Wall Street was stunned in September 2008 when this iconic investment banking firm filed for bankruptcy. Two years later, there was a similar reaction within the investment community when Lehman’s court-appointed bankruptcy examiner released his 2200-page report, the purpose of which was to identify the parties that could possibly be held civilly liable for the enormous losses suffered by Lehman’s investors and creditors. The focus of the bankruptcy examiner’s report was hundreds of billions of dollars of allegedly “accounting-motivated” transactions that Lehman had used to enhance its apparent financial condition. Lehman’s Repo 105s were short-term repurchase agreements that the company had chosen to record as “true sales” of securities under the auspices of the relevant accounting standard, namely, SFAS No. 140. The normal accounting treatment for repos is for the “seller” to record them as short-term loans. Why? Because most repos are, in substance, short-term loans in which the securities being “sold” are, in reality, simply the collateral for the given loan. An exception to SFAS No. 140 permits repo borrowers (sellers) to record these transactions as true sales of securities if they can demonstrate that they have “surrendered” control of the securities involved in the transactions. Lehman’s management used this “loophole” in SFAS No. 140 to significantly reduce its “net leverage ratio” and its reported liabilities by engaging in a huge volume of Repo 105 transactions. At the time, the most important metric that analysts used in monitoring the financial health of large investment banks was their degree of financial leverage—Lehman touted its net leverage ratio as the best measure of its financial leverage. This case provides a brief historical overview of Lehman Brothers and then dissects the accounting and financial reporting issues related to the company’s controversial use of Repo 105s. Of course, the principal purpose of this case is to examine the auditing issues raised by the Lehman debacle. The company’s audit firm, Ernst & Young, was among the parties most criticized by Lehman’s bankruptcy examiner. The bankruptcy examiner identified three “colorable claims” involving professional malpractice or negligence that could potentially be pursued in lawsuits filed against Ernst & Young. This case examines the auditing issues embedded in each of those claims.

Give at least 5:

1. FACTS

2. ISSUES

3. RECOMMENDATION