Professional Documents
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The 2008 global financial meltdown saw most of the top worldwide financial institutions
fall into bankruptcy and liquidation. The incident affected most of firms that either experienced a
drop in returns or liquidation. The failure of Lehman Brothers in the middle of the global
financial crisis was the most significant catastrophe to hit the financial industry in the U.S. On
September 15, 2008, the fourth largest investment bank in the U.S., Lehman Brothers (holding
over $600 billion in assets) filed for Chapter 11 bankruptcy protection, the largest bankruptcy
filing in the U.S history. This had raised concerns and questions by many famous players and
experts and players in international banking community. Lehman progressively turned to Repo
105 to reduce its reported net leverage and manage its balance sheet after a burden of huge
volume of illiquid assets that it could not readily sell. The acquisition of illiquid assets became
the subject for investigation relating to the valuation and liquidity issues. While Lehmans risk
decisions lay within the business judgment rule and did not give rise to debatable claims, those
decisions were labeled in review by many experts as poor judgment. Hence, there is the urgent
need for regulators of financial institutions to remove the gaps in their financial regulatory
framework that allow complex, large, unified firms like Lehman to operate without robust
consolidated supervision.
Thesis
This paper investigates the case of Lehman Brothers Inc., the fourth largest investment
bank in the U.S. in which financial statement fraud played a key role in its collapse because
some senior officers ignored and certified deceptive financial statements resulting in its failure.
Lehman progressively used Repo 105 to manage its balance sheet and reduce its reported net
leverage intended to make the balance sheet appear healthier than they actually were after
burdening itself with a big volume of illiquid assets that it could not readily sell. The banks
acquisition of illiquid assets became the subject for financial fraud investigation relating to the
valuation and liquidity issues. This paper also examines the key issues of financial fraud, the
causes of Lehmans failure, the significant impact of the issue on company, the overall US
economy and the world, and the necessary recommendation to reduce and prevent any future
occurrence in the financial market. The thesis will also examine the importance of internal
control and the various possibilities of how companies are able to cook the books and ways in
which this kind of behavior can be prevented. The objective is to discover how managers and
companies would produce consistent and truthful financial records. The interest lies on how
financial fraud occurs and how can it be prevented possibly in the very initial stages.
Background
Fraud and betrayal have existed fraud throughout history. For some reason, it appears that
greed for success and money are also part of human nature. During the earlier years many
amounts of corporate accounting scandals have been evident in the headlines; perhaps the most
renowned ones have been the Lehman Brothers in 2008 and the Enron case in 2001. In the Enron
case, the company as well as their accounting firm Arthur Anderson systematically produced
fraudulent financial reports and got involved in corrupt accounting by hiding liabilities and debts
as well as misrepresenting earnings (Roger 2010). When the depth of the deception materialized
to the public, creditors and investors retreated, forcing the company into bankruptcy in
December 2001. The company frequently used accounting gimmicks at the end of each quarter
to make its finances seem less shaky than they actually were. After the fall of Lehman Brothers,
other banks followed suit and this is believed to be the beginning of the 2008 global financial
One exciting fact is that most of these big companies caught in financial report fraud
cases have been audited by the Big Four auditing firms: KPMG, Deloitte Touche Tohmatsu
PricewaterhouseCoopers, and Ernst & Young (Wikipedia 2012). This raises eyebrows on how it
has been possible to cheat and scam the ones who should be there to assure the reliability of the
records. Or could there be something behind the scenes? Although big companies are the ones
ending up in the news, small firms experience unethical behavior and fraud evenly as much.
Implementing an internal control system is assumed to be one of the best ways to preventing
fraud. Many theory books write about the concept of the fraud triangle - motive, opportunity and
rationalization representing the three corners (Harrison, et.al, 2011, 236). All the three corners
of the triangle exist in which there is a high possibility for a person to commit fraud which will
be discussed later.
