Bankruptcy of Lehman Brothers - Case Study Example

 Bankruptcy of Lehman Brothers The collapse of Lehman Brothers Holdings, Inc. (Lehman) unmasked the presence of problematic loopholes in the accounting treatment for repos. Although Lehman filed for debtor-in-possession reorganisation (Chapter 11) in the United States of America, yet its financial shockwaves severely hit the global economy, prompting the International Accounting Standards Board (IASB) to reconsider its accounting framework towards the International Financial Reporting Standard (IFRS) 7: Financial Instrument. At the same time, the Securities and Exchange Commission (SEC) issued new additional disclosure requirements; and the Financial Accounting Standards Board(FASB) went to the extent issuing an exposure draft (ED) proposing to eliminate the criterion to account for Repo 105 transactions as sales. Lehman’s bankruptcy was considered as the largest one in the financial history of America. In 1850, Lehman took start as a modest retailer of textiles and clothing in Alabama; soon, it became a leading global financial services giant, investing mostly in investment banks, investment management and brokerage securities. However, the year of 2008 recorded the financial history with Lehman filing bankruptcy in September due to its exposure of the risks associated with the residential-mortgage loans; at the same time, Lehman owed $613 billion to its creditors. Lehman perpetrated its deception by using 102% in Statement of Financial Accounting Standards (SFAS) No. 140 (Pounder, 2011) in repos. A repo is associated with a transfer of financial assets when the borrower-transferor- wants to hold its ownership of the assets in the long term, but requires fulfilling the short term cash needs. Initially, the transferor commits that he would repurchase the financial assets in a given period of time after receiving a sum of cash- mostly smaller than the original value of the asset- for the financial assets. Upon maturity of the date, the transferor repays the amount originally received at the start of the transaction along with an agreed-upon sum of additional cash to the transferee. This transaction is accounted for as receiving a short term loan from the transferee and the financial asset is recorded as collateral in case the transferor is unable to repay the sum of amount. The accounting treatment for this type of accounting transaction is provided in (SFAS) No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.”, providing two accounting treatments applicable to such transfers. Under this standard, the transferor would account for the transferred assets as collateral provided to obtain a cash loan from the transferee. Additionally, in some cases, the transferor would account for the transfer as cash sales of assets. In addition, in repo accompanied transfer, the transferor could account for as a sale rather than borrowing if the value of transferred financial assets was more than 102% of the sum of cash received. Lehman carefully planned to reduce the impacts of short term debt on its balance sheet. Nothing more served in its deceptive planning than the loophole in SFAS No. 140! In order to minimise the impacts of the marketable securities on the balance sheet, just before the end of the each quarter, Lehman transferred marketable securities to unrelated counter parties, at the same agreeing to repurchase securities in a specified period of time. And, Lehman accounted for such transfers as sale rather than borrowing. Because of this sale of securities, Lehman became able to fulfil its short term debt needs. Then, after close of each quarter, Lehman incurred new short-term debt to repurchase the transferred securities, which were sold before the end of the quarter and were shown as a sale, from the counterparty. Consequently, the accounting treatment of the Repo 105 asset-transfer and the transactions of debt-reduction, and the timing of the accounting treatment were used in a way that neither the transferred financial assets, nor the sum of cash received accounted for in the financial statements of Lehman, particularly at the end of quarter. Additionally, the financial statements of Lehman did show less amount of short term debt at quarter-end than it would have had it not made transactions under the Repo 105 and paid down some part of its short term debt. Soon after end of quarter, Lehman’s short term debt reappeared on its balance sheet to its previous level, and the same trend was also visible in the marketable securities, pushing Lehman to raise more short term debt for cash to repurchase the transferred marketable securities. Different measures are proposed to fill up the problematic loopholes in the Repo 105. In the late March 2010, the SEC provided its response to the Lehman bankruptcy by sending a “Dear CFO” letter to the chief financial officers of the public companies (Pounder, 2011). The letter required the public companies to disclose information pertaining to the transactions involving the repo-accompanied financial assets. This would enable the SEC to understand the level and extent to which companies involved in the repo-related transactions. Additionally, in September 2010, the SEC issued the Release No. 33-9143, requiring the public companies to disclose additional information about their short-term borrowings. Also, an interpretative release No. 33-9144 was issued; the main purpose of issuing this interpretative release was to assist the public companies on existing disclosure liquidity and funding requirements. The IASB also issued its part of response for the repo-accompanied transfers. The IASB is an independent and not-for-profit, working in the public interest (About US). On October 7, 2010, the IASB