Roebuck and Company, Woolworth, Macy & Company, and B.F. Goodrich where all part of their earlier team deals with Goldman Sachs. It was making a big name for itself on Wall Street. During the Great Depression, much of the focus of Lehman went toward venture capital as the equity markets were being hammered. The case discusses the rise and fall of Lehman Brothers Inc (Lehman Brothers) from a small dry goods store to one of the leading investment banks in the US. It examines in detail the reasons that led to the subprime crisis since the year 2007 in the US and how it led to the collapse of 158 year old Lehman Brothers. The case highlights the role of several stakeholders in the mortgage business that contributed to the crisis. It examines the various factors that contributed to the fall of Lehman Brothers including leadership issues, excessive leverage, failure of risk measures employed like 'Value at Risk' and poor regulation of the investment banking industry. It also explains the role of certain OTC derivative instruments that led to the collapse of the company.

Key Issues Related to Auditing

1. When Lehman was unable to obtain legal opinion from U.S. firm regarding Repurchase 105 (Repo 105) transactions, should have triggered the auditors to examine the need for such repo

transactions by Lehman and the use of such transactions in the financial statement. This clearly has been accounting motivated transactions that the auditors of Ernst &Young let pass by them. 2. Getting paid 29.5 million for audit job for 2007 is a high amount which means that the auditors are overlooking the financial statements, which will trigger issues relating to auditors independence. 3. Auditors not addressing the Repo 105 transactions clearly makes it accounting motivated and lacked business purpose, auditors are supposed to evaluate such transactions and find their impact on financial ratios. 4. Materiality threshold for companys leverage ratio has been identified in the working papers as materiality is usually defined as any item individually or in aggregate the moves net leverage ratio by 0.1 or more. Repo moved the net leverage by a whole point which the auditors did not further investigated for misstatement. 5. At 2007 the company had $90 billion in assets and its equity at that time was only $22.5 billion which has to be further looked into for material misstatements 6. The housing market in general was collapsing in 2007 and 2008 and Lehman which trades Residential Mortgage Backed Securities (RMBS) made profit of $4 billion and $4.2 billion in 2006 and 2007 respectively, while it made only $1.7 billion in 2003 when the housing market was booming which indicates accounting motivated transactions has been involved or further investigations has to be done by the auditors regarding revenue recognitions. 7. The auditors insisted for off the balance sheet treatment for Repo 105 transaction was purely because it lacked business purpose. 8. When the value of the housing prices was going down the drain Lehman which involves in mortgage securities have increased their assets from 312.1 billion in 2003 to 691.1billion in 2007, which need to be reassessed (AS#8) for generally prevailing market conditions. 9. The leverage ratio changed from being 23.7 in 2003 to 30.7 in 2007 , but net leverage ratio only changed from 15.3 in 2003 to 16.1 in 2007 which is unusual and has been overlooked by the auditors when they know that the net leverage is the key to the decision making process. 10. The whistleblower allegation which the auditors did not further investigate to resolve it or followed up with it, and failure to take proper action by the auditors. 11. Lehman was using the exception in statement SFAS # 140 to manipulate the Repo 105 transactions which the auditors should have been aware of and looked into it. 12. Lehmans top executives profited enormously from strong reporting and its CEO took around $500 million in compensation, when compensation is based on performance it has more chances of material misstatement which the auditors should have evaluated for inherent risk and risk of fraud and should have included in audit planning (AS#9)

Responses to Case Questions

1. When Lehman was developing its Repo 105 accounting policy; did E&Y have a responsibility to be involved in that process? What role should an audit firm have when a