Introduction
The 2008 global financial crisis saw most of the leading financial institutions in the globe
crush into liquidation and bankruptcy (Mensah, 2012; Murphy, 2008). Those which were not
liquidated either experienced plummeting returns and their particular operations or filed for
voluntary bankruptcy (ISSER, 2008). The Lehman Brothers bankruptcy scandal in the midst of
the global financial crisis was the leading catastrophe to ever hit the U.S financial industry
(Morin & Muax, 2011). Lehman Brothers being the leader in the industry had assets worth over
$600 billion (DArcy, 2009). Apart from the well-known Enron failure in the early 2000, the
failure of Lehman Brothers was the largest unit financial institution to have collapsed with assets
so big (Jeffers, 2011). The leading US investment bank suffered massive losses within the month
of September. The stock price fell by 73% of its value in the first half of September and by the
mid of September 2008, lost about $3.9 billion in their effort to dispose of a majority of their
Prior to their liquidation, the global crisis pressed the bank to close its leading subprime
lender (BNC Mortgages) in 23 locations (Wilchins and DaSilva, 2010). The losses were so
sequential such that Lehman Brothers filed for voluntary bankruptcy at the US Bankruptcy Court
by September 15th 2008 (Murphy, 2008). The voluntary bankruptcy was necessitated by the
failed attempt for a possible mergers and government bail-out coupled with some acquisition
attempt by companies such as Barclays bank and many others. To explain for the possible causes
of the Lehmans failure, many financial analysts have advanced series of practical and academic
arguments aimed at unearthing the exact causes of the melt-down. Others have also conducted
Lehman and his brothers, Mayer and Emanuel. While Lehman flourished over the prevailing
decades, it had to undergo many challenges: the Russian debt default of 1998, the Great
Depressions of the 1930s, the two World Wars, amongst others. However, regardless of
Lehmans ability to endure these challenges, the subprime mortgage crisis brought the once
leading investment bank hurling to the ground. Lehmans troubles began with its decision to
enter the real estate business in 2003 during the U.S. housing bubble. Initially, this decision
under their CEO Richard Fuld appears credible. Record growth from Lehmans real estate
business allowed revenues in the capital markets unit to surge to 56% between 2004 and 2006. In
2006, the Company securitised $156 billion of mortgages, which represented a 10% increase
from 2005. For the full 2007 financial year, Lehman reported a record net income of $4.2 billion
on revenues of $19.3 billion (from $17.6 billion for the 2006 financial year).
In 2007, cracks started to surface in the U.S. housing markets with an increasing number
of defaults. Lehman began to experience the losses and resorted to illegal practices to mask its
loss. To hide its unhealthy financial situation, Lehman resorted to a window dressing method
known as Repo 105 (Repurchase Agreement) (Jeffers, 2011). Repo has historically been
implemented to enable companies to manage their short-term cash, however, in Lehmans case,
these transactions took on a strange spin that were intended to make Lehmans balance sheet
appear to look healthier than they really were (Jeffers, 2011, 46). Repo 105 allowed Lehman to
use arcane accounting practices to sell toxic assets to banks in Cayman Islands with the
understanding that they would ultimately be bought back. With the assistance of its auditors, this
accounting scheme was plotted to allow Lehman to create an impression that it had $50 billion
less in toxic assets on its books and $50 billion more in cash and artificially reduce its net debt
level (Valukas, 2010, 42). It was no surprise that Lehman consequently declared bankruptcy
Financial statement fraud played a key role in the collapse of Lehman, because some
senior officers ignored and certified deceptive financial statements. This is not shocking because
the 1999 study of 200 financial statement frauds by the COSO (Committee of Sponsoring
Organizations) of the Treadway Commission from 1987 to 1997 revealed that senior
management is the most likely group to commit financial statement fraud (KuTenk 2000,
external auditor, Ernst & Young for their failure to challenge or question inadequate or improper
disclosures in Lehmans financial statements (Valukas, 2010). According to the Public Company
Accounting Oversight Board, an external auditor is accountable to plan and perform the audit to
acquire reasonable assurance on whether the financial statements are free of material
misstatement, whether caused by fraud or error (CAQ, 2010). Lartey (2012) observes that
auditors need to establish a high level of objectivity and independence when reviewing financial
statements. This objectivity and independence was completely lost in the case of Lehmans
external audit. According to Cooper (2005), in the six years before Enron's collapse, ASIC's
American counterpart, the SEC, projected that investors lost US$100 billion owing to
misleading, faulty, or fraudulent audits. It was confirmed that those linked with the Enron fiasco,
including its auditor, Arthur Andersen, had been shredding thousands of pages of incriminating
financial reporting frauds that auditors appear to usually cover up. For example, WorldCom,
whose accounts were audited by the so-called professional auditors, experienced a more
terrible loss of 17,000 jobs, having inflated profits by approximately US$4 billion through
improper adjustments and deceptive accounting to the financial statements (Cooper, 2005). It is
obvious from the collapse of Lehman Brothers that many auditors seem to be involved in
financial statement frauds. In the case of Dynegy in which $300 million bank loan was masked
to look like cash flow, through a sequence of complicated trades, the complex nature of the
trades would have required considerable detective work on the part of the auditor (Ziff Davis
In the years leading to Lehmans bankruptcy in 2008, its exposure to the mortgage
market was risky since it borrowed considerable amounts to fund its investments. A major
portion of this leveraging was put in housing-related assets, making it susceptible to a downturn
in that market. Analyses conducted by many experts focused mainly on Lehmans valuation of
the following asset categories: residential whole loans, commercial real estate, collateralized debt
obligations, residential mortgagebacked securities, corporate equity and debt, and other
derivatives. This section discusses more of Lehmans business decisions that led to the collapse.
