Financial Statement Fraud And Corporate Governance: Case Study Of Lehman Brothers

Instruments used

Discuss about the Financial Statement Fraud and Corporate Governance.

Lehman Brothers was an international financial service provider firm. It was the fourth largest firm in the field of investment banking in the United States before September 2008. In September 2008, Lehman Brothers declared themselves as bankrupt and filed for Chapter 11 Bankruptcy. The main causes for failure and collapse of Lehman Brothers were not -assessment of risks on the part of the management and the condition was further aggravated by the auditors by not warning the management about the consequences that would follow because of negligence by the management (Cappelleto, 2010). The auditors also concealed such facts and figures from the financial statements, which if shown, would have saved the firm from collapsing. Hence, strong procedure and regulations is the need of the hour as it demands strict control and lead to an effective course of action.

Between the year 2001 and 2008 there a major boom in the housing market. Lehman Brothers assumed the investment in the housing market a highly profitable venture and it started borrowing heavily and invested all its proceeds in the mortgage market. By the time, the sub- prime mortgage business of housing finances had also become worse.  Another major part of exposure by Lehman Brothers at that time was in Real Estate, private financing and leveraged lending from its own capital (CPA, 2012). The firm had invested billions of money in risky portfolios without keeping the consequences in mind. And for all these investments, it had raised billions of dollars from various financers just like other investment bankers were doing.

A major disastrous and deceitful step that was taken by Lehman Brothers was the use of Repo 105 transaction in a wrong manner so as to present a rosy image of its balance sheet before the public who was investing in Lehman Brothers and the financial institutions in order to receive more lending. The Investment Securities were kept as collateral and the funds thus received were used to pay off the troubles obligations of the firm (Kruger, 2015). The firm was supposed to show the holding of securities as collateral by the third parties as a nothing in the financial statements and to show the securities as it is in the Balance Sheet, which was concealed with the help of auditors. The transaction was shown as for sale of inventory of securities and the securities were slowly and gradually decreased by these Repo Transactions (Christensen, 2011). Moreover, the loan taken against these securities were never shown in the Balance Sheet as the firm treated these Loans as Sales Proceeds of Investment Securities. All this was done to depict more liquid assets and funds and less risky liabilities in the Balance Sheet of the firm.

Auditing Standard ASA 701- Communicating Key Audit Matters in the Independent Auditor’s Report

The long-term investments securities and assets were being mortgaged for short-term borrowings by Lehman Brothers in form of Repo Transactions and Commercial Papers and in mid and late 2008, the firm was borrowing huge amounts on a daily basis. This firm was exposed to a huge risk because it borrowed huge sum of money. Once the obligation of debt enters the system, it leads to hype in the interest rate and ultimately a major iskOver the time, the financial institutions stopped accepting long-term securities as collateral against short-term borrowing and the firm gradually failed to meet its obligations (Hoffelder, 2012). All theses major transactions and facts had led to the collapse of Lehman Brothers.

The situations worsened more with the concealment of these material and key matters from the financial statements. Had all these risky ventures been forewarned by the auditors in the financial statements, the collapse could have been delayed or might have been avoided (Kaplan, 2011). The Auditors of Lehman Brothers were Ernst & Young LLP (one of the big four accountancy and audit firms) having its headquarters in New York.

It came into effect for financial reporting periods ending on or after 15^th December 2016. The main objects of inculcating this auditing standard are mainly to assess the key audit matters and once assessed, these matters should be communicated along with an unbiased opinion on such key matters to the management of the audited firm. The purpose of such communication is to ensure enhanced transparency in the financial statements audited and to enable the users of the financial statements to have a look into the matters which can in any way affect such users in future. In the case of Lehman Brothers, if ASA 701 was to be followed then the auditor would not have concealed the material fact that was key audit matters on the basis of which the financial statements were to be interpreted by its users and investors.

As per Roach (2010) Key Audit Matters are those matters which require significant attention of the auditor during the auditing process of financial statements and reports. For assessing such significance, the auditors have to find out the matters that have a high risk of material misstatement, high uncertainty and the effects of such transactions that have occurred during the audit period.

Following points explain in Lehman Brothers collapse case, the role of Auditors in Concealment of material facts and non-communication and now- disclosure of key matters that would have been disclosed if the ASA 701 was there at that point of time and was followed. However the unavailability of the standard and major loopholes in the system led to the total downfall.

Auditing Issues surrounding the Lehman Collapse

In the Repo Transactions undertaken by Lehman Brothers, the short-term financing transactions were treated as sales. In the Balance Sheet of the firm, the Securities offered as collateral were removed from the Balance Sheet and liability was reduced so as to depict that the liabilities were being paid off by selling off of securities thereby reducing the leverage. The actual treatment of Repo Transaction should have been that the Securities were to be shown as it is in the Balance Sheet and a nothing was to be given that the securities have been given as collateral to third parties against the funds raised from them (Wiggins et. al, 2014). Further, the loan raised from the third parties was to be shown in Balance Sheet till these were repaid. As the transaction was treated as Sales under FAS 140, hence the loan taken from third parties was shown nowhere and the securities shown as sold were reduced from the assets in the balance sheet (Parker et. al, 2011). All this was affirmed by the auditors of the firm and no nothing for the same were given in their Audit Report as the FAS 140 did not say anything about the independent obligation of disclosure and the same was taken advantage of by the firm and auditor too.