client develops an important new accounting policy? Comment on an audit firms responsibilities during and following that process? In a purchase or repo agreement, one party sells securities to another party while making a contractual commitment to purchase those securities at a later date. The agreed-upon repurchase price for the given securities is nominally greater than the original selling price. In substance, the original seller of the securities transferred to the purchaser as a collateral for the loan. According to Schlich, Lehman officials had consulted with E&Y while they were developing the companys Repo 105 accounting policy. Repo 105 transactions are a form of short-term financing that Lehman used to move as much as $50 billion off its balance sheet temporarily to show investors it wasnt carrying too much debt. Management is responsible for designing and implementing controls to prevent, deter and detect fraud. According to AU 110.03, responsibilities and functions of internal auditor states that management is responsible for adopting sound accounting policies and for establishing and maintaining internal controls that will, among other things, initiate, record, process, and report transactions as well as events and conditions consistent with managements assertions embodied in the financial statements. The managers of Lehman brothers are liable for the damages of the investors as well as Lehman auditing firm Ernest & Young. The auditor has not critically examined a systematical, large scale obfuscation scheme using Repo-105 transactions with served no other objective than to obtain balance sheet relief. After being informed about these facts, E&Y failed to exercise due to professional care at least with respect to its duty to notify the audit committee. According to the Standards of Field Work 314.44, the auditor should obtain an understanding of the entitys selection and application if accounting policies and consider whether they are appropriate for its business and consistent generally accepted accounting principles and accounting policies used in the relevant industry, or with a comprehensive basis of accounting other than GAAP. The understanding encompasses the methods the entity uses to account for significant and unusual transactions; the effect of significant accounting policies in controversial or emerging areas for which there is a lack of authoritative guidance or consensus; and changes in the entitys accounting policies. The auditor should also identify financials reporting standards and regulations that are new to the entity and consider when and how the entity will adopt such requirements. 2. Do you agree with the assertion that intent does not matter when applying accounting rules? That is, should reporting entities be allowed to apply accounting rules or approved exceptions to accounting rules for the express purpose of intentionally embellishing their financial statements related financial data? Defend your answer? No, one disagrees with the assertion that intent does not matter. The release of the bankruptcy report prompted a public outcry because it revealed that Lehmans executives had routinely used multi-billion dollar accounting-motivated transactions to embellish their companys financial data. Allegedly, those transactions had been executed for the express purpose of enhancing a financial ratio that regulatory authorities, stock market analysts, and investors considered to be a key indicator of the companys overall financial condition. For example, the balance sheet manipulation was intentional, for deceptive appearances, had a material impact on Lehmans net leverage ratio and caused financial reports to be misleading. Higher leverage determines a firms

