Corporate Collapse of Lehman Brothers - Case Study Example

Corporate Collapse of Lehman Brothers Table of Contents Table of Contents 2 Fraud, Creative, Mark to Market accounting and poor auditing 3 Examples of failure in the accounting procedure 4 Role of Accounting in Corporate collapses 5 The collapse of Lehman Brothers 6 References 9 Fraud, Creative, Mark to Market accounting and poor auditing The procedure of using fictitious accounting transactions which are generally prevented by the GAAP (Generally accepted accounting principles) is known as fraud accounting. The most common forms of fraudulent activities include 1) reporting fictitious revenues 2) understating liabilities and expenses 3) improper valuation of assets and liabilities (Klapproth, 2011). On the other hand, the procedure of creative accounting is used to create loopholes in the company’s regulatory system. In USA this procedure is a part of fraud accounting but in the UK it is used to provide flexibility in the existing accounting and regulatory system of the company. The sole purpose of accounting is to provide a true and fair view to the users of the financial information (Larson, 2008). Creative accounting does not necessarily mean the violation of GAAP rules or breaching of any terms and condition of the company. The accountants generally use this concept to insert flexibility in the accounting system and deliver a true and fair view to the users of the financial report and information (Jones, 2011). Mark to Market accounting on the other hand is used for updating the value of an asset or a liability to reflect the real market value of the asset/ liability (Wolnizer, 2003). This was mainly used for transaction related to future exchange and recently it is been used by banks and other financial institutions. This method got official recognition in the year 2009 by FASB (Financial Accounting Standard Board). This method was used to prevent inappropriate use of financial value. Companies usually use this method for assets and liabilities but it is also used for future exchanges to meet the profit margin requirements. If the margin accounts are not monitored regularly then the current market value could drop drastically below the required levels. The process of internal audit adds significant value by preventing fraud accounting within the company and improving financial control. Audit failure leads to misappropriation of funds and non detection of fraudulent activities within the company. Companies which rely on external source for internal auditing process are likely to detect less error than those who conduct the process themselves (Idowu and Çaliyurt, 2012). Examples of failure in the accounting procedure One of the most controversial accounting scandals was the “Enron scandal” in which Enron Corporation, a Houston based energy, service and commodities corporation filed for bankruptcy in October 2001. The shareholders of the company lost $74 billion and thousand of employee lost their retirement accounts and jobs. The CEO of the company Jeff Skilling and former CEO Ken had not portrayed the huge debt amount in their balance sheet. In October 2000, the share price of the company skyrocketed to $90 per share and later in the November, 2000 the stock price dipped to $1(Bierman, 2008). The stock price of the company went down because Sherron Watkins, an employer of the company had raised suspicion about the high stock prices through the whistle blowing method. The CEO of the company and his accomplice was eventually caught and were termed for 24 years in prison (Accounting Degree, 2013). This had tarnished the image of Enron Corporation completely and the management of the company who had sought plans for IPO (Initial Public Offering) for the internet department could not continue with the plans of IPO. Another similar incident which had sparked controversies in USA was popularly known as the “World com Scandal”. In the year 2000, the CEO of MCI Communications Mr. Bernie Ebbers became one of the wealthiest men in the nation even amidst the financial crisis faced by the telecom industry. He had capitalized the line costs instead of putting it in under the expenses heading. He had also falsified the accounts by inserting fictitious accounting transactions. The internal auditing department had detected fraud accounting which was worth $3.8 billion. This incident led to the company filing for bankruptcy and the CEO was sentenced to 25 years of prison for conspiring and committing fraudulent activities (Accounting Degree, 2013). These incidents reflect that fraud accounting and poor auditing can affect the future of the company. However, the definition of fraud varies from one country to another for example in UK there is no legal definition for fraud accounting. In the UK if an employer has suspicions related to fraudulent activities being committed in a company then he/she can take the matter to the court. In the year 1991, a UK based company named Polly Peck had collapsed due to the false and fraud accounting being committed by the CEO Asil Nadir. However, the CEO was not brought to the court because there was no alleged report against him (Jones, 2007). As per the UK Companies Act 1844 the financial reports have to be prepared by the board of directors and not by the auditors, it is the duty of the auditors to authenticate the financial reports (Power, 1994). In the USA, the CEO of Enron Corporation Jeff Skilling and former CEO Ken were immediately tried in the court in spite of no alleged complaint against them. This reflects that the legal definition for accounting system may vary from one country to another but every company needs to adhere to standard accounting systems and procedures. Role of Accounting in Corporate collapses An integral part of the company’s corporate governance is the internal audit process of the company. The process of internal auditing adds significant value through regular monitoring of the environment within the company to detect fraud and error in the accounting system procedure. This also signifies that the companies which perform internal audit themselves are more effective than those who rely on external source for internal audit. The main task of the internal auditor is to ensure that the financial information of the company is free of falsification and errors. Most of the corporate failures have occurred due to fraud accounting and poor internal control, auditing. As per the report of Association of Certified Fraud Examiners (ACFE) there are three types of fraud accounting which are asset misappropriation, fraudulent financial results and corruption and the most common type of fraud accounting is the financial statement fraud. In the year 2002 and 2003, 6 percent of the US company revenues were lost due to fraud accounting (Klapproth, 2011). As per the KPMG survey conducted in the year 2004, around 491 companies in New Zealand and Australia had lost their revenue due to fraud accounting (Coram, Ferguson and Moroney, 2007). The net worth of the losses incurred by these companied due to