1

Lehman Bothers Holdings, Inc. (Case 1.2)

Case Summary

On September 8, 2008, Lehman Brothers filed for bankruptcy on its

approximately $700 billion in assets, which made it the largest corporate bankruptcy

filing in United States history. This bankruptcy filing created a huge ripple effect for

stock market investors, as the market plunged and caused the U.S. and world economies

to enter into the Great Recession.

Lehman’s bankruptcy filing caused enormous outcry from the public, as it became

m
er as
known that the investment company routinely used what is known as “accounting-

co
eH w
motivated” transactions to embellish their financial data. The perceived intent of these

o.
multibillion-dollar transactions was to enhance the company’s net leverage ratio, which is
rs e
ou urc
considered to be a key indicator of the company’s overall financial condition.

For fiscal 2007, Lehman had remarkable operating results. However, management
o
aC s

recognized that the company had many deep problems as it had taken on billions of
vi y re

dollars of residential mortgage-backed securities. Management was faced with coming

up with a solution for lessoning its problems, as the housing market was collapsing.
ed d
ar stu

According to the case, “Lehman’s management chose an unconventional method to

reduce the company’s net leverage ratio. This improvised tactic involved engaging in a
is

large volume of ‘accounting-motivated’ transaction, known internally as Repo 105

Th

transactions” (Knapp, 28). These transactions were never filed with the SEC and

therefore, users of Lehman’s financial statements were unaware that Repo 105s were
sh

shaping the company’s net leverage ratio.

This study source was downloaded by 100000780071003 from CourseHero.com on 03-28-2021 03:29:51 GMT -05:00

https://www.coursehero.com/file/11245271/khuseland-Lehman-Bothers-Case/
 2

The gist of the accounting-motivated transactions was that Lehman would sell its

securities under a contract to repurchase (repo) them at a later date. This type of

agreement is essentially a contract to borrow funds for a period of time, as the transaction

of securities is made for more than the face value of the purchase agreement, with the

excess securities transacted acting as collateral for the funds.

Lehman’s management came up with the Repo 105 solution to influence the

public view of their financial statements because they realized that under the Statement of

Financial Accounting Standards (SFAS) No. 140, repo borrowers could record the

m
er as
transactions as sales of the securities, and not as repurchase agreements. Lehman’s

co
eH w
accounting team made this interpretation because under SFAS 140, unusual conditions

o.
allowed for repo borrowers to record transactions as sales and not as loans. The norm for
rs e
ou urc
Lehman’s repo deals was 102, meaning the company would transfer $102 million worth

of securities for every $100 million borrowed. Under Repo 105 though, the company
o
aC s

would transfer $105 million worth of securities for every $100 million borrowed. These
vi y re

larger transfers are what the company’s accounting team deemed unusual, meaning it was

an exception to SFAS 140.

ed d
ar stu

Through all of Lehman’s accounting motivated transactions and the exploitation

of SFAS 140, there has also been major outcry regarding Lehman’s audit firm and there
is

input on the whole situation. Ernst & Young has been Lehman’s independent audit firm
Th

from 1994 to 2008, with the final audit before the bankruptcy filing being for fiscal 2007.

According to the case, E&Y “told the bankruptcy examiner that E&Y had been aware of
sh

the Repo 105 transactions and was also aware that Lehman had not disclosed the

transactions in financial statements filed with the SEC” (Knapp, 32). E&Y also

This study source was downloaded by 100000780071003 from CourseHero.com on 03-28-2021 03:29:51 GMT -05:00

https://www.coursehero.com/file/11245271/khuseland-Lehman-Bothers-Case/
 3

mentioned that Lehman consulted them when they were developing the Repo 105

practice, but that they were not directly involved and did not officially approve the

practice.

E&Y has continually maintained in lawsuits that the bankruptcy filing by Lehman

were a result of conditions in the financial markets, and not caused by accounting

disclosure issues. E&Y also insists that the Repo 105 transactions Lehman performed

complied with the United States’ Generally Accepted Accounting Principals (GAAP).

E&Y claims that Lehman was not required to disclose the Repo 105 transactions at the

m
er as
time because the exception they found to the rule. The SFAS has since come up with

co
eH w
SFAS No. 166, which requires disclosure for transfer of financial assets, such as the Repo

o.
105 transactions.
rs e
ou urc
1.) When Lehman was developing its Repo 105 accounting policy, did E&Y have a

responsibility to be involved in that process? In General, what role should an audit

o
aC s

firm have when a client develops an important new accounting policy? Comment on
vi y re

an audit firm’s responsibilities during and following that process.

Although it is arguable that E&Y did not do anything legally wrong in the
ed d
ar stu

Lehman Brother case, one could argue that they did have a responsibility to be involved

in the process of developing the Repo 105 accounting policy for Lehman. The fact that no
is

law firm in the united States was willing to provide a legal opinion on the Repo 105
Th

policy should have been a red flag to E&Y, who should have gotten involved by, at the

very least, providing their opinion on the accounting motivated transaction. The case
sh

mentioned that E&Y was made aware of the new policy, but did not formally approve it.