Prior to the fall of Lehman, many investment decisions were made, which analysts
commercial real estate confirmed insufficient proof to conclude that Lehmans valuations of its
commercial portfolio were unreasonable as of the second and third quarters of 2008; however,
the findings indicated that real estate assets were unreasonably valued during these quarters and
Lehmans valuations of its Archstone bridge equity investment were unreasonable as of the first,
second and third quarters of 2008 (Valukas, 2010). Moreover, RWLs (Residential Whole Loans)
RWLs are residential mortgages that can be traded and combined during the first phase in
the securitization process, the result of which is the creation of RMBS (Residential Mortgage
Backed Securities). According to Valukas (2010), Lehman stated that it owned RWLs with an
aggregate market value of about $8.3 billion, as consolidated across subsidiaries as of May 31,
2008. With this revelation, the investigation identified lack of robustness in Lehmans product
control process for residential whole loans; and established that there was some risk of
misstatement in this asset class. With the aim of taking advantage of speculative opportunities
and managing its exposure to market and credit risks resulting from trading activities, Lehman
entered into derivative transactions on its behalf and that of its clients (Valukas, 2010).
According to Valukas (2010), Lehman held over 900,000 derivatives positions globally as of
May and August, 2008 with a net value of around $21 billion as of May 31, 2008; making up a
Valukas (2010) also argues that the term derivative is a contract between two or more
parties often referred to as a financial contract. Lehman experienced a drop of $17.0 billion in
CDOs (Collateralized Debt Obligations) in financial year 2008, compared with the $16.2 billion
and $25.0 billion generated in financial years 2006 and 2007 correspondingly (Valukas, 2010).
Although the 2008 decline is not as severe as is generally consistent with the decline in the
global CDO market, many contend that it contributed considerably to the collapse of Lehman.
Notwithstanding the billions of dollars worth of CDOs that Lehman originated from 2006
to 2007, Lehman accounted for just 3% of the total value of new CDO issuances; and their CDO
portfolio was subjected to the disruptions in the credit markets and deteriorating value of
mortgages and mortgagelinked securities that occurred in 2007 and 2008 (Valukas, 2010). As
the market declined, Lehman was not able to sell subordinate pieces of securitizations, and many
of Lehmans CDO positions were such pieces. For instance, of the $431 billion of CDOs
originated in 20062007, more than half had experienced events of default by November 2008,
with increasing numbers of defaults over time (Valukas, 2010). Krugman (2010, cited in
Swedberg, 2010 ) established that "in the years before the crisis, regulators did not expand the
rules for banks to cover the growing 'shadow' banking system, comprising of institutions like
Lehman Brothers that performed bank-like functions although they did not offer conventional
bank deposits." The financial crisis that broke out after Lehman's fall on September 15 made
some of Lehmans executives realize very quickly that something else had to be done than just
to improve its liquidity position, but efforts in raising additional capital in the weeks leading up
to its failure proved insufficient (Bernanke, 2010). Lehman's high degree of leverage - the ratio
of total assets to shareholders equity - was 31 in 2007, and its huge portfolio of mortgage
bankruptcy was many times more multifaceted than Enron's failure in 2001 as it was deeply
plumbed into the global financial system. According to Bernanke, "almost every large financial
institution in the globe in momentous danger of going bankrupt" (Bernanke, 2009, cited in
Swedberg, 2010).The following section analyzes some of the causes of Lehmans collapse, with
a particular emphasis on the implications of the bankruptcy on the international banking system.
