Recent accounting scandals at prominent companies such as Enron, HealthSouth, Tyco, and WorldCom appear to have shaken the confidence of investors. In the wake of these scandals, many of these companies saw their equity values plummet dramatically and experienced a decline in the credit ratings of their debt issues, often to junk status. Many of these firms were forced to file for Chapter 11 bankruptcy protection from creditors.
Revelations about the unreliability of reported earnings continue to mount, as evidenced by an alarming increase in the frequency of earnings restatements by firms in the last few years. The widespread failure in financial reporting has largely been blamed on weak internal controls. Worries about accounting problems are widely cited as a reason for the stock market slump that followed these scandals. (Agrawal and Chadha, 2005).
a) Identify an accounting scandal that happened in the past 2 decades and describe the background of the scandal.
b) Explain the accounting/financial reporting violations associated with this scandal in detail.
c) Based on your reading and analysis, what are the lessons to be learned from this scandal? How this scandal could have been avoided?
The main focus of the assessment is to review the case of Lehman Brothers which was a global financial firm which provided range of financial services to its clients. The business was well reputed in the market to provide quality services and therefore held a strong position in the market of the US. In 2008, the management of Lehman Brothers filed for bankruptcy which triggered a worldwide financial crisis and affected the faith of the stakeholders in such global firms.
For better understanding of the case, the corporate governance framework of the company would be considered along with some of the reporting policies which the company had adopted during this phase. The analysis would be focusing on the corporate scandal which was identified in case of the company and how the same led to the collapse of the business.
The analysis would be focusing on the accounting irregularities which were identified and the actions which were taken by the government and regulating bodies after the scandal. Furthermore, the analysis would be showing the lessons which can be learnt from the scandal and the measures which can be implemented so that such a scandal does not take place in future period.
Lehman Brothers was a well-established financial company which provided a range of financial services to its clients and operated at a global level. Some of the services which the business provided to its customers covered, investment banking, trading, brokering services and other financial services.
Due of the scale of its operations, Lehman Brothers was considered as one of the largest investment banks in the US until 2008. The business of Lehman Brothers was founded in 1850 by three brothers who immigrated to the US from Germany. The business started off its operations as a cotton trading firm and it was much later in the 20th century that the business decided to shift operations to financial services and public offerings (Digitalcommons.montclair.edu. 2023). The business had successfully diversified its operations to different services and established its operations in the market.
In 2008, the business reinvented its operations by becoming an independent asset management company which had access to 28000 employees and assets worth $ 600 billion. One of the aspects of the business in 2008 was that the business was heavily involved in subprime lending business. The subprime lending operations was attractive mainly due to the fact that the operation was driving unsustainable economic growth in operations.
The subprime lending or mortgage was one of the riskiest mortgages for the company as it was given to clients who did not fall in high income groups and such clients even had a bad credit history (Adu-Gyamfi 2016). It was due to the subprime mortgage option that the business had to suffer tremendous losses and the overall losses for the business accumulated to $ 50 million. The expansion in the subprime mortgage operations was a misstep which the management undertook and this affected the solvency of the business in a big way.
The management of Lehman Brothers were heavily involved in the collapse of the business as they tried to reduce costs, manage losses and sell off its mortgages but the efforts were not enough to stabilise the business. In 2008, the management of Lehman Brothers were forced to file for bankruptcy as the assets which were maintained by the business was at less value than it was reported by the management (Crosina and Pratt 2019).
The business further lost its creditability in the market considering the negative impact of assets which were misrepresented. One of the main issues for the business was also related to wrong accounting practices that the business utilised to present the assets of the business in the financial records.
An investigation on the case of Lehman brothers revealed that the business had aggressively engaged with subprime mortgage operations as it provided opportunity to generate higher earnings even though the mortgage was risky. Further reports recognised that Lehman brothers covered up its irrecoverable debts by utilising accounting loopholes and a tactics known as Repo 105.
The senior management of the company was a party to the scandal and they were involved in accounting fraud where entries were manipulated so that the business can present a favourable financial position to the stakeholders (Ganon, Donegan and Rotondo 2017). The main affected parties for the business were investors and clients who were involved with the operations of the business.
In an overall basis, it can be said that the aggressive investment style of the management to offer subprime mortgage can be regarded as the reason for the downfall of the company.
In terms of consequences for the scandal, the business faced lots of financial difficulties and had to opt for bankruptcy option in order to manage the debts which had accumulated for the business. The business further gained a bad reputation in the market for the accounting practice which the company employed to present their financial information (Ferreira 2020).
At the time of the bankruptcy for the business, Lehman brothers had assets worth $ 600 billion as per the balance sheet of the business and this showed the impact which the management faced in terms of solvency of the company. Due to the scandal and bankruptcy of the company, the assets of the business had to be liquidated in order meet the dues of the investors (Mazzola 2018).