fraud accounting and was $457 million (Coram, Ferguson and Moroney, 2007). Good corporate governance ensures that the board of directors and the managers of the company comply with GAAP accounting policies and procedures while financial reporting. Sometimes the internal auditor can use professional scepticism to detect scheming being conducted by the management of the company. Methods like Whistle blowing and investigation conducted by the internal auditor can detect fraud in time. The internal auditor measures compliances with the company’s policy and procedures and does not execute the activities in compliance with the company norms and regulations. It becomes the duty of each and every employer of the company to comply with the advice of the internal auditor. Audit failure will not help the company management to attain their objectives and goals in a systematic and disciplined approach. The key objective of the internal auditor is to provide the shareholders and stakeholders key assurance that risk management is being done effectively. Audit failure occurs due to the auditor’s incompetence or negligence to uncover the misrepresentation of the management (Gray and Manson, 2007). It also occurs when the internal auditor fails to prepare timely reports, improper assessment of risk management, non detection of misappropriation of funds etc. A proper internal control system checks the mathematical accuracy and the authenticity of the facts that are derived from the data capture procedure (Trenerry, 1999). Lack of a strong internal control system will not help the management of the company to attain the corporate goals of the company. Wrong information and inaccurate financial reporting by the internal auditor can lead to the incorrect decision being taken by the management of the company. The management of the company must realize that weak internal control system and financial reporting can lead to weakening of the company’s capital structure and can increase the risk exposure of the company (Sudarsanam, Ang and Frederikslust, 2008). The management of the company need to realize that audit failure occurs due to non detection of errors by the internal auditors and not due to misreporting by the internal auditor. The collapse of Lehman Brothers The collapse of Lehman brothers had sent shockwaves across the people in USA and other countries. This occurred when the company had filed for bankruptcy in the year 2008. This piece of news was also disturbing to the employees of Lehman brothers as most of them lost their jobs. There were many causes that led to the collapse of Lehman brothers which include their heavy investment in the real estate market, the development of the USA housing bubble, Subprime mortgage crisis, lack of a proper risk assessment and management etc. One of the major contributors of recession was the subprime mortgage crisis which was caused due to the rise in the then subprime lending rate, government housing policies. The subprime crisis had occurred due to huge increases in mortgage delinquencies and subsequent foreclosures of loans in America. Partial blame for the subprime crisis was laid on the banking policies and regulation because government allowed them to apply their own banking laws and regulation. Lehman brothers were not following a unique business model while the other institutions were following a high risk and high leverage business model. The company maintained $700 billion of assets on a capital of $25 billion. The assets of the company were long term and the liabilities were relatively short term. Lehman brothers was funding by borrowing hundreds of billion from the Repo market. The net assets of Lehman Brothers had increased by $146 billion in the year 2006, a 10 percent increase from its previous year. During the tenure 2003 to 2004, the management team of Lehman Brothers took advantage of the USA Housing Boom situation and acquired 5 mortgage lenders including BNC Mortgage and Auorra Loan Services. During the tenure 2004 to 2006, the management of Lehman Brothers reported high amount of profits. However, during the year when the subprime lending rate was at an all time high the company reported of accumulation a debt amount of $619 billion. As per the chapter 11 of the US bankruptcy code, a company can file for bankruptcy if the accumulated debts exceed $1,081,400 billion of secured debt and $360,475 billion of unsecured debt. Once Lehman Brothers filed for bankruptcy it was reported that the company would make $10 billion payment to its first creditor. The company also lacked an improper debt equity capital structure. The analyst of the company could not properly assess the risk associated with the real estate industry. Lehman brothers followed a very irrational investment strategy based on erroneous perception. The company increased its risk limit from 2.5 billion to 3.3 billion in the year 2006. Although, the company altered its risk limits for its other investment sector, and it refused to decrease its risk margin for the real estate sector. An inappropriate recommendation from the analyst of the company to invest heavily in the real estate market amidst the USA Housing bubble led to the bankruptcy of the company. To maintain liquidity and obtain favourable credit rating from the credit rating agencies the company paid the investors of the company from their money instead of the profits. The credit rating companies such as Moody, Fitch and Standard & Poor maintained a credit rating of A for Lehman brother during their crisis and until their collapse. The collapse of Lehman Brothers occurred mainly due to the above mentioned factors and not because of its failure in its accounting system and procedure. References Accounting Degree, 2013. The 10 worst corporate scandal [pdf] Available at:< http://www.accounting-degree.org/scandals/> [Accessed 08 April 2013]. Bierman, H., 2008. Accounting/finance lessons of Enron: A case study. Singapore: World Scientific. Coram, P., Ferguson, C. and Moroney, R., 2007. The importance of internal audit in fraud detection [pdf] Available at: [Accessed 08 April 2013]. Gray, I., and Manson, S., 2007. Audit process: Principles practice and cases.4th ed. London: Cengage Learning. Idowu, S.O., and Çaliyurt, K.T., 2012. Emerging fraud: Fraud cases from emerging economies. Berlin: Springer. Jones, M., 2007. Accounting for non-specialists. New Jersey: John Wiley & Sons. Jones, M., 2011. Creative accounting, fraud and international accounting scandals. New Jersey: John Wiley & Sons. Klapproth, U., 2011. Fraudulent financial reporting. Berlin: GRIN Verlag. Larson, C.R., 2008. Accounting fraud and institutional investors. Michigan: ProQuest. Power, M., 1994. The audit explosion. London: Demos. Sudarsanam, P. S., Ang, J.S. and Frederikslust, R.A.V., 2008. Corporate governance and corporate finance: A European perspective. London: Routledge. Trenerry, A., 1999. Principles of internal control. New South Wales: UNSW Press. Wolnizer, P.W., 2003. Mark to market accounting: True North in financial reporting. London: Routledge. Read More