Synopsis

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 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 leverageLehman 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.

Lehman Brothers Holdings, Inc.--Key Facts

1.Lehman Brothers, one of Wall Street's most prominent investment banking firms, became the largest corporate failure in U.S. history when it filed for bankruptcy in September 2008.

2.The release in March 2010 of a report by Lehman's court-appointed bankruptcy examiner prompted a public outcry when it revealed that Lehman had used multi-billion dollar "accounting-motivated" transactions to embellish its apparent financial condition during 2007 and 2008.

3.Similar to other investment banks, a key business risk factor for Lehman was the high degree of financial leverage that it employed; Lehman management persuaded financial analysts and other third parties that its "net leverage ratio" was the best measure of its degree of financial leverage.

4.The business risk faced by Lehman and the other major investment banks was amplified duringtthe 1990s and beyond when they became heavily involved in the rapidly evolving and high-risk financial derivatives markets.

5.When housing prices began plummeting in the U.S. in 2007, Lehman's financial condition worsened dramatically since it had large investments in RMBS (residential mortgage-backed securities).

6.To enhance its reported financial condition and its net leverage ratio, Lehman developed a plan to engage in a large volume of Repo 105s, which were repurchase agreements accounted for as sales of securities (the customary accounting treatment for repos was to record them as short-term loans).

7.Accounting for repos as sales of securities was permitted under certain restrictive conditions identified by the relevant accounting standard, SFAS No. 140; however, Lehman could not find a U.S. law firm that would issue an opinion confirming that Repo 105s could be treated as sales.

8.Lehman executed the Repo 105s in Great Britain after finding a British law firm that would issue an opinion that they qualified as sales of securities; the Repo 105s allowed Lehman to reduce its net leverage ratio by as much as 10 percent and its reported liabilities by as much as $50 billion.

9.Among the parties that were most heavily criticized by Lehman's bankruptcy examiner in his report was the company's audit firm, Ernst & Young.

10.The bankruptcy examiner concluded that E&Y could potentially be held liable for failing to properly investigate a whisteblower's allegations that Lehman's financial statements were materially misstated and for allegedly failing to properly investigate the impact of Repo 105s on Lehman's quarterly and annual financial statements.

11.Numerous lawsuits stemming from Lehman's collapse named E&Y as a defendant or co-defendant; to date, E&Y has made more than $100 million in payments to settle such lawsuits.

Questions

1.What is the responsibility of auditors when a client implements a new and controversial accounting policy that has significant financial statement implications?

2.What is the responsibility of auditors when clients have engaged in significant "accounting-motivated" transactions?

3.Identify auditors' responsibility to review or otherwise evaluate important "other information" that accompanies a client's audited financial statements.

4.What are factors that should influence key materiality decisions made by auditors.

5.What are the responsibilities of auditors when the integrity of a client's financial statements is challenged by a whistleblower?

6.What are auditors' differing legal exposure in lawsuits filed in state courts versus federal courts?