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Analysis of a Real Fraud: The Case of Lehman Brothers

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Analysis of a Real Fraud: The Case of Lehman Brothers

Introduction

Fraud, creative accounting and accounting fraud, are all perennial. Fraud or accounting fraud comprises both the use of deception to obtain an unjust or illegal financial advantage or intentional misrepresentation of financial statements (Jones, 2010). On the other hand, creative accounting is a form of accounting which complies with all regulations but gives a biased impression of the company’s performance (Jones, 2010). This usually achieved through the exploitation of loopholes in financial regulation. Accounting is a vital organ of any business. Proper accounting practices enable companies to document their activities which can be used to examine the performance of the business (Jones, 2010). The business industry has however realized various accounting malfunctions that stem from fraudulent accounting practices. However, creative accounting can be used to serve a given range of interests like to boost profit or increase assets. Creative accounting has to be audited to ensure that the required protocol is followed.

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Alternatively, in other cases the management may indulge in fraudulent accounting. Some companies engage in accounting fraud practices in order to cover up for their businesses poor performance. Other managers may record fictitious transactions or falsify records in order to satisfy their interests. This overlooks the required accounting rules and regulations. Often this leads to serious financial difficulties. In many cases, companies begin with smart accounting but ends up committing fraud (Jones, 2010). This paper endeavors to give an expansive analysis of the fraud scandal that led to the collapse of Lehman Brothers; a one time economic giant that has succumbed to the consequences of accounting fraud.

Specific Fraud Risk Factors

Lehman Brothers Company was an investment bank in the U.S. Before its collapse, Lehman Brothers Company was ranked amongst the top four investment banks in the United States. The company collapse in 2008 after becoming bankrupt. At the time of its collapse, Lehman Brothers had assets worth $639 billion and a debt of $619 billion. The company was started by two brothers in 1850 (Roberts, 2012).

The initial culprit

The company acquired five mortgage lenders in 2003 and 2004 at a time when the U.S real estate business was flourishing. At the beginning, the acquisitions showed great promise. In fact, within three years (2003-2006), the company’s capital market grew by a whooping 56%. By 2007, the company had netted $4.2 billion in profit (Roberts, 2012).

The company’s miscalculation

In 2007, the U.S mortgage industry was shaken due to defaults on subprime mortgages. Even though the stock market suffered a massive blow from the downfall in the Mortgage industry, Lehman Brothers reported sizeable revenues and profit in the first quarter of the financial year of 2007 (Roberts, 2012). The company’s chief financial officer (CFO) argued that the challenges caused by home delinquencies did not affect their company and the company’s earnings were not threatened (Roberts, 2012). The CFO also stated that the challenges in the subprime market were unlikely to affect the rest of the housing industry or the country’s economy at large (Roberts, 2012).

Warning signs

The collapse of two Bear Stearns hedge funds in August 2007 led to credit crisis. During that month, the company’s stock fell sharply (Roberts, 2012). Within the same month, the company got rid off an estimated 2,500 jobs related to in the mortgage department. In addition, the company closed down one of its satellite units (BNS unit). The company also closed three offices that were linked to Alt A chain. Despite the fluctuations in the housing industry, Lehman Brothers remained on as top mortgage lenders. In the last quarter of the financial year of 2007, the company’s sock rebounded. “This occurred at a time when the global equity markets experienced exceptionally new highs; this was also the case with prices for fixed price assets suffered a temporal rebound” (Roberts, 2012, p.1). Amazingly, Lehman Brothers failed to cut its enormous mortgage portfolio. This point defined the boundary between success and failure. Although the failure of the company was eminent, the top management could not read the red signal.

The red signal became obvious

The company had a questionable ratio in terms of total assets and shareholders equity. On top of that, the gigantic mortgage portfolio securities endangered the success of the company during the economic downturn. Towards the end of the first quarter of the financial year of 2008, the company’s shares fell to 48% following the downfall of a key player in the mortgage backed securities (Bears Stearns) (Roberts, 2012). Just before the beginning of the second quarter of the financial year of 2008, Lehman Brothers seemed to reaffirm its stability when the company managed to raise $4 billion via a preferred stock (the stock was converted into shares). This was short lived as the trend in stock reduction continued. In fact, at this moment hedge fund managers became skeptical of the valuation of the company’s mortgage portfolio. Another loss amounting to $2.8 billion was reported in the second quarter of the financial year 2009.The company began feeling the heat and made several attempts so as to reclaim its image. First, Lehman Brothers claimed to have received $6 billion from investors and that it hand enhanced its liquidity pool to $45 billion (Roberts, 2012). Secondly, the company announced that it had reduced its cut down leverage and gross assets by $7 billion to $146 billion respectively. In addition, the company claimed to have minimized its residential and commercial mortgages by 20 percent (Roberts, 2012).

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The steps taken did not yield much success. Lehman Brothers top management tried to make overtures to several investors, but all ended up in vain. In September 2008, the stock was at a soaring 77% (Roberts, 2012). The company reported decimal performance in the third quarter of the year 2008 (Roberts, 2012). Investors became concerned at how the CEO would keep the company together by selling a proportion of the management unit and commercial real estates assets. At this stage, small creditors, clients and other significant investors pulled back. Lehman Brothers was not able to withstand storm. The company reported a loss of $3.9 billion and a write down of $5.5 billion (Roberts, 2012).