The collapse of Lehman has made headline news in several newspapers and journals.
Several industry practitioners and authors have undertaken much research just to establish what
caused the failure of Lehman Brothers. This section examines the facts and issues relating to the
collapse of Lehman Brothers. What financial fraud factors that made Lehman Brothers go
bankrupt and how could its bankruptcy have such a huge impact on the financial system? How
could this event turn an economic crisis of some severity into a complete financial panic? These
In recent years, there has been a sequence of publications on what caused the failure of
Lehman Brothers. While some blamed Lehmans CEO Dick Fuld for his overconfidence in
trying to save something for shareholders and failure to identify that Lehman faced a critical
crisis, others stressed that the foundation for the collapse was far beyond the control of the Chief
Executive. One reason why Lehman would later go bankrupt has to do with the fact that anyone
who was alleged as a threat by Fuld was immediately eliminated including some critics who
early on realized that Lehman was headed for serious trouble (Azadinamin, 2012). As in most
investment banks, the employees of Lehman were paid extremely high salaries and bonuses,
which ate up more than half of what the company earned in pretax profit (Dash, 2010). The Bank
of America was blamed or ending takeover talks with Lehman in favor of buying its main rival
Merrill Lynch for $50 billion; and Barclays was also blamed for rejecting to buy Lehman
without US governments support in the form of emergency funding (DArcy, 2009). However,
DArcy (2009) also noted that Lehman failed mainly because of three things: losses, liquidity,
and leverage.
According to DArcy (2009), the best way to improve your returns during the good times
is to 'gear up' by borrowing money to invest in assets that are rising in value. In 2004, Lehman's
leverage was running at 20 and rose past the twenties and thirties before peaking at an
astonishing 44 in 2007, i.e. Lehman was leveraged 44 to 1 when asset prices started heading
south (DArcy, 2009). Different authors have described the collapse of Lehman as a result of the
abolishment of the 1933 Glass-Steagall Act. The Glass-Steagall Act was endorsed to separate the
activities of investment and commercial banking (Tabarrok, 2010). The U.S. has historically
maintained a separation between investment banking and commercial banking until the late
1980s. However, following the repeal of the GlassStegall Act, Lehman began to compete with
large commercial banks that reserved large amounts of funds, pursuing a path of high risk.
Before the passage of the Banking Act of 1933, banking regulation was greatly tightened in the
U.S which led to more than 9,000 banks failing during the great depression years of 1930-1933
(Laroche, 2010).
Various experts have blamed these failures on the so-called unethical actions arising from
the amalgamation of investment and commercial banking. In their paper, Altnkl, et al. (2007)
observed that investment banks governance has responded to the deregulation of commercial
bank entry into investment banking by virtue of the repeal of the Glass-Steagall Act. Competing
with commercial banks was a huge undertaking for Lehman; therefore the easiest way to
compete was to use high amounts of leverage, thus taking on more risk. For an investment bank,
pyramid balanced on a splinter of cash. Even though it had a massive asset base, Lehman did not
have enough by way of liquidity. Believing that Lehman did not have sufficient liquidity at hand,
other banks declined to trade with it, so they moved to protect their own interests by pulling
Lehman's lines of credit (DArcy, 2009). Many blamed Lehmans failure on insufficient liquidity
to meet current obligations and inability to retain the confidence of counterparties and lenders
(Valukas, 2010). Lehmans available liquidity is fundamental to the question of why Lehman
failed. Liquidity offers firms the ability to convert assets into cash without complexity, thus
ensuring that investment decisions are maintained and shortterm obligations are satisfied. The
firm also stated that it had boosted its liquidity pool to an projected $45 billion, decreased gross
assets by $147 billion, reduced its exposure to commercial and residential mortgages by 20%,
and cut down leverage from a factor of 32 to approximately 25 (Valukas, 2010). Valukas (2010)
noted that there was a crisis of confidence since the confidence of lenders reduced on two
successive quarters with massive reported losses, $2.8 billion in second quarter 2008 and $3.9
billion in third quarter of 2008. Lehmans accounting system was a failure. The Repo 105