According to the Public Company Accounting Oversight Board (PCAOB) AU Section

This study source was downloaded by 100000780071003 from CourseHero.com on 03-28-2021 03:29:51 GMT -05:00

https://www.coursehero.com/file/11245271/khuseland-Lehman-Bothers-Case/
 4

110.02, “The auditor has a responsibility to plan and perform the audit to obtain

reasonable assurance about whether the financial statements are free of material

misstatement, whether caused by error or fraud.” E&Y should have looked into the Repo

105 policy further during creation of the policy, as well as following the implementation.

2.) Do you agree with the assertion the “intent doesn’t matter” when applying

accounting rules? That is, should reporting entities be allowed to apply accounting

rules for the express purpose of intentionally embellishing their financial statements

or related financial data? Defend your answer.

m
er as
I disagree with the assertion that “intent doesn’t matter” when applying

co
eH w
accounting rules. I believe that each accounting rule exists for a certain reason, and when

o.
a company uses a rule even though its “intent doesn’t matter” for the application of the
rs e
ou urc
rule then they are misusing the rule.

3.) Do auditors have a responsibility to determine whether important transactions of

o
aC s

a client are “accounting motivated”? Defend your answer.

vi y re

Ethically speaking, auditors have a responsibility to determine whether important

transactions of a client are “accounting motivated,” as they have a responsibility to their

ed d
ar stu

profession. Under PCAOB AU Section110.10, “The independent auditor also has a

responsibility to his profession, the responsibility to comply with the standards accepted
is

by his fellow practitioners.” One of these standards is discussed in PCAOB AU Section

Th

110.05, which is one of the personal qualifications for an independent auditor, and says,

“In the observance of generally accepted auditing standards, the independent auditor must
sh

exercise his judgment in determining which auditing procedures are necessary in the

circumstances to afford a reasonable basis for his opinion. His judgment is required to be

This study source was downloaded by 100000780071003 from CourseHero.com on 03-28-2021 03:29:51 GMT -05:00

https://www.coursehero.com/file/11245271/khuseland-Lehman-Bothers-Case/
 5

the informed judgment of a qualified professional person.” Based on this, E&Y should

have determined that the Repo 105 transactions were important to providing an opinion

of a qualified professional person.

4.) William Schlich implied that E&Y’s British affiliate had responsibility for

reviewing the legal opinion issues by a British law firm regarding the treatment of

Repo 105s as sales of securities. Do you believe that Schlich or one of his

subordinates should have reviewed that letter? Why or why not? In general, how

should the responsibility for different facets of a multinational audit be allocated

m
er as
between or among the individual practice offices involved in the engagement?

co
eH w
Schlich or one of his subordinates should have reviewed the letter from the British

o.
law firm, as no law firm in the United States would review Lehman’s Repo 105
rs e
ou urc
accounting policy, which should have caused concern for E&Y that something with the

Repo 105 policy would be subject to legal issues. In the Lehman case, since the Repo 105
o
aC s

policy was reviewed and consummated in Great Britain, Lehman had to transfer assets
vi y re

from the U.S. to one of its British divisions. In general, any time a company transfers

assets to one of its international divisions, the independent audit firm should review both
ed d
ar stu

sides of the asset transfer, and maybe even use it own international divisions who are

more familiar with the foreign regulations to input various opinions. There should be
is

multiple offices involved from the audit firm involved in the engagement.
Th

5.) Lehman’s net leverage ratio was not reported within the company’s audited

financial statements but rather in the company’s financial highlights table and
sh

MD&A section of its annual report. What responsibility, if any, do auditors have to

This study source was downloaded by 100000780071003 from CourseHero.com on 03-28-2021 03:29:51 GMT -05:00

https://www.coursehero.com/file/11245271/khuseland-Lehman-Bothers-Case/
 6

assess the material accuracy of financial data included in those two sections of a

client’s annual report?

Auditors do not have any responsibility to assess the material accuracy of

financial data included in a company’s financial highlights table and MD&A section of its

annual report. In this case, E&Y probably should have reviewed the sections, although it

was not required to. Under SAS AU Section 110.03, “The financial statements are

management's responsibility. The auditor's responsibility is to express an opinion on the

financial statements. Management is responsible for adopting sound accounting policies

m
er as
and for establishing and maintaining internal control that will, among other things,

co
eH w
initiate, record, process, and report transactions (as well as events and conditions)

o.
consistent with management's assertions embodied in the financial statements.” The
rs e
ou urc
auditors are responsible for creating an opinion on the accuracy of the financial

statements, while it is up to management to create sound accounting policies and

o
aC s

practices.
vi y re

6.) The Repo 105 transactions reduced Lehman’s net leverage ratio from 17.8 to 16.1

at the end of fiscal 2007. Do you believe that was a “material difference”? Why or
ed d
ar stu

why not?

