CASE 1.2
LEHMAN BROTHERS HOLDINGS INC.
Synopsis
Wall Street was stunned in September 2008 when this iconic investment banking firm filed for
bankruptcy. Two years later, there was a similar reaction within the investment community when
Lehman’s court-appointed bankruptcy examiner released his 2200-page report, the purpose of which
was to identify the parties that could possibly be held civilly liable for the enormous losses suffered
by Lehman’s investors and creditors.
An exception to SFAS No. 140 permits repo borrowers (sellers) to record these transactions as
true sales of securities if they can demonstrate that they have “surrendered” control of the securities
involved in the transactions. Lehman’s management used this “loophole” in SFAS No. 140 to
significantly reduce its “net leverage ratio” and its reported liabilities by engaging in a huge volume
of Repo 105 transactions. At the time, the most important metric that analysts used in monitoring
the financial health of large investment banks was their degree of financial leverage—Lehman touted
its net leverage ratio as the best measure of its financial leverage.
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Case 1.2 Lehman Brothers Holdings, Inc. 9
Lehman Brothers Holdings, Inc.—Key Facts
1. Lehman Brothers, one of Wall Street’s most prominent investment banking firms, became the
largest corporate failure in U.S. history when it filed for bankruptcy in September 2008.
2. The release in March 2010 of a report by Lehman’s court-appointed bankruptcy examiner
3. Similar to other investment banks, a key business risk factor for Lehman was the high degree of
4. The business risk faced by Lehman and the other major investment banks was amplified during
5. When housing prices began plummeting in the U.S. in 2007, Lehman’s financial condition
worsened dramatically since it had large investments in RMBS (residential mortgage-backed
securities).
6. To enhance its reported financial condition and its net leverage ratio, Lehman developed a plan
7. Accounting for repos as sales of securities was permitted under certain restrictive conditions
8. Lehman executed the Repo 105s in Great Britain after finding a British law firm that would
9. Among the parties that were most heavily criticized by Lehman’s bankruptcy examiner in his
report was the company’s audit firm, Ernst & Young.
10. The bankruptcy examiner concluded that E&Y could potentially be held liable for failing to
properly investigate a whisteblower’s allegations that Lehman’s financial statements were materially
misstated and for allegedly failing to properly investigate the impact of Repo 105s on Lehman’s
quarterly and annual financial statements.
12. E&Y insists that its audits and reviews of Lehman’s periodic financial statements will ultimately
10 Case 1.2 Lehman Brothers Holdings, Inc.
1. To examine the responsibility of auditors when a client implements a new and controversial
accounting policy that has significant financial statement implications.
3. To identify auditors’ responsibility to review or otherwise evaluate important “other
information” that accompanies a client’s audited financial statements.
4. To identify factors that should influence key materiality decisions made by auditors.
Suggestions for Use
Here’s another case that you could use as a launching pad for an undergraduate or graduate
auditing course. This case will readily demonstrate to your students the huge challenges that
auditors can face in carrying out their responsibilities and the critical importance of independent
audits for not only individual companies but the national economy as well. Ernst & Young’s audits
of Lehman Brothers literally had economic implications for practically every U.S. citizen. In sum, I
believe a case such as this can be used as an “attention grabber” for auditing students by conveying
to them the importance of the professional responsibilities that they will soon be assuming.
The focal point of this case involves a critically important issue for accountants and auditors
alike, namely, the bottom line objective of accounting and financial reporting standards. Lehman
Brothers engaged in hundreds of billions of dollars of complex transactions that apparently had no
express business purpose. Instead, the transactions were used ostensibly to window dress the
company’s financial statements, that is, to improve Lehman’s critical net leverage ratio at a point in
time when the company was literally coming apart at the seams. Although there is still some
disagreement on this matter, there seems to be a general consensus that the “accounting loophole”
Case 1.2 Lehman Brothers Holdings, Inc. 11
the AICPA Code of Professional Conduct, “Accounting Principles,” effectively includes such an
“override” rule. [Note: In the draft of the Proposed Revised Code of Professional Conduct, see
“Accounting Principles Rule,” 1.320.001.]
