Lehman Brothers and the Repo 105 Scandal - Essay Example

LEHMAN BROTHER AND THE “REPO 105” SCANDAL By Lehman Brothers and the “Repo 105” Scandal The “Repo 105” is an accounting trick commonly used by banks and other financial institutions such as investment banks, whereby they report a short-term loan as a sale, which of course is not. The cash in from the said “sale” is used to offset debts, a move which allows the company to temporarily pay down its liabilities, thus significantly reducing its leverage. The temporal pay trick is usually long enough to reflect the said “sales” on the company’s published balance sheet, but after the company has declared its financial report, it later borrows money and repurchases its original assets. The trick works perfectly, and manages to lure unsuspecting investors into trusting the company’s financial reports. Banks however use Repo 105 for purposes of short term borrowing, while in the case of Lehman, it was used to reflect a healthier balance sheet than it actually was. Jeffers (2011, p. 2) observes that the Lehman brothers used the “Repo 105” in its accounting severally to report impressive financial statements and win the trust of potential investors, by showing healthy securities. The company was an investment bank which had gone global. Lehman’s’ auditors on three occasions used the Repo 105 creative accounting trick to boost investor confidence. The trick used by Lehman helped them temporarily remove from its balance sheet roughly $ 50 billion, making the balance sheet look better the actual status of the company’s financial statements. However, at the time of filing its bankruptcy case, the company has a total of $ 639 billion in assets and $ 619 billion in debts. This formed the biggest bankruptcy case that affected over $ 10 trillion in investments. The company’s scheme involved the use of collateral firms such as Alpha Ville, with counter parties from banks such as Barclays Bank of Britain, USB of Switzerland, Mizuho Bank and Mitsubishi UFJ Financial Group. To be exact, the company involved in Repo 105, the transactions’ worth was estimated at over 105 per cent of the actual cash it received. This meant that the company was experiencing a shortage through these transactions. When they repaid the cash it received from the counterparties, interest was included, which made it a very expensive technique, thus losing money. Repo 105 is a tricky phenomenon for any company which opts to use it as a model of reporting its financial status. According to accounting standards, it is wrong and unethical for a firm to alter its books of accounts (Nguyen & Gong, 2012, p. 31). It is an issue that is quite sensitive, deciding to report a misleading state of a company’s financial status. Whether such a situation finds its way to legal courts or not, it makes no difference, involved parties ought to hold responsibility for any eventuality through their actions. Not unless a company is planning on a strategy to defraud and steal from potential investors, it would never go to such lengths like Lehman did, with clear knowledge of the implications that are likely to come (Law, 2011, p 511). Some examiners hold that “Repo 105” actually is a “gross negligence” and does not amount to crime. However, the fact that Lehman altered its accounts with the intention of deceiving investors, rating agencies and perhaps the industry regulators is proof enough that this was criminal and that the presenters of the company acted in malice. The scheme led to the largest corporate bankruptcy case in the United States financial history (Sharp, 2010, n.p). Investors lost money, in the process. No matter how much conservatives refer to this as a form of negligence, it is still a crime. According to the accounting theories, Lehman accountants and managers contravened the theories of accounting and broke the oath of conduct of accountants. Although some scholars like Jennings (2011, p. 38) felt that the internal misleading of the company itself by the altered accounts could have been more serious than the damage caused to third parties, the damage to third parties still was evident after liquidation. Such is the ill motive of the company’s decision to defraud the public through altered accounts. Decision theory states that accountants should not focus more on the profits side of the accounting process, but rather provide information for decision making purposes (Schroeder, et al. 2005, p. 43). The principle is a modern deviation from the income theory that allowed accountants to account for the purpose of profits. Decisions always focus about the future, and information is crucial at every stage of the decision making process. Thus, whenever making his decision, an investor or a financial analyst will consider accounting information provided in the company’s books of accounts. Misleading information leads to wrong decisions, adversely affecting the investors. Lehman accountants did not act in accordance to the provisions of this theory. In fact, they contravened it, opting to use the historical income theory. They, in their books of accounts, opted to report good numbers in their books, and thus giving the investors and financiers a wrong picture of the company’s actual financial state (Sharp, 2010, n.p.). Measurement theory of accounting on its part is the manner in which accountants assign numerical values to represent specific attributes of events and objects that have been identified in the financial statements. To make a rational decision, a person, investor or a financier depends on the information provided in numerical form. The theory of measurement simply deals with the problem of accessing and evaluating data for the purpose of stating it correctly or representing it in an accurate manner. This theory states that the information provided should represent the true status of the company (Deegan & Unerman, 2011, p. 417). Objects and selected events for evaluation should reflect the objectives of the business decisions clearly and unambiguously. The reality of the matter that faced Lehman was the problem of disclosure. And when they did so, it was misleading information. Data provided in the firm’s financial statements could not be measurable in any form. The information contained therein was not true. The accountants, in conjunction with the management of the company conspired to doctor the statements of the company in such a way that any person who made use of them either made a decision regarding investment or financing the company was bound to be misled. The make-believe picture they created was totally different from the actual state on the ground. The company was facing financial problems, whilst the “Repo 105” made it to appear otherwise. Investors and financiers exhibited unbeatable trust in the company, putting their money into the organization without too much questioning. Eventually, the company went bankrupt, becoming the biggest bankruptcy case ever in the American