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ISSUES IN ACCOUNTING EDUCATION
Vol. 27, No. 2
2012
pp. 441–459

American Accounting Association
DOI: 10.2308/iace-50126

Lehman on the Brink of Bankruptcy:
A Case about Aggressive Application of
Accounting Standards
Dennis H. Caplan, Saurav K. Dutta, and David J. Marcinko
ABSTRACT: In September 2008, Lehman became the largest company in U.S. history
to file for bankruptcy. Nine months earlier, Lehman had reported record revenue and
earnings for 2007, and had started the year with a market capitalization of over $30
billion. Lehman’s precipitous fall has been attributed to a high-risk business strategy and
to aggressive interpretation of accounting rules. Lehman was both a victim of—and an
important contributor to—the worst U.S. economic recession since the Great
Depression, and the firm’s accounting choices warrant scrutiny.
This case is structured around collateralized short-term borrowings, commonly used
by financial institutions, called repurchase agreements. Lehman modified the terms of
the standard agreement and used an aggressive interpretation of SFAS No. 140 to
account for these modified agreements as a sale of the collateral. These transactions,
called Repo 105s, affected the firm’s reported financial position. The case requires
students to evaluate those effects, interpret financial ratios, critically read authoritative
accounting literature, and consider important questions about auditors’ responsibilities.
Key issues include the relative merits of principles-based versus rules-based accounting
standards, corporate governance, ethics, materiality, and whistleblowing.
Keywords: Lehman; Repo 105; collateralized borrowings; SFAS No. 140; financial
leverage.

INTRODUCTION

L

ehman Brothers was founded in the mid-19th century as a cotton trading company. The
latest entity (Lehman Brothers Holdings Inc.) emerged from a spin-off from American
Express in 1994. This company grew quickly, and for fiscal year 2007, the company
reported record income of over $4 billion on revenue of over $60 billion. In early 2008, Lehman’s
stock was trading in the mid-sixties with a market capitalization of over $30 billion. Over the next
eight months, Lehman’s stock lost 95 percent of its value and was trading around $4 by September
Dennis H. Caplan is an Assistant Professor and Saurav K. Dutta is an Associate Professor, both at the
University at Albany, SUNY; David J. Marcinko is an Associate Professor at Skidmore College.
We thank the editor, associate editor, and two reviewers for their helpful insights, comments, and suggestions. We also
acknowledge Wesley R. Bricker for his helpful comments, and our accounting students, who completed the case and
provided us valuable feedback.

Published Online: January 2012

441

Caplan, Dutta, and Marcinko

442

12, 2008. Three days later, Lehman filed for bankruptcy protection. By some measures, Lehman
was the largest company to fail in U.S. history.
In March 2010, Lehman’s bankruptcy examiner, Anton Valukas, issued a 2,200-page report
that outlined the reasons for the Lehman bankruptcy (Valukas 2010). The Examiner’s Report also
provides insight into how Lehman’s deteriorating financial position led to allegedly misleading
financial reporting practices, including a type of collateralized short-term borrowing arrangement
that Lehman dubbed ‘‘Repo 105.’’ The Examiner’s Report includes interviews with key Lehman
personnel and provides accounting students a rare ‘‘inside’’ look at the mechanics and dynamics of
aggressive accounting practices when carried out by a large and sophisticated company. In
December 2010, the Attorney General for the State of New York filed a lawsuit against Lehman’s
auditors, Ernst & Young LLP (hereafter, E&Y).1 In April 2011, Valukas testified before a
subcommittee of the U.S. Senate Committee on Banking, Housing, and Urban Affairs, in a hearing
on the role of the accounting profession in preventing another financial crisis (Valukas 2011). This
case summarizes information from these sources and requires students to address questions of fact,
as well as conceptual issues.
COMPANY BACKGROUND
Originally, Lehman’s business model was that of a brokerage firm and underwriter. In that role,
Lehman acted as an agent, marketing securities and acquiring assets on behalf of third parties. In
2006, Lehman’s management and Board of Directors decided to increase the firm’s risk profile and
pursue a higher growth strategy. Thereafter, Lehman acquired assets for its own investments, hence,
internalizing the risk and returns of those investments. That is, Lehman transformed itself from a
‘‘moving’’ business, in which it held securities only for a short time period, to a ‘‘storage’’ business,
in which it managed securities over a much longer period (Valukas 2010, Volume 1, p. 43).
According to a senior Lehman executive, the company pursued an aggressive 13 percent
growth rate in revenues (Valukas 2010, Volume 1, pp. 61–62). This business strategy was high-risk
in light of Lehman’s low equity and high leverage. The increased risk was borne by Lehman’s
investment in long-term assets, primarily commercial real estate, leveraged loans, and illiquid
private equity with high growth potential. When the subprime mortgage crisis hit the U.S. in 2006,
Lehman undertook an aggressive strategy of ‘‘doubling down,’’ rather than pulling back and
diversifying. By doing so, it violated its own internal controls on risk management. Lehman
increased its holdings in these long-term, illiquid, high-risk investments from $87 billion in 2006 to
$175 billion at the end of the first quarter of 2008 (Valukas 2010, Volume 1, p. 57). These newer
investments increased Lehman’s business risk in several ways. First, these assets were difficult to
liquidate in an economic downturn, primarily because a ready market did not exist and they could
only be sold at steep losses. Second, many lenders steeply discount the collateral value of illiquid
assets, making them less valuable as collateral against borrowings. Finally, there was no feasible
way to hedge these assets.
In order to finance these long-term investments, Lehman needed to borrow billions of dollars.
In late 2007, the company held assets of $700 billion on equity of $25 billion, with $675 billion of
liabilities, most of which were short-term. The mismatch between short-term debt and long-term
illiquid investments required Lehman to continuously roll over its debt, which increased the firm’s
business risk. In fact, Lehman borrowed tens of billions of dollars on a daily basis (Valukas 2010,
Volume 3, p. 751). Market confidence in a company’s viability and debt-servicing ability is critical
1