transactions used by the firm was described by its own accounting personnel as an accounting
gimmick, as it was a lazy way of managing the firms balance sheet (Valukas, 2010).This action
Amazingly, Lehmans external auditor, Ernst & Young took virtually no action to scrutinize the
Repo 105 allegations; and did not take any step to challenge or question the nondisclosure by
Lehman of its use of $50 billion of temporary, offbalance sheet transactions (Valukas,
2010).This unethical conduct by Lehmans auditor justifies Stern Stewarts (2002) conclusion
that accounting is no longer counting what counts and those in charge have not been wise or
strong enough to resist their ploys and to make the auditors definition of earnings into a reliable
measure of value. Many experts attribute that many companies fail and experience financial
crises because of disclosure fraud, accounting fraud, and accounting manipulation, that were
kept under cover; and auditors failed to warn the society and shareholders. Financial statement
fraud also played a key role in the collapse of Lehman because some senior officers overlooked
and certified misleading financial statements. For example, in the case of Crazy Eddie
Companys frauds, the auditors were rushed and did not have time to complete most of their
underwriter of property loans in 2007, by which Lehman had over $60 billion invested in CRE
(commercial real estate) and was very big in subprime loans, mortgages - to risky homebuyers
(DArcy, 2009). Lehman had vast exposure to innovative yet arcane investments such as CDOs
(collateralized debt obligations) and CDS (credit default swaps). These factors damaged the firm.
CDOs are derivative instruments through which a financial institution combines assets of
different types (prime and subprime mortgages). The packaged debt is later sold to a specific
vehicle, generally registered offshore in a low tax jurisdiction. The new entity then issues its own
bonds or equity to resell the debt to other investors, carving it up into diverse tranches with
different risk ratings using complex mathematical models (Wilks, 2008). Lartey (2012) argues
that overreliance on agency ratings of CDOs was a direct outcome of the strain in evaluating
such complex financial products. While many analysts have blamed Lehmans downfall on
complicit external auditors, others have expressed different views. It is argued that external
auditors are usually not effective in detecting fraud given frauds strategic nature (Carcello &
Hermanson, 2008). Also, Johnson (2010) argues that there is no assurance that all material
misstatements, whether caused by error or fraud, will be detected by auditors because auditors do
not examine every transaction and event (Ziff Davis Media Inc, 2004).
According to Lang & Jagtiani (2010), most of the initial losses in securities markets came
from CDOs and other structured securities that were linked to the residential mortgage market.
Thus, relative to their capital position, large financial institutions had highly concentrated
exposures to this organized but complex securities market. Fitch (2006, cited in Lang & Jagtiani,
2010) established that the number of subprime downgrades as of July-October 2006 was the
largest in its history. CDS are mainly credit derivatives in which the underlying asset is a
mortgage, loan, or any other form of credit. The risks in CDS and other types of OTC (over-
the-counter) derivatives played fundamental role in the financial crisis (European Commission,
2009). As property prices crashed and repossessions and debts increased, Lehman was caught in
a perfect storm and announced a $2.5 billion write-down due to its exposure to commercial real
estate (DArcy, 2009). While most authors blamed Lehmans bankruptcy on their 900,000
derivatives positions, the investigators did not find enough evidence to verify that Lehmans
Fraud
Fraud is one of the key concerns for corporate executives. During the modern years many
organizations have encountered corporate scandals due to fraud, making the executives
experience the consequences of prison time and large fines (Ernst & Young 2009). Fraud,can
manner that causes damage to that party (Harrison et al. 2011, 233). The Fraud Triangle Model
created by criminologist Donald R. Cressey, represents the three factors that push a normal
there is a high possibility to commit fraud (Harrison et al. 2011, 234). From these three factors,
opportunity and motivation are something the organization can have an effect on. The two
factors are directly influenced by management and the corporate environment. The opportunity
can arise by the lack of security and control within the company. The motivation or pressure can
be created by demands of higher earnings in the company (Ernst & Young 2009, 1.)