Suggested Solutions to Case Questions
1. No, auditors do not have an explicit responsibility to be involved in an audit client’s process of
developing new accounting policies. AU 110.03 of the PCAOB’s Interim Standards notes that “The
financial statements are management’s responsibility . . . [and] that management is responsible for
adopting sound accounting policies . . .” PCAOB Auditing Standard No. 12 requires auditors to
2. Again, for me, this question or issue is the focal point of the case—from both an
accounting/financial reporting point of view and from an auditing perspective. In my view, the
economic reality of a given transaction should be reflected in the accounting treatment applied to it.
That is, I believe that “intent does matter” and that the underlying intent of the accounting treatment
3. Recall that the SEC has specifically defined “accounting–motivated structured transactions” as
follows:
12 Case 1.2 Lehman Brothers Holdings, Inc.
‘Accounting-motivated structured transactions’ are ‘transactions that are structured in an
attempt to achieve reporting results that are not consistent with the economics of the
transaction, and thereby impair the transparency of financial reports.’ [Attempts] to
portray the transactions differently from their substance do not operate in the interests of
investors, and may be in violation of the securities laws.
4. There is not a specific auditing standard that mandated that Schlich or one of his subordinates
review the legal opinion issued by the British law firm. Having said that, given the critical
importance of the Repo 105 transactions to Lehman’s financial statements, it certainly seems that
doing so would have been a “good idea.” Reviewing that legal opinion would certainly have
provided Ernst & Young with an enhanced “understanding” of the Repo 105 transactions [see
5. The relevant section of the PCAOB’s Interim Standards in this context is AU Section 550,
“Other Information in Documents Containing Audited Financial Statements.”
AU 550.04: “Other information in a document may be relevant to an audit performed by an
independent auditor or to the continuing propriety of his report. The auditor’s responsibility with
respect to information in a document does not extend beyond the financial information identified in
his report, and the auditor has no obligation to perform any procedures to corroborate other
Case 1.2 Lehman Brothers Holdings, Inc. 13
information contained in a document. However, he should read the other information and consider
whether such information, or the manner of its presentation, is materially inconsistent with
information, or the manner of its presentation, appearing in the financial statements. If the auditor
6. Since there isn’t a “definitive” answer to this question, one objective you may want to
accomplish in addressing it is to acquaint your students with the principal materiality “rules” or
guidelines in the technical literature. Following are three viewpoints on materiality (the FASB
definition of materiality is included in the case):
FASB: Statement of Financial Accounting Concepts No. 2 defines materiality as follows: “the
magnitude of an omission or misstatement of accounting information that, in the light of surrounding
circumstances, makes it probable that the judgment of a reasonable person relying on the information
would have been changed or influenced by the omission or misstatement.”
SEC: The SEC’s principal statement regarding materiality can be found in Staff Accounting
Bulletin No. 99 issued in 1999. Here’s a key excerpt from SAB No. 99.
An assessment of materiality requires that one views the facts in the context of the “surrounding
circumstances,” as the accounting literature puts it, or the “total mix” of information in the
AICPA Professional Standards: AU–C Section 320, “Materiality in Planning and Performing
an Audit,” notes that “misstatements, including omissions, are considered to be material if they,
individually or in the aggregate, could reasonably be expected to influence the economic decisions of
users made on the basis of the financial statements” (paragraph .02).
14 Case 1.2 Lehman Brothers Holdings, Inc.
7. Allegations of financial statement misrepresentations by a whistleblower are not one of the
“standard” types of audit evidence identified professional auditing standards. Nevertheless, such
allegations will nearly always relate to one or more of the management assertions around which
auditors design their audit program or audit plan. For example, in this case, the whistleblower’s
8. Most elements of proof do not vary between civil lawsuits filed against audit firms in the state
and federal courts. For example, in either level of the court system, the plaintiff has to prove
“damages,” otherwise there is no basis for a lawsuit. The key factor that influences the legal
exposure that audit firms face in state versus federal courts is the level of misconduct or malfeasance
that the plaintiff must prove in order to prevail in a civil lawsuit filed against such a firm. When
suing an audit firm under the Securities Exchange Act of 1934, the plaintiff has to prove that the
audit firm was more than negligent in performing the given audit. Federal courts require a plaintiff
to establish that the defendant audit firm was either reckless or that scienter (intent to deceive) was
present (this element of proof varies across individual federal courts—approximately one-half of the
federal district courts require plaintiffs to establish at least recklessness, while the other one-half