A copy of the lawsuit is available at: http://www.ag.ny.gov/media_center/2010/dec/ErnstYoungComplaint.pdf
E&Y’s response to the lawsuit is available at: http://www.ey.com/US/en/Newsroom/News-releases/
Ernst—Young-Response-to-New-York-Attorney-General-Complaint

Issues in Accounting Education
Volume 27, No. 2, 2012

Lehman on the Brink of Bankruptcy: A Case about Aggressive Application of Accounting Standards 443

for the company to access funds of this magnitude. It was imperative for Lehman to maintain good
credit ratings from agencies such as Moody’s and Standard & Poor’s.
As economic conditions worsened and markets further declined in 2007–2008, Lehman’s
strategy proved to be a failure. Lehman had no choice but to reduce its exposure and leverage. The
more highly leveraged a company is, the more important it is for the company to act quickly when
market conditions turn against it. However, Lehman had difficulty selling its illiquid assets and,
therefore, was unable to reduce its leverage rapidly through market transactions. Lehman could only
offload assets at a steep loss, which would have a double-negative impact. First, recognizing losses
on the sale of these assets would reduce equity. Second, the market’s perception of the quality and
value of Lehman’s remaining assets would be negatively affected, making it more difficult for
Lehman to borrow needed funds at a feasible cost.
In response to these difficulties, Lehman developed and engaged in repurchase agreement
transactions that the company called ‘‘Repo 105’’ transactions. These transactions helped Lehman
improve its reported leverage ratios.
REPURCHASE AGREEMENTS
Sale and repurchase agreements (repos) are commonly used by financial companies to finance
their security position by transferring securities as collateral for short-term borrowings of cash. The
transaction is completed in two phases. In the first phase, the borrower receives cash, records a
liability, and transfers custody of securities to the lender as collateral for the loan. In the second
phase, at a date determined up front, the company repays the borrowed amount with interest to the
lender and repossesses the securities. To reduce the risk borne by the lender, the amount of
securities transferred as collateral slightly exceeds the amount borrowed. This slight excess of the
amount of collateral over the amount borrowed is known as the ‘‘haircut.’’ Under Statement of
Financial Accounting Standards (SFAS) No. 140, the transaction described above would be
regarded as a secured borrowing primarily because the borrower retains control over the securities
(Financial Accounting Standards Board [FASB] 2000). The transaction would also be regarded as a
collateralized borrowing under International Accounting Standard (IAS) No. 39 (International
Accounting Standards Board [IASB] 2003).2 As an example, if Lehman put up $1.02 million of
collateral to borrow $1 million and incurred $1,000 of interest expense, the journal entry would be
(all amounts in thousands):
Cash
Collateralized Financing

$1,000
$1,000

As a separate transaction, Lehman would use the cash it just borrowed to settle short-term
borrowings from other creditors. This transaction would be recorded as follows:
Short-Term Borrowings
Cash

$1,000
$1,000

The subsequent repayment would be recorded as:
Collateralized Financing
Interest Expense
Cash

2

$1,000
$1

See paragraphs 9, 98, and 100 of SFAS No. 140, and paragraphs 20 and 21 of IAS No. 39.