In an overall basis, it can be said that the reputation of the company was hampers and even changes were made in the accounting framework so that the accounting scandal can be avoided in the future period.
The analysis of the Lehman Brothers case reveals that the fault for the failure lies with the management in terms of aggressive lending for the subprime mortgage and also due to the wrong accounting policies which the business followed.
The financial policies and governance standards for the business can also be questioned as it impacted the integrity of the financial firms after the scandal was revealed and thereby it became imperative that steps were undertaken to ensure that the situation did not occur again in future period.
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The case of Lehman Brothers shows that the governance framework of the business was at fault and the downfall of the company was due to some of the bad decisions taken by the management. Further the management also used accounting tactics which were questionable just to portray that the financial reports were being presented in an appropriate manner.
The analysis of Lehman brothers show that management utilises Repo 105 for meeting their cash needs and also portrayed the financial records accordingly. In order to get a better idea regarding the accounting scandal which took place in Lehman Brothers, it is important that some clarity is achieved regarding Repo 105.
The use of Repo 105 or Repurchase agreement has been used by companies to manage their short term cash requirements and ensure that the liquidity scenario of the company was not affected in any manner (Nenovski, Jolevska and Trpovska 2017). The management of Lehman brothers utilises Repo 105 to manipulate their financial records so that the balance sheet of the company looked appropriate to the investors (Minko 2016).
Traditional repurchase arrangement were utilised by investment banking businesses to utilise its highly liquid security so that it can be exchanged for cash. Such transactions are treated as loans in the accounting records and therefore should be portrayed as a liability in the financial reports.
Further as per Repo 105 arrangement if the investment bank is unable to repay the loan than the lender has the option to sell the securities re recover the cash which is due (Betta and Betta 2016). The repurchasing arrangement also attracted some interest and these were treated as refinancing arrangement when it comes to maintaining accounting records.
The management of Lehman brothers did utilise the Repo 105 which was quite different from the normal practice of a repurchase arrangement and the practice was deceitful as it portrayed a favourable financial record (Flood 2021). The practice involved off balance sheet tactics where securities and liabilities were removed from the balance sheet of the company while reporting the quarterly information to the public.
Repo 105 was basically a mean to refinance the operations of the business and should have been treated as loans for the business but the same were portrayed as sales in the financial records (Stein, Salterio and Shearer 2017). This practice improved the financial health of the business more than it was actually was and this practice was deceitful. The management by removing the liabilities of the business was able to portray better liquidity in the financial records and the balance sheet of the company also looked healthier.
In actual practice, the business was only adding to the leverage of the business as the transactions were required to be treated as loans. The management wanted to portray good financial performance on quarterly basis so that in next quarter, the business can recover its financial performance and stabilise the operations. Such a practice only added to the financial burden of the company and at the time of the bankruptcy of the company, all assets of the business had to be liquefied for meeting the debts of the business (Juabin and Bawa 2020).
The transaction of repurchase arrangements were done at the end of the month in last 7-10 days. Lehman brothers basically would take short term cash loans from counterparties in exchange of its assets and then the business would completely remove such assets from the books which is not an accurate practice in terms of accounting (Awolowo et al. 2018).
Further the short term loans which is procured by the management is treated and shown as sales in the books so that the financial position of the business is well secured. Therefore, the management of Lehman would portrayed less risky assets, lower debts and more cash funds in its quarterly reports published to the people (Lewis 2015).
This practice induced many investors to make investments in the company considering the financial health of the business as per quarterly reports. In an overall basis, it can be said that the management utilised in appropriate practices for the purpose of reporting transactions and completely misrepresented loans as sales for the business.
The accounting practice which was applied by the management can be questioned as they accumulated the debts of the business on a quarterly basis in the hopes the financial situation would improve in the coming quarters (Ahamed 2015). The approach of the management towards repurchase arrangement itself was at fault and this affected the financial reporting process and position of the business.
In an overall basis, it can be said that the accounting irregularities were also responsible for collapse of the business. As the scandal was revealed the public lost its confidence in the company and overall market valuation of the company declined at a significant rate.
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The lessons which can be learnt from the case of Lehman brothers is that the financial accounts should be portrayed in an effective manner and it should be ensured that all information are represented in an appropriate manner. The business of Lehman brothers represented the short term loans taken as sales for the company and this is big manipulations of the accounts.
One of the main lesson was that accounting standards needs to be improved and a global accounting standard needs to be prepared so that the manipulations in the financial records can be managed. The approach should be to ensure that a level of transparency and accountability is achieved in the financial reporting process of the business (Sorensen and Miller 2017). It is important for the management to follow the guidelines of the accounting standards and avoid any practice which can affect the accuracy of the financial reports of the business.
