Question

1. How were the Lehman Brothers doing before their 2008 scandal?

2. What led to the Lehman Brothers' downfall?

3. Was there pressure to misrepresent earnings or financial positions for some reason?

4. Was it a simple case of fraud, or aggressive financial reporting?

5. Was the company in violation of GAAP or simply “stretching” the rules to misrepresent?

6. Explain the implications for the auditors. Were the auditors explicitly named in the case or infer what the impact was on the auditor in the PCAOB and/or SEC proceedings?

7. Is there any other information that could be useful in describing their situation?

Note: all answers are to do answered about the Lehman Brothers scandal.

Answer 1

1. How were the Lehman Brothers doing before their 2008 scandal?

Lehman Brothers were the fourth-largest investment bank in the United States. It was formed as a global financial service firm in the year 1850 and has a history of around 158 years. Internationally, 25,000 people were working at Lehman Brothers before their 2008 scandal.  

Lehman Brothers were considered one of the major players in the global banking and financial services industries. Its operations shifted to New York in 1858 when the city became home to a cotton and commodity trading. Over the next century and a half, the firm underwent numerous changes and engaged in several alliances and partnerships.  

2. What led to the Lehman Brothers' downfall?

By 2004, Lehman has acquired five mortgage lenders, including BNC Mortgage, a subprime lender. Lehman invested even more in securitized mortgages over the next few years, more so than any other firm. Lehman's big investment in mortgage securities made it especially vulnerable as the housing market started to crash. Lehman brothers started to correct the decisions made but it was too late, it didn't have the capital cushion to absorb its losses and its stock price continued to plunge. Lehman was forced to file for bankruptcy on Sept 15, 2008. The firm held more than $639 billion in assets.

3. Was there pressure to misrepresent earnings or financial positions for some reason?

Lahman Brothers were heavily involved in the mortgage market, owning the subprime mortgage seller BNC Mortgage. When the subprime mortgage crash affected the bank badly and in the first half of 2008, it lost of 73% of its value.

A subprime mortgage is a loan given to someone who has a poor credit score. Because subprime borrowers are seen less likely to be able to pay the money back, the lender is normally compensated with higher interest rates. However, in the years preceding the 2008 crash, these loans in the US were given out wit artificially low rates for the first couple of years of each mortgage.

What really happened - They sold toxic assets to the Cayman Islands banks under the repurchase agreement and recorded such transactions as sales instead of loans which let them to hid over $50 billion in loans disguised as sales. It created the impression that Lehman has $50 billion in cash and $50 billion less in toxic assets.

The firm survived many of the world's largest disasters, including two world wars, the Great Depression, and many more crises. However, it was its over-leveraging and unwieldy venture into subprime lending that caused its ultimate downfall.  

4. Was it a simple case of fraud, or aggressive financial reporting?

It was due to aggressive financial reporting i.e. reporting loans as part of sales made the bunder.

5. Was the company in violation of GAAP or simply “stretching” the rules to misrepresent?

The company did violate the GAAP rules and also misrepresented the financials. Due to a lack of evidence, the Securities and Exchange Commission did not prosecute the firm.

It was finally concluded that the Lehman Brothers had violated GAAP; even it was in technical compliance with accounting rules.

6. Explain the implications for the auditors. Were the auditors explicitly named in the case or infer what the impact was on the auditor in the PCAOB and/or SEC proceedings?

Ernst & Young's role at Lehman Brothers drew a lot of criticism in the field of the accountancy profession. It was Ernst & Yong that certified that Lehman had followed GAAP. It also pointed out that, although there was evidence that E&Y should have done something differently in the final weeks of Lehman's existence, there would be no trial on whether the firm's audit of the 2007 financial statements was bad. It was also noted that E&Y in its report stated that they did not evaluate the possibility that Repo 105 transactions were accounting-involved transactions that lacked a business purpose.

This certificate given by E&Y raised a few eyebrows ar the Public Company Accounting Oversight Board, which sets auditing standards and regulates auditing firms. They finally said that if Lehman's audit is in compliance with the auditing rules, it is time to review the rules.

7. Is there any other information that could be useful in describing their situation?

The collapse of Lehman Brothers transformed a US subprime mortgage crash into a global economic downturn which lasted until late 2009. Banks across the world were bailed out, including the Royal Bank of Scotland by the UK government; stock markets plummeted and debt spiralled, and hundreds of thousands lost their houses. No banks accepted the mortage-backed bonds as collateral for a loan, the banks refused to lend to each other and the financial system was threatened with collapse.