Rationalization is like a psychological factor that arises within the person. By rationalizing the
fraudulent behavior, the individual committing the fraud assures him/herself that it is suitable to
be doing so (Harrison et al. 2011, 234). The common types of corporate fraud include corruption,
fraudulent financial reporting, and misappropriation of assets (Ernst & Young 2009, 1.)
Cressey (1953) theorized that individuals commit fraud due to non-sharable financial
pressure. Non-shareable financial pressure is a financial strain experienced by a person that does
not intend to share with others. The individuals failure to communicate the financial strain
serves as a motivation to disobey the law to solve the problem. The literature on the pressure to
commit occupational fraud can be generally classified into financial and non-financial pressures
(Albrecht et al., 2012). Non-financial pressures can be further classified as work-related pressure
(Holton, 2009; Bartlett et al., 2004; Peterson & Gibson, 2003); pressure linked with drug
addiction and gambling (Kelly & Hartley, 2010; Howe & Malgwi, 2006); and pressure
associated with people who want to make a statement by living lavish lifestyles (Dellaportas,
personal achievement, is responsible for pursing success by any means necessary including
fraud (Choo & Tan, 2007: 209). A financial strain, such as a failed business or market
investment is the catalyst that drives many offenders to commit fraud (Dellaportas, 2013: 30). In
an organisational setting, financial pressures occur from the companys failure to meet Wall
Streets expectations (Power, 2013; Dorn, 2010). In other cases, financial pressure arises from
the companys failure to compete with other companies in similar industries (Albrecht et.al,
2004). Within these purviews, monetary incentives in the form of compensation bonuses are
given to executives to improve the companys financial performance (Brennan & McGrath,
2007). Financial incentives, combined with the companys interest in investors relations (i.e.
keeping stock price high and preserving investors confidence), serve as extra incentives for
and alleged inequities in the workplace. Hollinger and Clark (1983) observed that work-related
pressures associated with fraud, mentioning that employees dissatisfaction is one of the main
(Bartlett et al., 2004, 60-65), employees turn to fraud because of perceived inequities in the
work-place. These workers show little respect for the organisation they work for and generally
As earlier stated vices such as drugs and gambling represent another class of pressures
that motivate fraud (Dellaportas, 2013: 30). These increased opportunities motivate fraudsters to
steal assets and money to satisfy their chronic dependence on gambling (ACFE, 2012). Recent
studies have revealed that the vast majority of offenders, whose main motivation for fraud is
gambling, usually plough back their proceeds on gambling (Sakurai & Smith, 2003).
The offenders craving for material possessions creates pressure for them to live like their
more affluent colleagues (Everett & Rahaman, 2013). The type of pressure experienced by
offenders in this group differs by their individual circumstances (Morales et al., 2014). Many of
these offenders have selfish motivations and a desire to own more than one can afford,
(Dellaportas, 2013: 31). Egocentric motivations are an incentive to the fraudster and are said to
be any pressures to fraudulently increase personal prestige (Rezaee, 2005: 283). This type of
motive is commonly seen in those people with very hostile behaviour and desire to achieve
higher functional authority in the organisation (p. 283). Offenders in this category are extremely
ambitious and are obsessed with power and control; personality traits that make them more likely
to engage in risky behaviour that could lead to fraud (Dellaportas, 2013: 31).
The opportunity to commit fraud is the next element of Cresseys (1953) fraud triangle. A
perceived opportunity to commit a fraudulent act arises when someone in a position of trust
infringes that trust to address a non-sharable financial pressure (Cressey, 1953: 30). In the
accounting literature, opportunity has been studied within the context of weak internal controls
which, according to KPMG (KPMG, 2010), is a key factor attributable to fraud (Albrecht &
Albrecht, 2004; Harrison, & Turner, 2010; Kelly & Hartley, 2010; Strand et.al, 2010: 2013).
Such an opportunity arises when the individual has the knowledge and technical skills that
enables the fraudster to commit the fraud and conceal it (Coenen, 2008; 12). The opportunity to
engage in fraud increases as the organizations control structure to weaken, its corporate
governance becomes less operational, and the quality of its audit functions worsens (Power,
2013).