Issues in Accounting Education
Volume 27, No. 2, 2012

$1,001

Caplan, Dutta, and Marcinko

444

The amount of collateral does not constitute a part of the journal entry, although total securities
pledged as collateral would normally require footnote disclosure.
For a portion of its repo transactions, Lehman modified the terms of a normal repurchase
agreement by taking a bigger haircut (i.e., the excess of securities collateralized over cash received).
While a typical haircut was about 2 percent for the period under discussion (and in the example
above), Lehman created agreements that took haircuts of 5 percent for fixed income securities and 8
percent for equity securities; hence, the terminology that Lehman used for these transactions: Repo
105 and Repo 108 (Valukas 2010, Volume 3, p. 732).3 For example, if Lehman borrowed $1
million, the company would transfer either $1.05 million of fixed income securities or $1.08 million
of equity securities to the lender. By taking this larger haircut, Lehman characterized these
transactions as sales of securities in accordance with Lehman’s interpretation of SFAS No. 140.4
Instead of classifying these transferred securities as collateral for the loan, to be returned upon the
settlement of the loan, Lehman would record the transfer as a sale with an agreement to repurchase
on a specified date. As a separate transaction, Lehman would use the cash it just borrowed to settle
other liabilities. The borrowing phase of the Repo 105 transaction would be recorded as follows (all
amounts in thousands):
Cash
Option to Repurchase
Investment Securities

$1,000
$50
$1,050

Similar to the previous example, Lehman would use the cash it just received to settle short-term
borrowings from other creditors. This transaction would be recorded as follows:
Short-Term Borrowings
Cash

$1,000
$1,000

The repayment transaction would be recorded as:
Investment Securities
Interest Expense
Option to Repurchase
Cash

$1,050
$1
$50
$1,001

Lehman had vetted its interpretation of how to account for repurchase agreements under SFAS
No. 140 with E&Y prior to adopting a formal Repo 105 accounting policy (Valukas 2010, Volume
3, p. 765). Additionally, Lehman acquired an opinion letter supporting its accounting treatment of
Repo 105 transactions from Linklaters, a British law firm.5
There were many similarities between a Repo 105 transaction and an ordinary repurchase
agreement. For instance, in ordinary repo transactions, the borrower typically continues to receive
3

4
5

In the Examiner’s Report, the business press, and in this paper the term ‘‘Repo 105’’ often denotes Lehman’s
combined Repo 105 and Repo 108 activity.
The relevant section of SFAS No. 140 includes paragraph 218.
Despite Lehman’s sale of $1.05 million of securities for $1 million cash, no gain or loss was recognized on the
transaction because at the time of the sale, Lehman entered into a binding commitment to buy back those same
securities at a later date for $1 million. Hence, even though Lehman would ‘‘sell’’ $1.05 million of securities for
$1 million with an apparent loss of $0.05 million, the loss is offset by an apparent $0.05 million gain on the
commitment to purchase the same $1.05 million of securities for $1 million (a derivative asset). Recognizing the
$0.05 million gain from the commitment exactly offsets the loss. See Lehman Brothers Holdings Inc.,
Accounting Policy Manual Repo 105 and Repo 108 (Sept. 9, 2006), pp. 7–8 [LBEX-DOCID 3213290], as
referenced in Valukas (2010, Volume 3, p. 776, footnote 2990).

Issues in Accounting Education
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Lehman on the Brink of Bankruptcy: A Case about Aggressive Application of Accounting Standards 445