The repurchase arrangement which was followed by the management of Lehman Brothers was different from normal repurchase arrangement and therefore the management could have completely avoided the practice. The practice was one of the reasons that the debts of the company accumulated and this forced the business to apply for bankruptcy.
The accounting practice which was followed by the management was at fault as the practice did not disclose complete information and even manipulated the books so that better financial position can be portrayed for the company.
In terms of external situation, the business was also affected by inappropriate decision making in terms of their lending options. The business followed aggressively subprime mortgages which had an unsustainable returns and targets clients who had a low income and bad credit history. It is clear that the risk associated with subprime mortgages will be high and therefore too much investments in such type of mortgages affected the assets of the business.
Further the subprime mortgage was the reason that the short term liquidity of the business was compromised. With the help of Repo 105, the business used to take short term cash loans in exchange of its assets so that the liquidity situation of the company can be maintained.
The business would have been in a different position if it had not pursued the subprime mortgage option and understood the risks which is associated with the option. In an overall basis, it can be said that corporate governance of the business and the account practice followed by the management can be blamed for the downfall of the company.
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The analysis which is undertaken above considers the accounting scandal which was committed by Lehman Brothers and also shows the immediate causes which led to the downfall of the company. The analysis shows that the approach of the management towards subprime mortgage was a cause for the downfall of the company as this attracted an accumulated loss of $ 50 million.
The business in order to portray a solid image in the market manipulated the books by showing the cash loans as sales for the business by removing assets exchanged. The impact of the manipulations was on the financial reporting process and also on the reputation of the business. The business had to make efforts to stabilise operations by reducing expenses, discontinuing some operations and raising capital.
As per the analysis, the auditors also gave the company a clean chit regarding the accuracy of the financial statements and this also shows that the accounting framework needs to be improved so that transparency is maintained.
The analysis further shows the accounting irregularities which can be seen in the case of Lehman Brothers and how the repurchase arrangement of the company was different from the normal practice which is followed by investment banks.
Furthermore, the analysis covers the lesson which can be learnt from the failure of Lehman Brothers and what sort of measures can be implemented so that transparency and accountability is maintained in the reporting process. In an overall basis, it can be said that the accounting standards needs to be improved so that quarterly manipulations are not possible and the financial reports reveal complete information.
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Ahamed, N., 2015. Corporate governance: Panting to keep up with scams. Prabandhan: Indian Journal of Management, 8(11), pp.42-53.
Awolowo, I.F., Garrow, N., Clark, M.C. and Chan, D., 2018. Accounting scandals: Beyond corporate governance. In 9th Conference on Financial Markets and Corporate Governance (FMCG).
Betta, M. and Betta, M., 2016. Three Case Studies: Australian HIH, American Enron, and Global Lehman Brothers. Ethicmentality-Ethics in Capitalist Economy, Business, and Society, pp.79-97.
Crosina, E. and Pratt, M.G., 2019. Toward a model of organizational mourning: The case of former Lehman Brothers bankers. Academy of Management Journal, 62(1), pp.66-98.
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Ferreira, H.M.P., 2020. Financial accounting scandals and the role of auditors (Doctoral dissertation).
Flood, J.M., 2021. Wiley GAAP: Financial Statement Disclosure Manual. John Wiley & Sons.
Ganon, M.W., Donegan, J. and Rotondo, G., 2017. Embedding Values in Corporate Culture: Applying Schein's Organizational Theory to Lehman Brothers. International Journal of Business & Applied Sciences, 6(1).
Juabin, M. and Bawa, J.D., 2020. The Collapse of Barings Bank and Lehman Brothers Holdings INC: An Abridged Version.
Lewis, M., 2015. The Fall of the Lehman Brothers Could IT Have Been Avoided?. Available at SSRN 2572716.
Mazzola, P., 2018. Power and Influence in the US Investment Banking Industry–a Case Study of Lehman Brothers.
Minko, D., 2016. Implications of the Qingdao metals scandal for commodity repurchase agreements.
Nenovski, T., Jolevska, E.D. and Trpovska, S., 2017. How Investment Banking Influenced The Appearance Of The World Economic Crises-The Cases Of Lehman Brothers And Goldman Sachs. Journal of Sustainable Development, 7(17), p.50.
Sorensen, D.P. and Miller, S.E., 2017. Financial accounting scandals and the reform of corporate governance in the United States and in Italy. Corporate Governance: The International Journal of Business in Society, 17(1), pp.77-88.
Stein, M.J., Salterio, S.E. and Shearer, T., 2017. “Transparency” in accounting and corporate governance: Making sense of multiple meanings. Accounting and the Public Interest, 17(1), pp.31-59.
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