Lehman Bros - Examiner's report just published

probe

Some light weekend reading on the collapse of Lehman Bros, for anyone interested in this insolvency case.....

http://lehmanreport.jenner.com

Inquitus

Love to see E&Y go the way of Andersen over this.

Brian222

Read a summary on it this morning. I'm interested in seeing the effect this has on E&Y as well.

Oafley Jones

They did a fantastic job with Anglo in this country as well. Quality organisation.:D

probe

E&Y has a different corporate structure to Arthur Andersen. Andersen was more akin to a multi-national company run out of Geneva and Chicago.

E&Y is a "brand name" for a global collection of partnerships.

The affair has many similarities with Enron. The "Repo105s" used by Lehman are akin to Enron's SPVs - to get stuff off the consolidated balance sheet.

Lehman took advantage of the big weakness in US accounting standards which are rules based - rather than accounting principle based.

It is interesting that Lehman couldn't get a US law firm to sign off on the Repo105 trick - which is basically like pawn broking. They dumped $50 billion of assets into a British entity just before the accounting period end in return for cash - and reversed the transaction a few days after. A principle based review of that carry-on would stop it in its tracks - because there is no real substance to the transactions other than to inflate the cash position of the US entity for reporting purposes.

Lehman found a law firm - Linklaters in London who were prepared to sign off on the legals. Which probably acted as a "letter of comfort" for E&Y. Both parties no doubt collecting massive fees from the exercise. Linklaters were obviously were working on a rules based approach being lawyers.

It doesn't say much for the legal and accounting professions in London. International Accounting Standards have been hijacked by the British.

They (IAS) need to be re-examined from a fundamental point of view - with an emphasis on principles and showing a true and fair view. Standard unqualified audit reports have got longer and longer with statutory amendments after each major screw up over the years with no real benefit.

Lehman was a partnership until the early 1990s - and this accounting trickery would never have taken place in a partnership environment - where the top guys are jointly and severally liable for the firms debts.

Similar to the "too big to fail" issue - it seems to me that there may be a "too big to account for" - or rather "too complex and lacking in substance" to see the wood for the trees from an accounting point of view.

While there is no problem accounting for a big thing like WalMart, in a global banking environment where nobody working for the bank really understands the totality of what is going on - it is very difficult to see how one can expect an outsider like a firm of auditors to walk in and find out everything and make a judgment on it. CDSs, derivatives, swaps, dark pools etc etc - the financial engineering impact of an "explosion" in one part of the system is incalculable as it ricochets across the "financial networks".

The traders setting up these deals have nothing to lose - if a deal works they get a big bonus, if the whole thing goes belly up the shareholder and / or taxpayer in some cases has to carry the can. And the traders move on to another outfit collecting a sign-on bonus and a nice new Porsche 911 to replace 11 month old one they had in the previous job. And of course the traders only understand their little bit of the picture - enough to make money - in what is mostly a zero-sum game.

http://www.ft.com/cms/s/0/2e412d50-2d6e-11df-a262-00144feabdc0.html?nclick_check=1

dudara

It is interesting that the only Big 4 firm I've heard mentioned in relation to the banking mess is EY.

hivizman

dudara wrote: »

It is interesting that the only Big 4 firm I've heard mentioned in relation to the banking mess is EY.

PwC was criticised a lot over Northern Rock - see for example this Accountancy Age article:

http://www.accountancyage.com/accountancyage/news/2199941/pwc-slammed-northern-rock-non

hivizman

probe wrote: »

E&Y has a different corporate structure to Arthur Andersen. Andersen was more akin to a multi-national company run out of Geneva and Chicago.

E&Y is a "brand name" for a global collection of partnerships.

Good point. The report (page 747, footnote 2896) notes: "Ernst & Young refers only to Ernst & Young LLP (i.e., Ernst & Young North America) unless stated otherwise."

hivizman

probe wrote: »

Some light weekend reading on the collapse of Lehman Bros, for anyone interested in this insolvency case.....

http://lehmanreport.jenner.com

Thanks for the link. Obviously there's enough here for several months' worth of light weekend reading.

Thanks also for your long post on Lehmans and E&Y. I certainly agree that this is a classic example of exploiting the strict wording of a US accounting standard (you can't blame international accounting standards here, since Lehman prepared its accounts under US Generally Accepted Accounting Principles and hence used Statements of Financial Accounting Standards). Indeed, the offending standard, SFAS140, has been replaced more recently as part of the US/International convergence process.