FIGURE 1
Repo 105 Usage

the income from coupon payments of the securities that were transferred to the lender as collateral.
Similarly, during the term of a Repo 105 transaction, Lehman continued to receive the stream of
income through coupon payments from the securities it transferred. Additionally, just as in an
ordinary repo transaction, Lehman was obligated to ‘‘repurchase’’ the transferred securities at a
specified date. Moreover, Lehman used the same documentation to execute both Repo 105 and
ordinary repo transactions, and these transactions were conducted with the same collateral
agreements and substantially with the same counter-parties (Valukas 2010, Volume 3, p. 746).
Repo 105 was a more expensive source of financing compared to ordinary repo agreements
because of the opportunity cost of the increased collateral, as well as transaction costs incurred by
channeling these transactions through Lehman’s British subsidiary. Consequently, its usage was timed
around the end of reporting periods. The Examiner’s Report analyzed the intra-quarter data on the usage
of Repo 105 and concluded that its usage spiked at quarter-ends and fell off on an intra-quarter basis.
The amount of Repo 105 activity at period-end from late 2007 to mid-2008 ranged from $39 billion to
$50 billion. Figure 1 is excerpted from the Examiner’s Report (Valukas 2010, Volume 3, p. 875).
MATERIALITY AND LEVERAGE
The leverage ratio is a widely accepted measure of the additional risk placed on common
stockholders as a result of the decision to finance operations with debt. Lehman defined its leverage
ratio as assets (net of certain items) divided by equity. The items that were netted out in the
numerator of the leverage ratio were: cash and securities segregated and on deposit for regulatory or
other purposes, securities received as collateral, securities purchased under agreements to resell,
securities borrowed, and identifiable intangible assets and goodwill (Valukas 2010, Volume 3, p.
734).
The importance of the leverage ratio in analyzing Lehman’s financial statements was widely
recognized. In fact, the Global Treasurer of Lehman remarked to the bankruptcy examiner that
‘‘ratings agencies were ‘most interested and focused on leverage’’’ (as quoted in Valukas 2011,
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446

TABLE 1
Repo 105 Usage and Net Leverage
Date
Q4, 2007
Q1, 2008
Q2, 2008
a

Amount of
Repo 105 Usage

Reported
Net Leveragea

$38.60 billion
$49.10 billion
$50.38 billion

16.1
15.4
12.1

As an example of the derivation of the net leverage ratio, refer to pp. 29–30 of Lehman Brothers Holdings Inc. Form
10-K for the fiscal year ended November 30, 2007.

3–4). In addition, E&Y identified a separate materiality threshold specifically for leverage, defining
materiality as an amount that ‘‘moves’’ net leverage by a tenth of 1 percent. Table 1 shows data from
the Examiner’s Report on the usage of Repo 105, and Lehman’s reported leverage ratio (Valukas
2010, Volume 3, p. 748)
Despite their materiality threshold for leverage, E&Y’s lead audit partner on the Lehman audit
team, William Schlich, told the bankruptcy examiner that E&Y did not have a ‘‘hard and fast rule
defining materiality in the balance sheet context’’ (Valukas 2010, Volume 3, p. 890). This assertion
is consistent with the independent auditor’s professional standards, as promulgated by the Auditing
Standards Board (ASB) and the Public Company Accounting Oversight Board (PCAOB), which
generally avoid providing auditors specific quantitative benchmarks for materiality. Professional
standards state that the ‘‘auditor’s consideration of materiality is a matter of professional judgment
and is influenced by his or her perception of the needs of a reasonable person who will rely on the
financial statements’’ (AU §312.10, AICPA 2009). The importance of considering the user’s
perspective in determining what is material is underscored in the auditor’s professional literature:
‘‘In all instances, the element or elements selected should reflect, in the auditor’s judgment, the
measures most likely to be considered important by the financial statement users’’ (AU §9312.11,
AICPA 2009). Also, qualitative factors should include the potential effect of the misstatement on
trends, and the potential effect on the entity’s compliance with regulatory provisions (AU §9312.17,
AICPA 2009).
Professional standards on materiality appear consistent with the prevailing view by the courts.
In 2011, in Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309, the U.S. Supreme Court
reaffirmed its commitment to a ‘‘reasonable person’’ standard in the assessment of materiality in the
context of financial reporting and disclosure. Matrixx, a pharmaceutical company, argued
unsuccessfully that evidence of adverse side effects caused by its cold remedy medication was
immaterial by virtue of the fact that the evidence failed to meet tests of statistical significance. The
Court characterized Matrixx’s argument as an attempt to apply a ‘‘bright-line’’ definition of
materiality, and concluded that materiality cannot be reduced to a bright-line rule. The Court
reiterated its position from an earlier case that materiality is satisfied when there is a substantial
likelihood that the disclosure of the omitted fact would have been viewed by a reasonable investor
as significantly altering the ‘‘total mix’’ of information available.
In his Senate testimony, the Lehman bankruptcy examiner said that ‘‘existing rules require
analyses of qualitative materiality—particularly when management is trying to actively manage the
financial statements—and not just number-crunching, to determine if an issue is material’’ (Valukas
2011, 13) (emphasis in the original). Valukas recommended that these rules need to be tightened or
enforced more aggressively, and that auditors must avoid the mindset of finding a way to describe
an issue as immaterial.
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Lehman on the Brink of Bankruptcy: A Case about Aggressive Application of Accounting Standards 447