history. Information theory on its part holds for facts, observations or anything that amounts to knowledge in a firm. Information is essential to the organization in making informed decisions that are geared in helping the organization realize its full potential in the use of resources, capital and labor. Information is regarded as a resource and, and thus, the information theory takes it in with a lot of seriousness. The results of proper information use is the achieved by matching the casts of production against the benefits. Costs of doing business ought to be less than the benefits in cost accounting. Costs in any organization are inclusive of operating costs, production costs and added costs such as marketing and distribution costs (Rajasekaran & Lalitha, 2011, p. 37-39). All this information is extracted from the books of accounts of the company. Any financing decision, as well as budgeting is done in relation to the balance sheet data and other financial reports statements. Any misleading information leads to poor decisions by the organization, which at times proves to be crucial to the organization’s survival. Financing and budgeting for Lehman must have been a hectic exercise for managers. Not with “gimmicks” and the doctoring of the liabilities being reflected as “sales”. Not only would an outsider be confused by the outcome of such a revelation, the decision making committee too would have a hard time in trying to separate the two. Unless the management was keen enough to maintain other counter efficient books of accounts, decision making for the firm would have been a messy idea. For such a cumbersome situation, time must always have been lost in drawing a final budget. 2. Accounting manipulation is a phenomenon where accounting numbers are altered with a sole intention of misleading the users of the financial information, which is mostly for personal gains. Jamnik (2011, p. 56) states that contents of the accounts are manipulated in such a way that accounting is used to alter the numbers reported indicate the indentations of the firm, and give a wrong picture of the actual performance to the user of the said information. A firm can either choose to use pure accounting choices, opportunistically classifying and disclosing items or by structuring and timing the real transactions in order to have a goal in the reporting of the information. The manipulation classified according to the time it takes place, such as inter-period and intra-period manipulations. There are a number of reasons why organizations opt for creative accounting. The conflict of interest that lies between various groups is the main cause for this unethical phenomenon. Managers want to pay minimal taxes in reference to the profits made by the company and at the same time pay the shareholders low dividends, while the employees on their part are concerned about acquiring good salaries and higher profit shares. They achieve this by inviting more investors into the company, and when its reports are not impressive, it opts for creative accounting or manipulation (Marciukaityte & Szewczyk, 2011, p. 102). To invite more investors into investing in their company, the Madoff brothers used creative accounting to reflect a false state of their company’s state. For years, the company top decision making hid behind this phenomenon, and were not discovered until it was revealed that the company had been involved in funds misappropriation and creative accounting. Many people lost their invested funds, while the company’s managers were prosecuted (McCarthy, 2009, p. 2). On their part, the authorities want to acquire high taxes, as the shareholders aim for high dividends. The various interests vested by the various people responsible in the organization are the major facilitators of this problem of creative accounting. Starbucks coffee outlet chain was faced by a huge tax scandal case where it had avoided a tax payment since the year 1998. The leading coffee outlet had paid just 8.9 million pounds for the period between 1998 and 2008 despite having made revenues totaling to 1.2 billion pounds in United Kingdom (Baker, 2012, p. 5). The company may alter its accounts where the managers, in trying to manage the interests of the shareholders have to balance between paying low in taxes, but at the same time maximize on the dividend payment. Another reason for accounts manipulation according to is to attract external financiers by reporting an impressive performance by the firm. 3. Financial regulations aim at bringing sanity to the accounting profession by setting codes of conduct and the mode of reporting by accountants around the world. The International Accounting Standards adopted in 2002 aims at regulating the activities of the accountants to perform their jobs with diligence and exhibit high morals and integrity in the financial accounting and reporting of financial information. It is such creative accounting that prompted the drafting and implementation of the accounting regulations. Through strict regulations, such discrepancies in the financial statements of companies are detectable and rectified before turning out into a crisis, just like in the case of Lehman brothers. Stringent accounting regulatory measures means that before financial statements and reports are released for public use, the regulatory authority has to scrutinize them to ascertain their status (Ya-Fang et al. 2005, p. 150). The authority is likely to have its auditors and supervisors, who compare the actual state in the field to the report provided in the financial statements. Any discrepancy detected, or inconsistency in the statements would raise alarm, and the regulatory authority would take appropriate action. For example, Ya-Fang et al. (2005, p. 156) observes that any IPO offer by Taiwan firms, mandatory disclosure of the company’s books of accounts are seen to be an opportunity for industry regulators to save the public from wicked business people. A close look into the company’s books of accounts would have shown the trend that they used to affect the Repo 105. Lehman, in an aggressive means to put its books and assets in order, set the repurchase price of assets sold at 105%, something that made the company lose a lot of money during the dealings (Chang, et al. 2011, p. 36). A closer scrutiny of its financial statements later after the scheme was discovered, analysts were able to identify the foul play in the company’s books. Such measures would have been more fruitful and prevented more damages done by unscrupulous business people who commit white collar robbery. Such is an emerging trend that is worrying the world. Business people who want to be overnight billionaires have turned investment banking into a money minting business. In the process, the business has become risky, pushing investors away. The much faith that people had in the business has slowly been eaten away by the worrying emerging trend. 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