Lehman and its Auditor firm decided not to show the impact of the Repo 105 transactions on the balance sheet as it would make it clear to the investors and the financiers that the leverage effect was not changing and the firm was already under huge loan liabilities. The Auditors should have disclosed all the impacts related to the wrong method of treatment of Repo 105 transactions that were being done by Lehman Brothers (Christian & Metrick, 2014). Hence, the auditor decided not to disclose the impact of Repo.

Lehman had made an internal policy of Repo 105 and Reverse Repo and to further treat the same in the balance sheet as trading (sale and repurchase) of investments. This policy was made after the approval and affirmations from Auditors. The Auditor should have stopped Lehman from doing so and should have forewarned them against the consequences that this policy could have in future.

Afterward Lehman had also started Repo 108 transactions in which equities were used in place of fixed income securities as collateral. The same was also affirmed by the Auditors of the firm.

Approval of Lehman’s Repo 105 Policy for manipulating the Balance Sheet

For treating the Repo 105 transactions as Sales under FAS 140, the firm had to obtain a true sales opinion that stated the transactions are fully complying the legal criteria to be followed for transfers /sales. This True Sales Opinion was not obtained by Lehman in the US. Afterward he tied up with finances of UK to enter into Repo transactions where he had obtained true sales opinion with a condition that the investment securities will only be traded within the UK and the securities should also be sited in the UK (Manoharan, 2011). Lehman Brothers entered into a number of transactions on the basis of this opinion through which he collateralized fixed income securities amounting to billions of dollars (Fazal, 2013). After some time, without disclosing it to UK financers, Lehman started transfers of billions of dollars of American fixed income generating securities also. The auditors had full knowledge of the above situations but never disclosed the same in financial statements.

There was an obligation on the part of Lehman to buy back the billions of dollars of securities that were transferred temporarily to the third parties. This was nowhere disclosed by Lehman Brothers in their Financial Statements regarding the same. All such transactions were merely presented as Balance Sheet Fluctuations in the management reports (Baldwin, 2010).

 Secondly, the obligation to repurchase these securities at a lower rate were treated as derivatives on the balance sheet and these derivatives were hidden in a large group of derivatives mentioned in the footnotes of the financial statements (Heeler, 2009). All this was approved by the Auditors which was a total concealment of material misstatements.

As per IFAC (2015) the leverage ratio had materially declined in the year 2008 as compared to the year 2007 for the firm. Moreover, the reduction was temporary and falsely created by Repo 105 transactions. After the end of fiscal quarters, Lehman used to repay the debts of Repo transactions and the securities would again get shown in the Balance Sheet. This would affect the leverage ratios up to a material level that had to be disclosed by the firm in financial statements and by the auditor in his audit report (Fazal, 2013).

The above-said points clearly explain as to what were the key matters in the case of Lehman Brothers that were to be communicated to those charged with governance. If the Auditing Standard ASA-701 was followed and were there for the persual of Lehman Brothers and its auditors, the auditors might have strictly followed the same and saved a lot of investors and mainly Lehman Brothers from such huge irrecoverable losses. Therefore, the standard ASA-701 could have acted as a safeguard and provided a remedial course of action.

Auditors should also correctly depict and audit the financial statements. Auditors have the responsibility of the society as a whole to correctly audit the books of accounts and to report the misappropriation of the company. Auditors should comply with the auditing standards and completely apply them in use of audit. Auditors are the watch dog and not bloodhounds, but they should be able to correctly understand the working of the company and audit the books. Auditors can be held responsible for the loss to the third parties who relied on the financial statements audited by the Audit firm as seen in the case of Lehman Brothers. Hence auditors should correctly report all misappropriations done by the management in their audit report. Further, the collapse of Lehman indicates that there was huge gap between the regulations and the real implementation. The failure indicates the pitfall in the regulatory mechanism hence, urging for stringent supervision and audit standards. It is essential for policy makers like IFRS, Accounting Standard Board, and Basel to implements stringent norms so that ethical practice are followed.

Conclusion

The case of Lehman Brothers provides many important lessons to every organization, be it small or large with regard to corporate governance and the ethical standards to be followed by the management and its evaluators including the auditors. The organizations should strictly adhere to the accounting policies and standards that have been set as these have been set keeping in view the impacts of each and every aspect of financial matters that are to be incorporated while preparation of financial statements and that can even get a country’s economy at stake if misled (Larcker & Brin, 2011). It is recommended that the companies should do such reporting of true and correct financial transaction which should not mislead the stakeholders. Also, the financial statements should reflect the correct picture of the books of accounts and company`s operations. In such case, the company should try to resort to the adoption of regulatory accounting and auditing standards.

References

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