Accounting Justification - Case Study Example

Simplified hypothetical Balance Sheets that roughly approximate Lehman  financial positi0n in late June 2008, as of June 30, 2008, and a few days later  (in billions) are estimated as:

Assets         June 26           June 30         July 2          Liab & Equity      June 26            June 30           July 2

  (In billions)

Cash            $         6                  6              5.95              Trade payables $        90      90         90  

Inv (C Bonds)                350                  297.5         350              Short term debt         200    150       200

Collateralized                                                       Collateralized   

     agreements              400                   400    400              financing                385    385        385

Other                    44             46.5             44         Equity                           25               25          24.95

Total            $    800            750  799.95                                       $        800            750         799.95

The entries that would have been made for the Repo 105 transactions that cause the changes in the financial statements are:

Entries 6-26                                                                      Entries 7-2

Cash           50                                                                             Cash            50

Other            2.5                                                                          Short debt           50

          Inventory        52.5

                                                                                         Inventory      52.5

Short debt    50                                                                            Interest Ex        .05

          Cash               50                                                              Cash            50.05

                                                                                                  Other              2.5

The theoretical accounting justification that this treatment as a “sale” and a contract for repurchase is that the 5% extra of assets transferred is so much greater than interest for the short period that repurchase is obviously different from a pure loan. (Per the legal letter from the Linklaters law firm in London in 2001.)

The crux of the E & Y argument is that SFAS 140 (adopted in 2000) in paragraph 98 states that such Repos “shall” be treated as a sale.  Several amendments and changes to SFAS 140 were made prior to 2007 and 2008 when the Repos became a big problem for Lehman and SFAS 160 more recently.  The SEC apparently does not have sufficient confidence to charge former Lehman executives with fraud but is further investigating E & Y.

Required:

1. Based on reading SFAS 140 and subsequent modifications, do you believe that Repo 105:
2. does not follow the letter of the law, requirements to be treated as a sale,
3. meets the letter of the law, but clearly violates the principles of accounting set forth by

                 FASB, or

1. meets both the spirit and letter of the standards as written?

     Use precise language from one or more SFAS to justify your answer.

******Hint:  Use the Codified FASB database as with Stock Options earlier *******

3. What action do you think the SEC should take following its investigation of E & Y based on your answer to part one above?
4. Regardless of your answer in part two above, why might the SEC be equally reticent to take action against E & Y as apparently happened with Lehman?

Answer:

          The status of SFAS 140 indicates all conditions set by the letter of the law. SFAS also violates the principles of accounting set by FASB. Many potential investors offer false promises hence altering the accounting information.  Rules set in accounting often offer misleading information as it is in the case of SFAS 140. The practice aids accountants remove the temporary liabilities from company balance sheets on temporary purchasing agreements. This is because the transaction is handled as a sale instead of a liability. The controversy of SFAS 140 did not arise in 2008. The standard was under controversy for amendment reasons. The amendment was to re-examine parts of the provisions set for SFAS 140 that may offer misleading information.

          The issue experienced with Lehman brought about the issue of forefront. SFAS 140 is used by accountants to move assets transfer in the form of sale under certain conditions. SFAS 1140 however has many controversies since its rollout. Investigations have been called for as the practice has been surrounded by controversies since it became famous. According to SFAS 140, “If the servicing asset or liability was purchased or assumed rather than undertaken in a sale or securitization of the financial assets being serviced, it shall be measured initially at its fair value, presumptively the price paid” 

Question 2

          No legal action should be placed on Ernst and Young (E&Y) for working with the rule set forth by the governing bodies of the profession. The company delivered given the situation they were under. Due diligence and professional skepticism went into the investigation Repo 105 before E&Y put it on paper. Setting regulations or due process would be the appropriate thing to undergo given the situation. Regulators and auditors need to place concern on certain rules before passing them.

Question 3

          Authorities could not place E& Y under disciplinary action because the rules of SFAS were under revision hence knowledge of problems with the set standard.  The other reason is that E&Y holds the financial statement of clients hence ensures that they are not misleading.  The company could have provided its investors with a qualified report. The company should have done more to discourage the practices of Lehman under the SFAS 140 hence discouraging the practice.  E&Y in the second reason should have supported the first reason’s terms by providing a report to analyze the situation. Auditors have the right to provide an honest opinion on a situation even if it strays from the set standards.

There are rare situations where following U.S GAAP will mislead investors.