Lehman Brothers were founded by the German immigrant, Henry Lehman in 1844, in Mogomentary, Alabama. The company was started up with a small shop which used to sell groceries and dry goods to some local cotton farmers and later changed its focus from general merchandising to commodities trading, mostly cotton trading (1). With time, Lehman Brothers became very successful as they operated at a wholesale level, dealing with governments, companies, and other financial institutions. The firm was consisted of about 23,000 employees worldwide (Dhillon, 2014). Lehman Brothers were established for almost 160 years, until they filed a chapter 11 bankruptcy on 15th, September, 2008.
During their business years, Lehman Brothers became the fourth largest investment bank in the US and operated globally. They were also involved in real estate hedge fund, in which a limited partnership of investors use high-risk methods, such as investing with borrowed money, in hope of realizing large capital gains (Glossary for Robo-Advisors,2017). The firm was also became the part of the subprime mortgage where loans are extended to customers who would otherwise not be accepted for credit due to their poor credit scores (Adu-Gyamfi, 2016). A crucial part of these subprime mortgages was the adjustable interest rate. The adjustable mortgage rate set up by Lehman Brothers allowed them a fixed interest rate and then changed to a floating rate in addition, to a margin (Adu-Gyamfi, 2016). Despite the fact, subprime borrowing came with a higher interest rate, however; its risk of default was much higher (Investopedia, 2007)
Like, most U.S banks, Lehman Brothers benefited of the housing boom prior to 2007 and extended in huge subprime mortgage. When the mortgage prices were still high, the firm continued to benefit from higher interest rate as the firm could remortgage to other borrowers without necessarily being affected (Adu-Gyamfi, 2016). They also took advantage of higher returns and attractiveness of the subprime mortgage market, securitized the subprime mortgage portfolio and sold them to investment banks and hedge funds who thought they could benefit from high returns(Adu-Gyamfi, 2016)
Nonetheless, the downfall of the firm began when the housing prices started to fall in 2007. Unfortunately, the higher interest rate resulted in a massive default, and coupled with the low prices of houses, the firm made huge lost worldwide in write-downs of subprime mortgages. In addition to default, there was a loss of confidence from investors including hedge funds and other investment banks which resulted in a leverage problems(Adu-Gyamfi, 2016). Lehman Brothers and other investment banks were advised to reduce their leverage by selling off assets to avoid downgrades ratings. This high leverage had too much pressure on firm’s liquidity and with the poor performance of the subprime mortgage and the resultant defaults, the liquidity problem compounded (Adu-Gyamfi, 2016).
Nevertheless, instead of selling off some assets to pay off its debt, the firm increased its use of Repo 105 transactions. In Repo assets are being sold are worth 5% more than the cash received. The practice of using Repo transactions is perfectly legal and is done by banks all the time; these transactions are material and should be disclosed in the notes to the financial statements. However, Lehman Brothers used this practice along with some sneaky and illegal accounting techniques without disclosing it the notes to the financial statements.
For instance, Lehman would enter into Repo transactions near the end of each quarter and make repayment —using borrowed money—at the beginning of the next period, usually within seven to ten days (Hartwell,2017).The assets would be removed from the books and the cash used to pay down other short-term debt, reducing its leverage ratio on quarterly and annual reports. Upon repayment, the assets and liabilities would be put back on the books, and the leverage ratio would increase to the pre-transaction levels, which would overcollateralized of 5% (Hartwell,2017). In other words, Lehman Brothers took the loan and disguised it as sales. By doing so, the firm made their company’s cash seem more than it actually was. The firm was accused of using Repos transactions to window dress its financial statements to deceive investors, regulators and the public at large (1).
The deceit was borne out of the fact that Lehman Brothers were using Repos to hide its high leverage during reporting times. In fact, they used Repo transactions to sold toxic assets, . are assets that become illiquid when the secondary market for buying and selling them disappears(investopedia,2017). Lehman Brothers sold $50 billion worth of toxic assets to different banks in the Cayman Islands with the promise that they would repurchase them in a short time. Research shows the firm used Repo transactions ranged from $39 billion to over $50 billion from the end of 2007 through the second quarter of 2008 (Hartwell, 2017). The worse happened when the housing market continued to decline, and in the second quarter of 2008, Lehman Brothers reported their first loss since going public in 1994 (Hartwell, 2017). Unfortunately, banks refused to extend lines of credit to Lehman Brothers and, without cash, the firm was unable to continue operating and atlas filed for bankruptcy on September 15, 2008.
Lehman Brothers bankruptcy not only impacted the company itself, but it also had a ripple effects worldwide. For example, the bankruptcy indicated that over 25,000 employees of the firm had lost their jobs. Also, most of employees had substantial investments in the stock of the firm, and due to the unprecedented fall of the firm’s stock price, the employees had a drastic impact on their investments.
Moreover, the bankruptcy had a significant effect on the returns of stock markets. For instances, the U.S. stock market had a devastating impact on some major stock indexes such as NASDAQ Composite dropped by 3.6%, being the worst single-session percentage decline since 2003. Also, major Asian indices such as India’s Sensex, Taiwan’s benchmark, and Singapore’s STI dropped by 5.4%, 4.1%, and 2.9% respectively. Also, Japan’s Nikkei, Hong Kong’s Seng Index, and South Korea’s KOSPI suffered a similar fate (Adu-Gyamfi, 2016). The bankruptcy of Lehman Brothers is considered the major contributor to the worst performance of certain major market indices across the World at the time.