On my admittedly quick reading, it seems that the Bankruptcy Examiner was scratching around for anything that might get the auditors on the hook. It's not the so-called "Repo 105" transactions in themselves that are objectionable (after all, Lehman had been doing vast quantities of conventional repo business for years), not even how they were accounted for, as the lack of clear disclosure of what was going on.

probe

hivizman wrote: »

On my admittedly quick reading, it seems that the Bankruptcy Examiner was scratching around for anything that might get the auditors on the hook. It's not the so-called "Repo 105" transactions in themselves that are objectionable (after all, Lehman had been doing vast quantities of conventional repo business for years), not even how they were accounted for, as the lack of clear disclosure of what was going on.

These Repo105s were to conceal and window-dress. If the substance of the Repo105 transactions prior to the last year of activity were clearly disclosed - it would still have pulled the rug from under them ..... Chapter II would almost certainly have been on the cards. eg

Note 512: "The cash amount shown in our balance sheet includes $50 billion of cash we received two days ago from an affiliated entity incorporated in England (or wherever), under what is basically a pawnbroking deal. We pawned a similar value (in nominal terms) of toxic assets with these idiots, but will have to pay the $50 billion back + interest tomorrow. Please be advised that we were only doing this to pull the wool over your eyes. The intelligent investor is advised to re-draw the balance sheet in their own books to get a true and fair view of the state of affairs of the company".

While this Examiner's report goes on for 2,200 odd pages, the annual reports of big banks now often run to 400 to 500 pages. What shareholder or journalist or investment analyst has the time to read the entire document - among all the other companies that they may be involved with?

And while Lehman prepared their accounts under US standards, the British entity that facilitated the fraud was presumably reporting under the British version of IAS. In any event, I go back to my original emphasis of "true and fair view, substance over form" etc. It is a matter of priorities - and these are surely the #1 priority. The level of disclosure and presentation standards are secondary. And if you get obsessively detailed about disclosure details and presentation you end up with financial statements as big a tome as the Examiner's report! Where do you draw the line in terms of disclosure? If WalMart's annual report ran to 10 million pages including a copy of every sales ticket issued by every POS terminal in every store in small print for the shareholders to review. Better to get a single page financial report from a source you can trust.

hivizman

probe wrote: »

These Repo105s were to conceal and window-dress. If the substance of the Repo105 transactions prior to the last year of activity were clearly disclosed - it would still have pulled the rug from under them ..... Chapter II would almost certainly have been on the cards. eg

Note 512: "The cash amount shown in our balance sheet includes $50 billion of cash we received two days ago from an affiliated entity incorporated in England (or wherever), under what is basically a pawnbroking deal. We pawned a similar value (in nominal terms) of toxic assets with these idiots, but will have to pay the $50 billion back + interest tomorrow. Please be advised that we were only doing this to pull the wool over your eyes. The intelligent investor is advised to re-draw the balance sheet in their own books to get a true and fair view of the state of affairs of the company".

While this Examiner's report goes on for 2,200 odd pages, the annual reports of big banks now often run to 400 to 500 pages. What shareholder or journalist or investment analyst has the time to read the entire document - among all the other companies that they may be involved with?

And while Lehman prepared their accounts under US standards, the British entity that facilitated the fraud was presumably reporting under the British version of IAS.

This raises an interesting question - if the British entity was using the Financial Reporting Standards issued by the Accounting Standards Board, then under Financial Reporting Standard 5 Reporting the Substance of Transactions, it would be very difficult to account for the Repo 105 transactions any differently from conventional repos (that is, they would be regarded as, in substance, short term loans, with the underlying securities not being taken off the balance sheet). However, when the financial statements of the British entity were consolidated into the Lehman Brothers accounts, they would have to be stated in accordance with US Generally Accepted Accounting Principles. So how the transactions were reported in the UK could be quite different from how they were reported in the USA.

probe wrote: »

In any event, I go back to my original emphasis of "true and fair view, substance over form" etc. It is a matter of priorities - and these are surely the #1 priority. The level of disclosure and presentation standards are secondary.

I agree entirely here. However, the idea of a "true and fair view" independent of accounting standards probably died back in the 1980s, and even though accounting standards (at least if we believe the propaganda from the International Accounting Standards Board) aim to give a faithful representation of the financial position and performance of entities, what actually constitutes a "faithful representation" in a specific case can be very difficult to decide. Lehman constructed the Repo 105 structure so that they could claim that the transfer of securities counted as a "sale" rather than as a "secured loan", and it's certainly possible to argue that they could do this only because SFAS140 provided them with a pathway towards the outcome they wanted. That is, the rules-based approach of US financial reporting encouraged companies to see how far they could stretch the rules without breaking them.

