Lehman Brothers Scandal

Lehman Brothers Accounting Scandal Repo 105 Subprime Mortgage Crisis Financial Statements Bankruptcy Auditing
The Lehman Brothers scandal emerged after the collapse of Lehman Brothers in late 2008. It involved using a loophole in US accounting standards known as 'Repo 105' to hide substantial losses on the subprime mortgage market.
On this page

Lehman Brothers Scandal

Definition

The Lehman Brothers scandal arose after the collapse of Lehman Brothers, the fourth largest U.S. investment bank, in late 2008. To conceal substantial losses associated with the subprime mortgage market, Lehman Brothers exploited a loophole in U.S. accounting standards known as “Repo 105”. This loophole permitted the firm to reclassify certain transactions in a way that masked billions of dollars in debt, thereby temporarily enhancing the appearance of its financial health.

Examples

  1. Repo 105 Transactions: Lehman Brothers used accounting techniques labeled “Repo 105 and Repo 108” agreements, which are short-term repurchase agreements that momentarily raised cash by selling assets with an obligation to repurchase the same assets shortly after. This maneuver enabled the bank to move assets off its balance sheet.

  2. Reduction in Gearing: By treating these transaction-induced reductions in assets and corresponding liabilities as outright sales rather than loans, Lehman Brothers lowered its reported leverage, giving a misleading picture of its financial resilience.

Frequently Asked Questions (FAQs)

Q1: What is Repo 105?
A: Repo 105 is an accounting technique used by Lehman Brothers to temporarily remove liabilities from their balance sheets by classifying short-term repossession agreements as sales.

Q2: Was the use of Repo 105 illegal?
A: While Repo 105 was legally permissible under certain accounting standards, the issue was Lehman Brothers’ failure to disclose the practice, which misled stakeholders about the true financial health of the company.

Q3: What impact did the Lehman Brothers scandal have on the auditing industry?
A: The scandal led to increased scrutiny and significant fines for Lehman Brothers’ auditors, Ernst & Young, and prompted regulatory changes aiming to enhance transparency and accuracy in financial reporting.

  • Subprime Lending: Lending to borrowers with poor credit histories who are considered higher risk for defaulting on loans. Lehman Brothers’ investments in subprime mortgages contributed to their financial collapse.

  • Sale and Repurchase Agreement (Repo): A form of short-term borrowing for dealers in government securities; the dealer sells the government securities to investors, usually on an overnight basis, and buys them back the following day.

  • Gearing: Also known as financial leverage; it is a measure of a company’s debt level compared to its equity.

  • True and Fair View: An accounting concept meaning that financial statements should present an accurate and unbiased picture of the company’s financial performance and position.

References to Online Resources

  1. Investopedia: Lehman Brothers Scandal Explainer
  2. SEC Document on Repo 105
  3. Summary of Impact on Auditing Standards

Suggested Books for Further Studies

  1. “The Collapse of Lehman Brothers: A Case Study” by Dr. Samiha Fawzy
  2. “When Genius Failed: The Rise and Fall of Long-Term Capital Management” by Roger Lowenstein
  3. “Too Big to Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System from Crisis - and Themselves” by Andrew Ross Sorkin

Accounting Basics: “Lehman Brothers Scandal” Fundamentals Quiz

### What accounting loophole did Lehman Brothers exploit to hide its debts? - [ ] Double-entry bookkeeping - [x] Repo 105 - [ ] Off-balance-sheet financing - [ ] Revenue recognition timing > **Explanation:** Lehman Brothers used the 'Repo 105' accounting loophole to temporarily remove debts from its balance sheet. ### How did Repo 105 transactions provide a misleading view of Lehman Brothers' finances? - [ ] It overstated revenue. - [ ] It understated liabilities. - [x] It temporarily reduced balance sheet liabilities. - [ ] It increased apparent net income. > **Explanation:** Repo 105 transactions allowed Lehman Brothers to move liabilities off their balance sheet temporarily, thus reducing reported leverage and providing a misleading view of their financial health. ### What caused Lehman Brothers to file for bankruptcy? - [x] Massive overexposure to subprime mortgages and misreported financial position. - [ ] Operational failures and internal fraud. - [ ] Declining market share and product recall. - [ ] Patent lawsuits and regulatory fines. > **Explanation:** Lehman Brothers filed for bankruptcy primarily due to massive losses from subprime mortgages and misleading financial statements. ### Who was the auditor for Lehman Brothers when it collapsed? - [ ] Deloitte - [x] Ernst & Young - [ ] PricewaterhouseCoopers - [ ] KPMG > **Explanation:** Ernst & Young was the auditor for Lehman Brothers at the time of its collapse and faced significant scrutiny and fines afterward. ### What aspect of accounting did Lehman Brothers fail to properly disclose to stakeholders? - [ ] Revenue sharing agreements - [x] Use of Repo 105 transactions - [ ] Future market projections - [ ] Executive compensation details > **Explanation:** Lehman Brothers failed to disclose the use of Repo 105 transactions, misleading stakeholders about the firm’s true financial condition. ### What financial measure did Repo 105 transactions initially impact? - [ ] Share price - [ ] Net profit - [ ] Cash flow statement - [x] Gearing (financial leverage) > **Explanation:** Repo 105 transactions initially impacted the gearing (financial leverage) of Lehman Brothers by artificially lowering it. ### Which regulatory body provides guidelines that Repo 105 exploits? - [ ] The Financial Conduct Authority (FCA) - [x] The Financial Accounting Standards Board (FASB) - [ ] The Comptroller and Auditor General - [ ] The International Accounting Standards Board (IASB) > **Explanation:** The Financial Accounting Standards Board (FASB) oversees the guidelines that Repo 105 exploits. ### What type of lending played a central role in the Lehman Brothers scandal? - [ ] Commercial lending - [ ] Microfinance lending - [x] Subprime lending - [ ] Payday lending > **Explanation:** Subprime lending, which involves granting loans to borrowers with poor credit histories, played a central role in the collapse of Lehman Brothers. ### What was the total debt declared by Lehman Brothers at the time of bankruptcy? - [ ] $400 billion - [ ] $500 million - [x] Over $600 billion - [ ] $100 billion > **Explanation:** At the time of its bankruptcy, Lehman Brothers declared over $600 billion in debt. ### What major lesson did regulatory bodies learn from the Lehman Brothers scandal? - [x] The necessity of transparency and full disclosure in financial statements. - [ ] The redundancy of internal controls. - [ ] The importance of acquiring more assets quickly. - [ ] The need for complete elimination of leverage. > **Explanation:** One of the key lessons was the necessity of transparency and full disclosure in financial statements to ensure the true financial health of an organization is conveyed.

Thank you for diving deep into the Lehman Brothers scandal with us. Our aim is to provide exhaustive understanding and learning through our extensive accounting resources and challenging quizzes. Continue pursuing excellence in financial literacy!

Tuesday, August 6, 2024
Lemon
Legislation
Accounting Records January 1, 1
Accounting Records January 1, 1
Audit January 1, 1
Auditors' Remuneration January 1, 1
CAFR (Comprehensive Annual Financial Report) January 1, 1
Certified Public Accountant (CPA) January 1, 1
Clean Opinion (Unqualified Opinion) January 1, 1
Complete Audit January 1, 1
Expectations Gap January 1, 1
Footing January 1, 1

Accounting Terms Lexicon

Discover comprehensive accounting definitions and practical insights. Empowering students and professionals with clear and concise explanations for a better understanding of financial terms.