Lehman Bros Ernst&Young Audit

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  • Topic: Lehman Brothers, Balance sheet, Repo 105
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Lehman Brothers 2008

Auditing Final Project
Mariya Zdravkova MIAF 2011, IE

Table of Content:
1. Company Introduction……………………………………………………..…………………………………….3 2. Collapse……………………………………………………………………………………..…………………………..3 3. The Report of Anton R. Valukas…………………………………………..……….…………………………3 4. The accounting fraud (Repo 105)…………………………………………………...……………………….3 5. The Auditor……………………………………………………………………………………………..……………..4 6. Ernst and Young role in Lehman Brothers´ case……………………………………………………….4 7. The “Netting Grid”……………………………………………………………………………….………………….5 8. Materiality issue…………………………………………………………………………….……………………….5 9. Fraud charges…………………………………………………………………………………………………….6 10. Conclusion…………………………………………………………………………………………………………6 Sources……………………………………………………………………………………………………………………7

1. Company Introduction. Lehman Brothers was a company with a long and interesting history. It was founded in 1850 as a family business, by three brothers who immigrated to the US, and started as a shop, which later entered trading with cotton. Eight years later it opened its office in New York. During the more than 150 years existence the company became the fourth largest financial firm in the world. Before announcing bankruptcy on 15th of September 2008, they were providing full range of financial services. The head quarter of the company was in New York, and there were two regional headquarters in London and Tokyo. In 1984 Lehman Brother was acquired by American Express. Ten years later they went public again as an independent company under the name Lehman Brothers Holding, Inc.

2. Collapse. The first problems, which probably led to the accounting fraud, Lehman faced in August 2007. The mortgage crisis strongly affected them, resulting in huge losses. They had to close their subprime lender department, which led to after-tax charges of $25 million and also a reduction in their balance sheet – $27 millions of Good Will. In 2008 they continue suffering huge losses (graph 1) – during the first half of the year their stock fell by 70%. This tendency continued in the following months, until in the beginning of September the stocks lost 45% of their value in one day. On Monday, September 15th, Lehman Brothers filed for Chapter 11 bankruptcy protection. This is a part of the US legislation that allows a business to reorganize its activity as a debtor in possession.

Graph 1 Lehman´s shares movement

3. The Report of Anton R. Valukas. Anton Valukas, as a part of the law firm Jenner and Block, was appointed by the court to examine the reasons for the bankruptcy of Lehman Brothers. Just in this report and no earlier was revealed the fraud in the financial reporting of Lehman Brothers. The report reveals the use of both Repo 105 and Repo 108 by the company, in order to hide their hard financial situation. Later in this text, the report will be widely used due to its profound investigation of the auditor´s involvement in the fraud and its relevancy to our case.

4. The accounting fraud (Repo 105). Repo 105 is a financial instrument, a repurchase agreement, used by companies to finance their short term debt. They sale the asset and they report it as a sale and use the money to pay their lenders. Later after their financial report is published, they repurchase the asset. So an operation which is borrowing money or issuing debt is presented in the financial report as a sale. In fact the company is much highly leveraged than it appears to be. Repo 105 and 108 are identical instruments where the only difference is the cost of debt. In the case of the first is 5% of the value of the asset and in the second case this number is 8%. The company used the Repo to finance its short term debt, until they recover from some losses, but the problem with Lehman came from the fact that their stocks continued falling and their financial situation was not improving. The counterparties lost their trust in the company´s ability to...
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