Introduction to Accounting and Corporate Governance
INTRODUCTION
The memo is to address the accounting maneuver of Lehman’s Repo 105 (or 108) from perspectives of accounting and corporate governance. The memo will illustrate the role of repo transaction in Lehman’s business model, analyze the accounting irregularities regarding repo by Lehman, observe auditors’ role in these irregularities, and discuss the corresponding accounting and corporate governance issues. In addition, the memo will provide recommendations on how to prevent financial institutions from abusing regulatory deficiencies by emphasizing on the importance of accounting regulation, auditors’ role, and business ethics.
ROLE OF REPO 105 IN LEHMAN’S BUSINESS MODEL The major goal of Lehman’s Repo 105 is to temporarily remove troubled securities from its balance sheet while presenting favorable financial statements to its investors, creditors, rating agencies, and the public. By temporarily removing these securities from its balance sheet, Lehman made its leverage ratio much lower. With low leverage ratio, Lehman would keep its credit rating at high level and maintained its customers’ confidence. A repo, or sale and repurchase agreement, is an agreement in which one party transfers to another party as collateral for a short-term borrowing of cash, while simultaneously agreeing to repay the cash and take back the collateral at a specific point in time (SFAS 140). An ordinary repo should be treated as a financing transaction and should be accounted for as a secured borrowing. An ordinary repo is a commonly-used form of secured loan between financial institutions. In fact, repo does not have real economic substance. However, by the Repo 105 transactions, Lehman did the same in an ordinary repo, but because the assets value were 105 percent or more of the cash received, accounting rules permitted the transactions to be treated as sales rather than financing. Lehman aggressively employed Repo 105 transactions before reporting
The memo is to address the accounting maneuver of Lehman’s Repo 105 (or 108) from perspectives of accounting and corporate governance. The memo will illustrate the role of repo transaction in Lehman’s business model, analyze the accounting irregularities regarding repo by Lehman, observe auditors’ role in these irregularities, and discuss the corresponding accounting and corporate governance issues. In addition, the memo will provide recommendations on how to prevent financial institutions from abusing regulatory deficiencies by emphasizing on the importance of accounting regulation, auditors’ role, and business ethics.
ROLE OF REPO 105 IN LEHMAN’S BUSINESS MODEL The major goal of Lehman’s Repo 105 is to temporarily remove troubled securities from its balance sheet while presenting favorable financial statements to its investors, creditors, rating agencies, and the public. By temporarily removing these securities from its balance sheet, Lehman made its leverage ratio much lower. With low leverage ratio, Lehman would keep its credit rating at high level and maintained its customers’ confidence. A repo, or sale and repurchase agreement, is an agreement in which one party transfers to another party as collateral for a short-term borrowing of cash, while simultaneously agreeing to repay the cash and take back the collateral at a specific point in time (SFAS 140). An ordinary repo should be treated as a financing transaction and should be accounted for as a secured borrowing. An ordinary repo is a commonly-used form of secured loan between financial institutions. In fact, repo does not have real economic substance. However, by the Repo 105 transactions, Lehman did the same in an ordinary repo, but because the assets value were 105 percent or more of the cash received, accounting rules permitted the transactions to be treated as sales rather than financing. Lehman aggressively employed Repo 105 transactions before reporting
References: Anton R. Valukas (2010). Lehman Brothers Holding Inc. Chapter 11 proceedings examiner’s report. United States Bankruptcy Court southern district of New York. Chang, C. , Duke, J. , & Hsieh, S. (2011). A loophole in financial accounting: A detailed analysis of repo 105. Journal of Applied Business Research, 27(5), 33-39. Retrieved from http://search.proquest.com.lib-proxy.fullerton.edu/docview/889140206/fulltextPDF?accountid=9840 Financial Accounting Standard Board. (2000). Financial accounting standards no. 140. Retrieved from http://www.fasb.org/cs/BlobServer?blobkey=id&blobwhere=1175820919404&blobheader=application%2Fpdf&blobcol=urldata&blobtable=MungoBlobs Lehman Brothers Holding Inc. v. Debtors., 9 N.E. (Bankr. N.Y. 2010)