capacity to absorb financial shock. Even though financial statements are responsibility of management, auditors are required to read such statements by management in case something conflicts with details in the financial statements theyve audited. 3. Do auditors have a responsibility to determine whether important transactions of a client are accounting-motivated? Defend your answer. The bankruptcy examiner criticized E&Y for not addressing the possibility that Lehmans Repo 105 transactions were accounting-motivated transactions that lacked a business purpose According to the examiner, E&Y should have recognized, or at least considered the possibility, that the Repo 105s were simply intended to improve Lehmans apparent financial condition, in particular, its net leverage ratio. The auditors had full understanding of the transactions and didnt take a stand on whether Lehmans extensive use of the devise was material and it must be reported. 4. William Schlich implied that E&Ys British affiliate had the responsibility for reviewing the legal opinion issued by a British law firm regarding the treatment of Repo 105s as sales of securities. Do you believe that schlich or one of his subordinated should have reviewed that letter? Why or why not? In general, how should the responsibility for different facets of multinational audit is allocated between or among the individual practices offices involved in the engagement? First, AU states that a legal letter that includes conclusions using certain qualifying language would not provide persuasive evidence that a transfer of financial assets has meet the isolation criterion of FAS. Not only was the Linklaters letter replete with qualifying statements, but also E&Y knew that no United States law firm had approved the Repo 105 transactions and that Lehman had to conduct the Repo 105 transactions through a United Kingdom-based affiliate. E&Y failed to consider whether it could rely on the Linklaters opinion letter at all, much less in connection with securities that originated in the United States. In addition, Martin Kelly, Lehmans former financial controller, testified that he discussed the Repo transactions with Schlich in late 2007. Kelly told the bankruptcy examiner that he had a certain degree of discomfort with the Repo 105s, ostensibly because Lehman had been unable to obtain a legal opinion from a U.S. law firm that supported the companys decision to record those transactions as sales of securities. According to Kelly, Ernst & Young was comfortable with the treatment under GAAP for the same reasons that Lehman was comfortable. Kelly also discussed with Ernst & Young Lehmans inability to get a true sale opinion under the U.S law. 5. Lehmans net leverage ratio was not reported within the companys audited financial statements but rather in the companys financial highlights table and MD&A section of its annual report. What responsibility, if any, do auditors have to assess the material accuracy of financial data included in those two sections of a clients annual report? The leverage ratio is a key ratio 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 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 . The importance of the leverage ratio in analyzing Lehmans financial statements was widely recognized. Ernst &Young work papers identified a separate materiality threshold specifically for leverage, defining materiality as an amount that moves net leverage by a tenth of 1 percent. Regardless of their materiality threshold for leverage, Ernst &Yongs lead audit partner on the Lehman audit team, William Schlich, told the bankruptcy examiner that Ernst &Young did not have a hard and fast rule defining materiality in the balance sheet context. This assertion is consistent with the independent auditors professional standards AU 312.10 PCAOB, which generally avoid providing auditors specific quantitative benchmarks for materiality. The standard state that the auditors 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. The importance of considering the users perspective in determining what is material is stated in AU 9312.11 PCAOB as In all instances, the element or elements selected should reflect, in the auditors judgment, the measures most likely to be considered important by the financial statement users.. Also, according to AU 9312.17 PCAOB the qualitative factors should include the potential effect of the misstatement on trends, and the potential effect on the entitys compliance with regulatory provisions. 6. The Repo transactions reduced Lehmans net leverage ratio from 17.8 to 16.1 at the end of fiscal 2007. Do you believe that was material difference? Why or why not? A major goal in Lehman's Repo 105 transactions was to show favorable financial leverage. A favorable financial leverage means that the company is earning a return on borrowed funds that exceed the cost of borrowing the funds. An examination of Lehman's ratios when the company used the Repo 105 technique shows that the company was well capitalized and less risky. The ratio was totally misleading and covered the leverage, and the low profitability and poor asset utilization of the firm. If creditors would know about this situation, might have demanded that the company pay some of its debt back by selling its assets. Thats why Lehman Brothers wanted to hide this situation since there was no market for their toxic mortgage assets. By using Lehman's Repo 105 techniques, all of the ratios were overstated. Therefore the overstated ratios resulted in an inaccurate interpretation of the financial position of the company and resulted in misleading financial statements. The impact of the Repo 105 transactions allowed Lehman to temporarily remove approximately $50 billion of bad assets from its balance sheet at the end of its first and second quarters of 2008. These amounts are material, and window-dress Lehmans balance sheet to present to the public and appear as extremely healthy at a time when the financial markets were shaking. Lehman's failure to disclose the use of this accounting technique to significantly lower their leverage created a misleading representation of Lehman's true financial position. These window dressing practices mislead investors, creditors, and other interested parties and led to huge losses to these people. These practices also ultimately led to the downfall of Lehman Brothers and huge losses to investors and creditors. 7. In general, what responsibility do auditors have to investigate whistleblower allegations that relate to the material accuracy of an audit clients financial statements?

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. Therefore, Lehmans audit committee identified and treated the senior member as a whistleblower. The audit committee instructed Lehmans internal audit group and external auditors to investigate the allegation. However, according to AU 326 the allegation of whistleblower is not considered a type of audit evidence. Under AU 326.21, the competence of evidential matter is defined as To be competent, evidence, regardless of its form, must be both valid and relevant. Ernst & Young failed to reveal the extensive steps taken by executive leadership to conceal financial problems. Because of the reliability of the source of whistleblower and the nature of the allegation, E&Y as a firm of certified public accountants expected to honor and uphold an industry-wide code of ethics, Ernst & Young may be accused of being responsible for gross negligence and lack of corporate responsibility. E &Y should seriously consider this allegation challenges because it changed the reliability of management assertions. 8. E&Y is a defendant in Lehman-related lawsuits filed in both state and federal courts. Identify the factors that influence E&Ys legal exposure between lawsuits filed in state courts versus those filed in federal courts. Under the law, investors have the option to sue auditors under state law or federal law. Laws vary from state to state, but claims under state law declare auditor negligence which occurs when the auditor breaches a duty of care causes damages. Under federal law, investors may sue auditors based on Section 10(b)-5 of the Securities Exchange Act of 1934. Rule 10b-5 prohibits the use of any "device, scheme, or artifice to defraud," and creates liability for any misstatement or omission of a material fact, or one that investors would think was important to their decision to buy or sell the stock. Under federal law, investors may combine their claims into a class action proceeding, which increases the auditors liability exposure. In addition, investors do not need to demonstrate reliance on either the financial statements or the audit report. Instead, federal courts presume investors relied on both the financial statements and the audit report when equities are traded on a securities market. Claims under Rule 10(b)-5 are based on intent to defraud or a severe recklessness standard.