Hence, the Bankruptcy Examiner didn't think that the issue of whether or not the Repo 105 transactions were accounted for as sales under SFAS140 was really relevant (see page 964 of the report). Instead, he argued that there is a prima facie case that Lehman's lack of disclosure of sufficient information about the transactions (in particular the fact that they took about $50 billion of assets and liabilities off the Lehman balance sheet over the financial year-end period in 2007) could lead to a finding of negligence against, among others, E&Y.

probe wrote: »

And if you get obsessively detailed about disclosure details and presentation you end up with financial statements as big a tome as the Examiner's report! Where do you draw the line in terms of disclosure? If WalMart's annual report ran to 10 million pages including a copy of every sales ticket issued by every POS terminal in every store in small print for the shareholders to review. Better to get a single page financial report from a source you can trust.

I've heard it suggested that, instead of having financial reports prepared by companies (with all the temptation to mislead), the financial reporting of the future will be pretty much what you suggest - that stakeholders would be able to get electronic access to companies' financial systems, download all their transactions (in some richly coded form to include all the information that different stakeholders might need), and run the transactions through their own financial reporting packages. Then, if particular stakeholders preferred certain accounting treatments (for example, strict historical cost) they could generate financial statements in the form they wanted, rather than having to take a single set of accounts and try to make their own adjustments.

The notion of a single page financial report would be a great idea if we could come up with a set of items about a company that could provide all the information that stakeholders need to evaluate the company. In the 19th century, company financial statements were much shorter documents, but investors and other users demanded more information, and this trend continued through the 20th into the 21st centuries. As businesses become more complex, it's not surprising, though it may be unfortunate, that their periodic corporate reports also become more complex.

hivizman

hivizman wrote: »

I've heard it suggested that, instead of having financial reports prepared by companies (with all the temptation to mislead), the financial reporting of the future will be pretty much what you suggest - that stakeholders would be able to get electronic access to companies' financial systems, download all their transactions (in some richly coded form to include all the information that different stakeholders might need), and run the transactions through their own financial reporting packages. Then, if particular stakeholders preferred certain accounting treatments (for example, strict historical cost) they could generate financial statements in the form they wanted, rather than having to take a single set of accounts and try to make their own adjustments.

That's an interesting concept - would put the big 4 auditors out of business too!

Cookie_Monster

glasso wrote: »

That's an interesting concept - would put the big 4 auditors out of business too!

Judging from this whole worldwide mess recently they don't appear to be doing much anyway.

crapmanjoe

Inquitus wrote: »

Love to see E&Y go the way of Andersen over this.

Yes thats exactly what this country needs - another 800 skilled / part qualified professionals to go on the dole

"Originally Posted by dudara View Post
It is interesting that the only Big 4 firm I've heard mentioned in relation to the banking mess is EY."

In fairness KPMG as Irish Nationwide auditors are as much as to blame for the directors loans transfers as well

jessup

KPMG did raise their concerns re the 'bed and breakfast' arrangement for Sean Fitzpatricks loans with the Irish Nationwide Audit Committee.

The fact that the Audit Committee didn't react to these concerns is another can of worms entirely........who was on the Audit Committee, were they up to the job, was 'Mickey Fingers' really calling the shots etc. etc.

Funny how both Anglo and Irish Nationwide failed to comply with many of the most basic principles of Corporate Governance and they ended up in the most shi*e. Ex CEO becoming Chairman, Cross Directorships, lack of independent non executive directors, management override of internal controls etc. etc.

I suppose a bigger issue might be the lack of whistle blowing legislation in Ireland. Should there not be a mechanism whereby KPMG could have gone to the ODCE or Fin Reg once they found out the Audit Committee was going to sit on the info and do nothing.

Perfect example of that today in the news. A government minister tries to interfere with a Garda investigation and will face no arrest or prosecution. The Garda who leaked the information about the attempt to corrupt the legal system to the media (which is most certainly in the public interest) does get arrested and may be prosecuted for actions that amount to 'whistle blowing' and should be protected by the law not prosecuted.

Good Article on Lehman....

On March 18 2008, Erin Callan, Lehman Brothers’ chief financial officer, told a conference call that the bank was “trying to give the group a great amount of transparency on the balance sheet” by providing more details. The analysts on the line even thanked her for it.