The reduction of the net leverage ratio from 17.8 to 16.1 at the end of fiscal 2007
is

was a material difference. According to Disraeli, “…Papers prepared by… Ernst &
Th

Young, regarding the process for reopening or adjusting a closed balance sheet stated:

‘Materially is usually defined as any item individually, or in the aggregate, that moves net
sh

leverage by 0.1 or more (typically $1.8 billion). Repo 105 moved net leverage not by

tenths, but by whole points’’ (Knapp, 32). Repo 105 moved the net leverage ration by 1.7.

This study source was downloaded by 100000780071003 from CourseHero.com on 03-28-2021 03:29:51 GMT -05:00

https://www.coursehero.com/file/11245271/khuseland-Lehman-Bothers-Case/
 7

7.) In general, what responsibility do auditors have to investigate whistleblower

allegations that relate to the material accuracy of an audit client’s financial

statements?

Whistleblower allegations should be taken seriously by auditors and reviewed

thoroughly. The whistleblowing that happened in the Lehman case advised that, “Assets

and liabilities were routinely misstated by ‘tens of billions of dollars’ in the company’s

periodic balance sheets” (Knapp, 34). The whistleblowing should have been a red flag for

E&Y, or any auditor, as the Statement of Accounting Standards (SAS) AU 316.06

m
er as
suggests that one of the misstatements relevant to an auditors consideration of fraud

co
eH w
misstatements arising from fraudulent financial reporting, which “Are intentional

o.
misstatements or omissions of amounts or disclosures in financial statements designed to
rs e
ou urc
deceive financial statement users where the effect causes the financial statements not to

be presented, in all material respects, in conformity with generally accepted accounting

o
aC s

principles (GAAP). Fraudulent financial reporting may be accomplished by the

vi y re

following: Manipulation, falsification, or alteration of accounting records or supporting

documents from which financial statements are prepared.” Lehman deceived its financial
ed d
ar stu

statement users by manipulating its net leverage ratio.

8.) E&Y is a defendant in Lehman-related lawsuits filed in both state and federal
is

courts. Identify the factors that influence E&Y’s legal exposure between lawsuits
Th

filed in state courts versus those filed in federal courts.

E&Y has maintained that it did not act improperly, and that Lehman’s accounting
sh

followed the accounting standards set in the United States. According to Jessica Dye, “In

his ruling, Kaplan noted that whether Ernst & Young complied with national accounting

This study source was downloaded by 100000780071003 from CourseHero.com on 03-28-2021 03:29:51 GMT -05:00

https://www.coursehero.com/file/11245271/khuseland-Lehman-Bothers-Case/
 8

standards was the sole federal-law question in the attorney general's lawsuit.” With that

said, the lawsuits against E&Y that suggest the audit firm helped Lehman move billions

of dollars to improve its net leverage ratio are not covered by the federal court, and must

be handled in the state court.

m
er as
co
eH w
o.
rs e
ou urc
o
aC s
vi y re
ed d
ar stu
is
Th

References
sh

Knapp, M. (2014). Comprehensive Cases. In Contemporary Auditing: Real Issues and

Cases (10th ed., p. 28, 32, 34). Boston: Cengage Learning.

This study source was downloaded by 100000780071003 from CourseHero.com on 03-28-2021 03:29:51 GMT -05:00

https://www.coursehero.com/file/11245271/khuseland-Lehman-Bothers-Case/
 9

AU Section 316 Consideration of Fraud in a Financial Statement Audit. (n.d.). Retrieved

January 18, 2015, from
http://www.aicpa.org/Research/Standards/AuditAttest/DownloadableDocuments/AU-
00316.pdf

Dye, J. (2012, March 22). Ernst & Young suit over Lehman heads to state court.
Retrieved January 18, 2015, from http://www.reuters.com/article/2012/03/22/us-
ernstyoung-lawsuit-lehman-idUSBRE82L1DH20120322

Responsibilities and Functions of the Independent Auditor AU Section 110.02 Distinction

Between Responsibilities of Auditor and Management. (n.d.). Retrieved January 18,
2015, from http://pcaobus.org/Standards/Auditing/Pages/AU110.aspx

Responsibilities and Functions of the Independent Auditor AU Section 110.03 Distinction

Between Responsibilities of Auditor and Management. (n.d.). Retrieved January 18,
2015, from http://pcaobus.org/Standards/Auditing/Pages/AU110.aspx

m
er as
Responsibilities and Functions of the Independent Auditor AU Section 110.10

co
eH w
Responsibility to the Profession. (n.d.). Retrieved January 18, 2015, from
http://pcaobus.org/Standards/Auditing/Pages/AU110.aspx

o.
rs e
ou urc
o
aC s
vi y re
ed d
ar stu
is
Th
sh

This study source was downloaded by 100000780071003 from CourseHero.com on 03-28-2021 03:29:51 GMT -05:00

https://www.coursehero.com/file/11245271/khuseland-Lehman-Bothers-Case/
Powered by TCPDF (www.tcpdf.org)