SUBSTANCE OVER FORM
According to professional standards, the objective of the independent auditor’s report ‘‘is the
expression of an opinion on the fairness with which [the financial statements] present, in all material
respects, financial position, results of operations, and its cash flows in conformity with generally
accepted accounting principles’’ (AU §110.01, AICPA 2009). Generally accepted accounting
principles provide auditors a common, uniform framework with which to judge the ‘‘fairness’’ of
the audit client’s financial statement presentation. Auditing standards adopted by the Public
Company Accounting Oversight Board for public company audits state that the auditor’s judgment
should be based on whether, among other considerations, (1) the accounting principles selected and
applied have general acceptance, (2) the accounting principles are appropriate in the circumstances,
and (3) the financial statements, including the related notes, are informative of matters that may
affect their use, understanding, and interpretation (AU §411.04, AICPA 2009). Auditing standards
also state: ‘‘generally accepted accounting principles recognize the importance of reporting
transactions and events in accordance with their substance. The auditor should consider whether the
substance of transactions or events differs materially from their form’’ (AU §411.06, AICPA 2009).
Lehman personnel believed that by late 2007, none of Lehman’s peer investment banks were
applying the same accounting treatment to Repo 105-type transactions (Valukas 2010, Volume 3, p.
739). Further, Lehman used a London law firm for the opinion letter supporting Lehman’s Repo
105 accounting, and conducted its Repo 105 activity out of England. Finally, according to
Lehman’s former Global Financial Controller, a careful review of Lehman’s 10-K and 10-Q filings
would not reveal Lehman’s use of Repo 105 transactions (Valukas 2010, Volume 3, pp. 734–735).
The lawsuit that the New York Attorney General filed against E&Y in December 2010 stresses
the role of substance over form in financial reporting, and also the auditor’s responsibilities in
connection with financial statement audits. The lawsuit is premised on E&Y’s implicit approval of
Lehman’s accounting for Repo 105 transactions. It alleges that E&Y failed to meet Generally
Accepted Auditing Standards in their audits of Lehman’s financial statements because:

E&Y failed to treat Repo 105 transactions as sufficiently unusual to warrant informing
Lehman’s audit committee.
E&Y failed to conduct a bona fide investigation of Lehman’s accounting for Repo 105
transactions, even though it was aware, or should have been aware, that Lehman’s intended
use of its Repo 105 accounting policies was to manage balance sheet metrics without
changing the economic substance of the underlying repurchase agreements.
E&Y did not object when Lehman’s management made false and misleading assertions
regarding Lehman’s liquidity position in press releases, earnings calls, and in management’s
discussion and analysis (MD&A) in Lehman’s Form 10-K and Form 10-Q filings from 2001
through 2008.
THE WHISTLEBLOWER

In May 2008, Matthew Lee, a Senior Vice President in Lehman’s Finance Division, submitted
a letter to senior Lehman management in which he alleged various financial reporting practices that
potentially violated Lehman’s own code of ethics (Valukas 2010, Volume 3, p. 956). Section 301
of the Sarbanes-Oxley Act requires audit committees to establish procedures for the receipt,
retention, and treatment of complaints received by the company regarding accounting, internal
accounting controls, or auditing matters. Consequently, Lehman’s audit committee identified and
treated Lee as a whistleblower. The audit committee instructed Lehman’s internal audit group and
external auditors to investigate Lee’s concerns.
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Volume 27, No. 2, 2012

Caplan, Dutta, and Marcinko

448

Lee’s letter contained six allegations, but did not refer to Lehman’s Repo 105 activity. On June
12, E&Y’s engagement partner and another member of the audit team interviewed Lee. The
auditor’s notes of the interview indicate that Lee verbally informed E&Y that Lehman had used
Repo 105 transactions to remove $50 billion of inventory from its balance sheet for the quarter just
ended (the second quarter, ending May 31), and returned the inventory to its balance sheet
approximately one week later (Valukas 2010, Volume 3, p. 957). Lee could not have included this
specific allegation in his letter, because his letter preceded the quarter-end. However, the Repo 105
activity had been almost as high at the end of the prior quarter, and Lee could have, but chose not
to, include that matter in his letter.
On the day following this interview, E&Y met with Lehman’s audit committee, but did not
inform the committee of Lee’s allegations regarding the Repo 105 activity, even though the
chairman of the audit committee specifically inst…

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