But what Ms Callan did not tell them is that Lehman had shifted $49bn (€36bn, £32bn) off its balance sheet in the quarter just ended, using a process it nicknamed Repo 105. That was expressly to help bring down the bank's reported leverage – or the ratio of assets to equity – the very reduction of which she was promoting to the analysts.

That and other similar deals came to light last week in a 2,200-page report by Anton Valukas, the bankruptcy court-appointed examiner. With little or no economic rationale, they are simply a form of the age-old accounting wheeze of windowdressing the books to look better temporarily.

What has grabbed attention two years on is the matter-of-fact way the arrangements were discussed inside the bank by senior executives and were accepted by its counterparties – other financial groups with which Lehman did business before its collapse that September.

Yet even inside Lehman, not everyone saw the mechanism in so benign a way. Bart McDade, who became chief operating officer in June 2008, called Repo 105 “another drug we [are] on” in an e-mail and planned to slash its use, amid howls of protest from some departments. Martin Kelly, global financial controller, warned his bosses about the “headline risk” to Lehman's reputation if the deals were to become public.

The process even cost the bank money. As one e-mail from another staffer put it: “Everyone knows 105 is an off-balance sheet mechanism so counterparties are looking for ridiculous levels [of prices] to take them.”

But the pressure to do more of the deals grew in 2008, as did the outside world’s obsession with the bank’s precarious finances, particularly its leverage. Internal e-mails exhorted managers to work harder to get assets off the books. Although Dick Fuld, chief executive until its demise, has said through a lawyer that he could not recall discussions of Repo 105, Mr McDade told the examiner he had given his boss a June presentation on the topic.

Among the questions the Valukas report raises about the appropriateness of the accounting – and the auditing conducted by Ernst & Young – lies a bigger issue: how did this sort of financial engineering come to be considered a legitimate business tool and what, if anything, can be done about it?

Window-dressing the accounts is not new and can take many forms, ranging from the relatively benign to outright fraud. In manufacturing companies, for example, a manager might engage in “channel stuffing” – shifting products just before quarter-end, even if they have not been expressly ordered – to help meet targets and boost reported revenues. This is not far removed from the retail store manager who, knowing he or she has achieved the monthly target, delays recording sales for a couple of days to help meet the next one.

Gimmicks to manipulate reported income are more common than those that, like Lehman's Repo 105s, focus on the balance sheet. But the US bank was hardly alone.

Indeed, one reminder came only yesterday with the arrest of Sean FitzPatrick who, also in 2008, resigned as chairman of Dublin-based Anglo Irish Bank following the revelation that he had for years concealed personal loans worth up to €87m ($119m, £77m). He did so by transferring them to another bank just before his bank's year-end, then returning them after the balance sheet date.

Two years before Mr FitzPatrick’s departure, the US Securities and Exchange Commission forced a group of Puerto Rican banks to restate their accounts following its investigation into several misdemeanours, including managing earnings through a series of simultaneous purchase and sale transactions with other banks.

The practice is hardly recent; in 1973, the UK’s London and County Securities collapsed after a government-initiated credit squeeze helped fulfil widespread market suspicions about its rocky finances. Eerily like the latest crisis, the failure of L&C threatened confidence in the country’s banking system and forced the Bank of England to launch a rescue to keep its rivals afloat.

On unpicking L&C’s accounts, the liquidators found, among many sharp practices, a window-dressing system involving a ring of banks that deposited funds with each other just before year-end to boost their reported liquidity.

Lehman's Repo 105s have attracted attention because attempts to hide assets by shifting them off the balance sheet are associated with dodgy accounting and best known for the interminable tangle of vehicles created by Enron, the failed US energy group, to hide its debts.

But the reason this issue keeps rearing its head in so many guises is that the question lies at the very heart of accounting, which was originally intended to give a company's owners a fair report of its business activities. Therefore, what goes on, and what stays off, the books is a permanent area of debate.

In spite of rulemakers’ repeated, and increasingly lengthy, efforts to clarify matters, accountants and company managers know there remain many grey areas. This makes it a middle ground where managers can challenge their auditors – with some comfort – that, in spite of the shadiness implied by the term “off balance sheet”, they are legitimately debating an area without absolutely definite rules for all situations.