modified the IFRS 7, “Financial Instruments: Disclosures,” requiring additional disclosures in case a disproportionate sum of financial-asset transfer transactions involved around the end of a reporting period. Both the SEC and the IASB share a considerable similarity over the additional disclosure requirements. Mostly, both focus on the additional disclosure requirements instead of demanding a change in accounting treatment towards the repo-related transactions. However, still some difference does exist in the disclosure requirements, such as the SEC’s focus on the impact of the transactions on the financial statements of a company in contrast to the IASB’s approach focusing on the transactions themselves. The FASB did not share the same attitude towards the repo-related transactions. The main objective of the Board is to improve the transparency of financial statements (Massoud and Raiborn, 2003). Additionally, the FASB is designated organisation in the private sector in the U.S. (Business wire).On November 3, 2010, the FASB issued an exposure draft (ED), proposing a change to the Generally Accepted Accounting Principles (GAAP). The proposed change requires the elimination of the criterion of the Repo 105 transactions as sales, expecting the less use of such criterion in the future the Repo-related transactions. Consequently, this would change the accounting treatment towards the transactions like Lehman’s Repo 105. Comparatively, this approach is considerably different to the approach proposed by the SEC and the IASB. The impact would vary entity to entity. Entities working under the SEC would require to disclosing the additional information regardless whether they deal with repo-related transactions. A different type of disclosure is expected from the entities applying the IFRS. And the entities following the U.S. GAAP are required to apply for a modified process for identifying the relevant accounting treatment for repo-related financial asset transfers. Detail the accounting technique presented in the case? The Repo-accompanies accounting treatments are provided in Statement of Financial Accounting Standards (SFAS) No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” In 2000, the FASB provided two accounting treatments applicable to such transfers. In its accounts, the transferor would incorporate the transferred asset as collateral pledge to receive a cash loan from the transferee. In the second method, the transferor would account for such transfer as a sale of assets for cash. What are the solutions proposed? Solutions vary from one regulator to the other. The SEC has provided its solutions, focusing mostly on the additional disclosure requirements. Simultaneously, the SEC is putting more focus on the impact of the repo-related transactions on the entity’s financial statements. Interestingly, the SEC has not prohibited transactions like Repo 105, nor has recommended different accounting treatment. Almost, the same sort of response is also given by the IASB, emphasizing on the need of disclosing additional disclosures when a disproportionate amount of financial-asset transfer transactions are carried out especially before the end of a period of reporting. But, the FASB has proposed the abolishment of such accounting treatment as Lehman Repo 105 transactions accounted for as sales. This action is totally aligned with the FASB, whose objective is to serve the public interest by ensuring transparent information (Jenkins, 2002). Instead of demanding more additional disclosure requirements, the FASB has proposed to alter the entire accounting treatment relevant to Lehman’s Repo 105 transactions. What would be the role of regulators in preventing non ethical accounting and business Behavior? The regulators cannot do much in this regard. They can devise and issue accounting treatments and accounting policies. They can develop stronger regulatory and compliance requirements. However, they cannot perfectly prevent any non-ethical accounting and business behavior. For instance, before the collapse of Lehman, the jolts released by the serious debacle of Enron were still felt. Although many financial and regulators were aware of the fact that the Enron storm was politically cultivated as Dick Cheney, the then Vice President of America, had a close relationship inside the corridors of Enron. Additionally, the SEC is regulatory body in the U.S. since its creation in the year of 1934. Interestingly, the SEC’s main objective is to protect investors and maintain efficient markets (what we do). However, the SEC has been failed to prevent the financial market crisis of 1987, Enron collapse in 2001, and the more recent severe financial crisis initiated with the debacle of Lehman in 2008. Till this point of time, the regulators have not been successful in preventing such financial disasters; they have been insufficient in their practical actions against preventing such huge financial disasters. Works Cited Pounder, Bruce ,’A common framework for accounting standards,(FINANCIAL REPORTING)’ Strategic Finance, Institute of Management Accountants Inc., High Beam Research,  2010, 23 April. 2011 Massoud, Masor, Raiborn, Cob. (2003), "Accounting for goodwill: are we better off?", Review of Business, Vol. 24 No.2, pp.26-32. "US FASB and IASB Seek Views on Two Consultative Documents on the Conceptual Framework." Business Wire, Business Wire. 2008. High Beam Research. 23 Apr. 2011 . “About US,” The IASB and the IFRS foundation, 2011, web. 23 April 2011. “What we do.” The Securities Exchange Commission, 2011, Web. 23 April, 2011. Jenkins, E. (2002), "Testimony before the House Energy and Commerce Committee", The FASB's Role in Serving the Public: A Response to the Enron Collapse (June 26), Read More