Several days before the news got into the public domain, Moody’s investor service, a key investor in the company, indicated that it was reviewing the credits rating of Lehman Brothers (Investopedia Editorial Team, 2012). The investor also indicated that it was going to sell a majority of its stake to other investors so as to prevent chances of a reduction in their rating. At the end of the final week of the last quarter, the company had remained with only $1billion. At this moment, collapse was inevitable. The very last effort that the company used involved a spirited attempt to champion for a take over by Barclays PLC and Bank of America. By the time the company was announcing its bankruptcy on the 15th of September 2008, the stock had stood at 93%.

How the Fraud was detected

The fraud in the Lehman Brothers was detected long after its collapse. The courts appointed an examiner to investigate the collapse of the company (Investopedia Editorial Team, 2009).

How the Fraud was accomplished

According to the report produced by the investigator, the company did not publicly reveal the use of Repo 105 transactions (Investopedia Editorial Team, 2009). The report indicated that Lehman Bothers made use of the Repo 105 transactions in order to reduce the balance sheet. The company also misrepresented the financial statements of Repo practice. Under normal circumstances involving repo transactions, a financial institution take funds using securities of treasuries as collateral (Jones, 2010). Jones argues that:

The collateral stays on the borrower’s books, the cash injection often increases the bank’s balance sheet, as if assets were duplicated. In addition, a liability arises from the borrowed amount, because of the maturity of the Repo, the borrower returns the cash, plus interests and gets the securities back (2010, p.5).

On the other hand, one cannot provide any guarantees that “the repurchase of the securities will be favorable at favorable prices” (Jones, 2010, p. 9). Repo transactions may be adventitious in that, if successful, they will enable the borrower to generate capital. Amazingly, Lehman brothers made use of the Repos transactions because they had some financial reasons behind their decision, but in fact, they thought of them as disposal assets (Investopedia Editorial Team, 2009, p. 1). “Lehman Brothers circumvented the two problems mentioned earlier by and used Repo transactions to minimize its leverage prior to the disclosure period” (Investopedia Editorial Team, 2009, p.1). These Repo proceeds amounted to $50 billion by September 2008. Thus, because of the Repo 105 initiative, the company reported a leverage drop of 1.8 in the second quarter of 2008. However, the company was not able to disclose these transactions. The Repo transaction was driven through the UK subsidiary due to the fact that there were legal limitations put on it in the United States. (Investopedia Editorial Team, 2009, p.1). They were clearly used as leverage reducing transactions at lower rates. Instead of reporting Repo transactions as sales; the CFO reported them as financing transactions. Apparently, Repo transactions increased from late 2006 to May 2008 (Investopedia Editorial Team, 2009). The transactions exceeded the set limits, and they occurred at the end of each quarter at the time when financial reports were released.

Moreover, “the investigator appointed by the courts found out that Ernst & Young failed to the accounting policy but rather became comfortable with the policy for the purposes of auditing, financial statements” (Roberts, 2012, 2009, p. 1). In fact, according to the conclusion provided by the examiner, there were quite enough evidence that” to support a finding that claims of breach of fiduciary duty exist against the top management of Lehman Brothers” (Roberts, 2012, p. 1). In addition, the evidence also supports colorable claim of professional malpractice exists against Lehman Brother’s auditor (Ernst & Young) (Roberts, 2012).

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Recommendations

A number of approaches can be employed to curb accounting fraud. This may involve the proper use of creative accounting. They include (Jones, 2010);

Aggressive accounting

This approach is remarkably similar to creative accounting. Aggressive accounting involves the use of accounting rules and regulations to deliver a particular result, but working within the system (Jones, 2010).

Earnings management

This strategy involves using flexibility within accounting to deliver a predetermined profit (Jones, 2010). This approach enables the company to devise the implement necessary requirements so as to achieve the set figure. Analysts often offer forecast of firms taking part in stock exchange. Therefore, firms strive to attain the forecasted figures to avoid their stock value from falling. Companies that fall short of their targets thus seek to manage their profits.

Impression management

This strategy represents an attempt by the management of the firm to give an impression of the firm’s earnings (Jones, 2010). This strategy can be essential in analyzing the trend of the company I terms of profits. However, managers should be keen to avoid fictitious reporting to give an otherwise impression. The actual impression should be given so that corrective measure can be deployed immediately in case of red signals.

However, other accounting practices like profit smoothing should be avoided at all cost. Profit smoothing encompasses the use of accounting techniques to ensure a steady profit (Jones, 2010). In the real sense, the natural peaks and troughs of accounting profit are eliminated. The current business environment naturally rewards performing companies and punishes non performing ones. The stock market boosts well performing firms but unwillingly taints the image of non performing ones. Therefore, non performing firms may engage in profit smoothing to avoid negative publicity by the stock market. This practice should be avoided at all cost because it amounts to accounting fraud.

Lesson learnt

Companies need to handle poor performance by the use of sound problem solving strategies rather than resorting to fraudulent accounting techniques as a cover up.

References

Investopedia Editorial Team. (2009). Case Study: The Collapse of Lehman Brothers. Investopedia. Web.

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Jones, M. (2010). Setting the Scene. Web.

Roberts, N. (2012). Business Day: Lehman Brothers Holding Inc. New York Times , p. 1.

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