“It’s always easier to break a rule than to draft a general rule in this area that says what the treatment ought to be,” says Allan Cook, a former technical director of the UK Accounting Standards Board. He recalls receiving a series of letters from accountants and managers suggesting specific rules for off balance-sheet accounting and giving examples in which they would apply. “The problem is you can’t write a standard as a series of good solutions to individual situations; the rules have to be phrased in general terms,” he adds.

Before the UK rulemaker was set up in 1990 (17 years after its US equivalent, the Financial Accounting Standards Board, began life) accountants from the era recall a series of running battles with clients and their lawyers over what should, and should not, be allowed.

Sir David Tweedie, now head of the International Accounting Standards Board, described the 1980s, when he was a partner at KPMG, as an era of “creeping crumple” where clients tested boundaries. “[It was] the picking off of auditors by investment bankers, selling a scheme that perhaps was just within the law to a client, persuading two major auditing firms to accept it, whereupon it became accepted practice and [lawyers] would tell a third auditor that he could not qualify [the company’s financial report],” he said in a 2008 speech.

Some of these transactions used the sort of financial vehicles heavily implicated in the recent crisis. Other schemes were seemingly more prosaic, such as allowing retailers to “sell” their stores to their bank but with an agreement that they can buy any of the properties back at any point. Accountants were – and are – leery of calling that sort of deal a true sale since in reality, the seller has retained control. But one accounting expert says: “I remember investment bankers telling us that we’d never stop it.”

All this means that it is unclear in many real situations exactly where the line falls between the legitimate exploitation of accounting rules, questionable window-dressing and sharp, or actually fraudulent, practice.

“One way of getting the lowest possible cost of funding is getting your presentation right,” says one senior accountant of Lehman’s Repo 105s. “Put yourself in a position where analysts are constantly writing about your leverage and you believe you’re technically entitled to reduce the cost of money by presenting your accounts this way. Its not then quite so unreasonable for you to say, ‘well, they've written the rules and I am within them’.”

But Lynn Turner, former chief accountant of the SEC, is more scathing about Lehman's use of Repo 105s. “I don’t think it’s just financial engineering, I think i’'s cooking the books. It is just amazing to me that we’re back here again,” he says.

Privately, US auditors will talk of meetings with clients where they have been asked bluntly, “tell me where it says I can’t do this”.

“In financial reporting, no one wants to be left behind and have their competitors steal a march on them. It is a bit like an arms race, or a bloodsport,” says Jack Ciesielski, editor of Analysts’ Accounting Observer, a research service on the investment impact of accounting issues. “The best analogy in real life might be a tax return and how some people feel they’re being a chump if they don’t go right up to the line, taking every deduction they can.”

The Valukas report has dragged accounting and auditing back into the spotlight. Ernst & Young says it retains confidence in its actions, adding that the last audited accounts of Lehman, to November 2007, were “fairly presented” in accordance with US accounting principles.

Senior staff at rival firms among accountancy’s “big four” wonder privately what might have been uncovered if other failing institutions, from AIG and Bear Stearns to Royal Bank of Scotland, had been put under a similar year-long microscope that had access to three petabytes of information – equivalent to roughly 350bn sheets of paper.

Internally, the profession has for years been arguing over how to bring in broad-based principles in a world where auditors increasingly face the risk of litigation. In court, detailed rules can provide better protection. Now, the Group of 20 leading economies has called on regulators to settle on a single global set of standards by 2011. In reality, this requires the US to switch from its own rules to the IASB’s more principles-based system.

But the cynics are already warning that while sweeping statements can help force managers to follow the spirit, rather than simply the letter, of the law, they also leave more room for individual interpretation. In other words, the sort of grey area exploited by Lehman will never really go away.

Banks use repurchase agreements, known as repos, all the time for short-term financing. One borrows cash and gives the other securities, such as government bonds, as collateral. Both agree to unwind the arrangement on a set date. The deals, which usually run only for days or weeks, are accounted for as financings, and remain on the books with banks recording an asset – the cash – and a matching liability in the promise to buy back the collateral.

Lehman’s 105 was different – instead of handing over securities equivalent to the cash it received, the bank gave more than was necessary. The point was to exploit a loophole allowing such over-collateralised deals to be accounted for as true sales. Lehman then reported its obligation to repurchase the securities at a fraction of the full cost, and used the cash it had received to pay off its liabilities, thereby “shrinking” its balance sheet.

Use of Repo 105 spiked sharply at the end of each accounting quarter – more so in 2008 as pressure grew on Lehman to reduce its leverage – and fell just as dramatically soon after the new accounting period began, as deals were unwound.