Furthermore, the bankruptcy also had a tearing effect on its creditors and investors. The investors were negatively affected as they could not escape from the financial crisis, for example on September 16, 2008, Bank of New York Mellon Corp share price fell in value to the US $0.991 due to its holding in Lehman Brothers. In a similar vein, Federal Home Loan Mortgage Corporation, also had the significant loss due to firm’s bankruptcy(Adu-Gyamfi, 2016). Investors from other countries, who had bought the mini-bonds and pension fund had also incurred losses due to the collapse of the Lehman Brothers (Lartey, 2012). The bankruptcy also had severe effects on some major companies and many financial institutions outside the United States and Europe.More than 75 distinct bankruptcy proceedings were recorded following the bankruptcy of Lehman Brothers (Adu-Gyamfi, 2016)
Nevertheless, the financial disaster of firm not only took a toll on the employees, financial markets, investors, and the global economy, but it had also affected the one of the top accounting firm, Ernst ; Young. The E;Y audited Lehman brothers from 2001 to 2008, and during that time E;Y reportedly earned more than $150 million in fees from Lehman Brothers ( Coenen, 2016). However, proceeding the bankruptcy, Ernst and Young were accused of issuing an unqualified opinion on the financial statements of Lehman when it was well aware that the bank was using an accounting maneuver known as ‘Repo 105’ to make itself appear healthier than it really was (Mahon, 2015). In 2010, the lawsuit was filed, suing Ernst ; Young for over $150 million in money earned from executing business with Lehman Brothers (Freifeld,2015). However, the recent development of the case has found the settlement of $10 million for the auditing scandal associated with Lehman Brothers. Luckily, the criminal case concluded that E;Y were not responsible in any way for the collapse of Lehman Brothers (Freifeld,2015)
The scandal of Lehman Brothers did shudder not only the international financial system but also had the explosive impact on the world’s economy. This problem could have been prevented long before it was occurred or could have been less severe impact than it had. For example, bankruptcy would have less affected, if Lehman Brothers would have identified the risks inherited in the subprime mortgage market, set limits of exposure, continuously monitor those risks, and take pragmatic measures to reduce exposure where necessary (Adu-Gyamfi, 2016).
The scandal could have been prevented, if Lehman Brothers would have followed CAS 210 properly, which states that management is responsible for adopting sound and appropriate accounting policies, implementing and maintaining adequate internal controls; and providing fair representations in the financial statements. Nevertheless, the firm not only violated CAS 210, but they were also unethically behaved. For instances, the excessive use of Repos 105, the timing of the transactions and misrepresentation of its treatment hid very vital information investors needed to make investment decisions. If investors were aware of the financial health of firm earlier, they would not have invested in the company.
In addition, the firm violated the management assertions, which are claims made by management about certain aspects of business such as classification of transactions, related account, and classification and presentation or disclosure in the financial statement ( Arens. Et al, 2016). The effects of Lehman Brothers fraud would have been less severe if the firm would have been more honest in presenting management assertion such as disclosing the use of Repo 105 in the notes to the financial statements and correctly record related loan and sales account in the financial statements.
Despite the fact, preparation of financial statement and internal control are management’s responsibilities, audit firms play an important in providing correct information to users.. According to CAS 200, an audit of financial statements is to be conducted by an independent auditor, with the objective of expressing an opinion (assessment) whether the financial statements are both free from material misstatement, and presented fairly (Arens. Et al, 2016 ). E;Y, audited Lehman Brothers financial statements from 2001-2007 and they were first made aware of Lehman Brothers intentions and manipulation of accounting figures. The firm’s scandal would have been prevented if audit firm were more careful and attentive towards assessing firm’s financial statements.
Moreover, the scandal could have been prevented, if the audit firm would have focus carefully on the flow of transactions to identify at which point the risk of misstatement could have occurred and what transaction could have mitigated those risk ( Arens. Et al, 2016). The effects of fraud would be minimal if audit firm carefully assessed management’s assertion. For example, obtaining sufficient appropriate audit evidence to support all management assertion in the financial statement by accumulating evidence in support of the appropriate combination of transaction-related, balance-related, presentation and disclosure and audit objectives. ( Arens. Et al, 2016). Another way, by which the scandal could have been prevented if audit firm would have been carefully performed the risk assessment such as identifying the possibility of wrongdoing in financial statements, performing tests to address those risk before issuing an audit report ( Arens. Et al, 2016).Overall, It can be clearly seen that Lehman Brothers were involved in both the fraudulent financial reporting and misappropriation of assets which harmed both the users of financial statement and the creditors and investors (Arens. Et al, 2016). The scandal of Lehman Brothers could have been prevented, if auditors properly plan and perform the audit to detect the material misstatements.
There are some reasons to choose this topic. First, it was fascinating to see how Lehman Brothers started up their business from a small shop and gradually strengthened their business roots by trading, investing and becoming the fourth largest investment bank in the US. Second, it was fascinating to find out that how big firms like Lehman Brothers when faced with financial distress could easily manipulate and violate accounting policies, rules and regulations and ethically misbehave to prevent from downgrade ratings. The third reason to choose this topic is to clear out the misconception that big and successful firms do get involved in fraud and misinterpret information just to seem successful to others. The fourth reason to choose this topic is to show that when a firm fails, it not only affects the firm itself, it has a ripple effect which negatively affects all the people who are associated with the firm such as employees, investors, and creditors.