On September 15, 2008, Lehman Brothers Holdings Inc., one of the world’s most respected and profitable investment banks, filed for Chapter 11 bankruptcy protection in the United States Bankruptcy Court in the Southern District of New York.1 Although Lehman Brothers (LB) had reported record revenues of almost \($60\) billion and record earnings in excess of \($4\) billion for the fiscal year ended November 30, 2007, only ten months later, their bankruptcy proceeding became the largest ever filed.2 How and why this happened is a complex story, part of which involves financial statement manipulation using a technique that has come to be known as Lehman’s Repo 105 to modify information provided to investors and regulators about the extent to which LB was using other investors’ funds to leverage their own.

Banks generate revenue and profit principally by investing funds borrowed from other investors, such as depositors or lenders. Although some of the funds they invest are their own, banks can increase their activity by attracting and using other investors’ funds—an approach that is known as “leverage” because it is using the bank’s own capital to attract investments from others to increase or lever revenue- and profit-generation investments beyond the capacity of the bank’s own limited resources. A bank’s profit from lending activities is generated by “the spread”—the higher rate of return at which a bank lends funds than it pays outside depositors and investors for the use of their funds. However, outside investors or depositors will invest with a bank only if they are convinced that the bank’s own capital is sufficient to provide an adequate cushion against loss of their investment in the event that the bank suffers losses. Consequently, outside investors want accurate information on the extent of leverage employed by the bank, which is usually provided as a ratio as follows:

In its simplest form, the Repo 105 mechanism—a multiple-step technique3 combined with the failure to disclosure promises to reacquire assets—was used by LB to reduce the reported total assets and net assets included in the leverage ratio, thus showing a lower ratio or more conservative use of leverage than was actually the case. Consequently, bank investors were misled about LB’s ability to cushion losses with its own equity compared to banks that did not artificially depress their leverage ratios..........

Questions:-

1. What was the most important reason for the LB failure?
2. What is leverage and why is it so important?
3. Prepare the journal entries for a Repo 105 transaction sequence for \($1\) million in securities.
4. In your opinion, how large should a Repo 105 transaction be to be considered material and why?
5. Was LB’s interpretation of SFAS 140—Repo 105 transactions could be treated as sales—correct? Provide your reasons.
6. If, as the Examiner’s Report states,41 LB continued to collect the revenue from the securities involved in the Repo 105 transactions, how could LB say that they had given up ownership?
7. An emerging issue Interpretation Bulletin42 accompanying FAS 140 gives examples indicating that Repo 102 transactions would not qualify as sales but that Repo 110 would. Why do you think this Bulletin was issued?
See Q&A 140—A Guide to Implementation of Statement 140 on Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities at http://
www.fasb.org/cs/ContentServer?c¼
Document_C&pagename¼FASB%2F Document_C%2FDocumentPage&cid ¼1175801856780 (accessed March 27, 2011).
8. Knowing that LB could not obtain a “true sale” opinion from a U.S. lawyer under U.S. law, should LB have tried to obtain the opinion from a U.K. law firm? Why and why not?
9. Do the Repo 105 arrangements constitute fraud? Why and why not?
10. What is the auditor’s responsibility if a fraud is suspected or discovered?
What professional standards are most important in such cases and why?
11. If you were the audit partner in charge in the United States, what would you have required be done in regard to the Linklater “true sale”
letter?
12. Should consolidated financial statements of a U.S. parent company include (i.e., consolidate) foreign subsidiary accounts prepared on a basis not considered appropriate U.S.
GAAP?

13. Would the adoption of IFRS have prevented the Repo 105 misrepresentations?
14. What should the following have done on learning of Matthew Lee’s whistleblower’s letter—LB’s management, Board of Directors, and the external auditors, E&Y?
15. Arthur Andersen tried to keep its Enron audit problems quiet, whereas E&Y spoke out in its own defense.
Was it a good idea for E&Y to send a letter, such as the one reproduced previously, to their clients? Why and why not?
16. Based on the letter, should E&Y be in the clear of any wrongdoing related to the Repo 105 and 108 transactions and reporting? Provide your reasons for and against.
17. If an auditor explains a problem to the chair of an audit committee, is there any further obligation on the part of the auditor to ensure that the full board has been notified and why?
18. Organizations who use the Enterprise Risk Management (ERM) framework43 should work through the following stages: review on the internal environment, identification of the organization’s risk appetite or objectives, risk identification and measurement, risk assessment, risk response, providing risk information and communications, and risk monitoring. In which of these did LB fail? Who was to blame for the failure?
19. How should the U.S. Bankruptcy Examiner’s Report be regarded—as a neutral set of findings or as a signpost intended to point creditors in the direction of potential recoveries?
What are the implications of each?
20. After the Enron and WorldCom fiascos, regulators sought to avoid future misrepresentation by enacting the Sarbanes-
Oxley Act (SOX) in 2002. Why did SOX not prevent Lehman’s use of Repo 105 and 108 misrepresentations? Does that mean that SOX is a failure?

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Leverage Ratio = Total Assets Shareholders' Equity (the bank's own capital)