Others look to the criminology literature for explaining the opportunity to commit fraud
(Benson & Simpson, 2009). (Colvin et al. (2002) claimed that social support and coercion are
necessary conditions for criminal behaviour. Individuals, who are deprived of access to social
support from legitimate sources, may pursue social support from illegitimate sources (p. 25). In
the absence of social support, people that learn to manipulate others in order to gain social
support and in the process develop a calculative social bond, intermediately intense, will be more
likely to approach a criminal opportunity with a calculating spirit (p. 31). Donegan and Danon
(2008) examined opportunity from the perspective of sub-cultural deviance. They argued that the
opportunity to commit fraud comes from a sub-culture, which through its practices either sends a
any guilt arising from their misconduct (Dellaportas, 2013: 32). It is a mechanism by which an
employee determines that the fraudulent behaviour is okay in his/her mind. For those with
poor moral codes, the process of rationalization is easy. For those with higher moral standards, it
may be harder, they may have to convince themselves that a fraud is satisfactory by creating
excuses in their minds (Coenen, 2008: 12). The social criminology and psychology literature
both provide a great deal of help in understanding rationalisation. According to (Sykes & Matza,
1970: 669), criminals normally use the techniques of neutralisation to justify their acts.
Neutralisation techniques are often used to shield the individual from his/ her internal values
The psychological process of sanitising one's principles was expanded upon more lately
by Murphy and Dacin (2011). Building on the work of Bandura (1999) (moral disengagement
theory), they found three psychological pathways to fraud nestled within rationalization/attitude:
(1) lack of awareness, (2) instinct attached to rationalisation, and (3) reasoning. The authors used
their framework to describe how fraud becomes standardised within an organisation and how
executives rationalise their criminal acts because they see it as an essential part of their job.
Rationalisation also involves the fraudster integrating his/her actions with commonly
accepted principles of trust and decency. According to (Dorminey et al., 2010: 19), self-serving
and morally acceptable rationalization is essential before the crime occurs. Maybe this is
because a fraudster who does not view him/herself as a criminal must justify his/her misdeeds
The present discussion on the elements of the fraud triangle is structured around research
that assume fraud is committed by dishonest individuals lacking morals and it is the
employees from committing fraud or at least to detect fraud in a timely way (Morales et al.,
2013: 184). Other variants used diverse articulations to increase the descriptive potential of the
fraud triangle as a modern fraud diagnostic tool (Krancher, Riley & Wells, 2010). Albrecht et al.
(1984) introduced the Fraud Scale Model suggesting that the probability of fraud occurring can
be evaluated by examining the relative forces of opportunity, pressure, and personal integrity.
Rezaee (2002) provided another one referred to as the 3-C model that consists of three
Choice. Wolfe and Hermanson (2004) proposed another dimension, capability, to the fraud
triangle and transformed it into a Fraud Diamond. Others prefer to combine the fraud triangle
with criminology, sociology, and psychology theories. Choo and Tan (2007) explain corporate
fraud by relating the fraud triangle to Messner and Rosenfelds (1994) work on the ADT
Financial fraud
The two most common types of fraud impacting financial statements include Harrison et
2. Fraudulent financial reporting: In this case, managers make misleading and false entries to the
financial statements, making the company seem better than it really is. Although fraudulent
financial reporting appears to be the least common form of fraud, it is by far the most expensive,
in terms of financial long-term damage (Ernst and Young, 2009, 2). The Association of Certified
Fraud Examiners has created a list of common accounting fraud schemes and related red flags,
on which managers should be conscious of. They mostly occur with understating expenses
overstating revenues, or improper asset valuation. The following paragraphs will describe them
in more detail.
These are one of the most common types of financial statements fraud. The schemes
include: recording gross revenue, instead of net; recording revenues of other companies when
acting as a broker; recording sales that have not occurred; recording future sales in the present
period and; recording sales of products that are out on consignment. The red flags in these kinds
of circumstances are: increased revenues, without a consistent increase in cash flow; unusual
transactions, especially ones closed near the end of a financial period; in receivables the unusual
expansion of days sales; or high revenue growth when competitors are experiencing poor sales
Understating expenses
This is another common type of financial statement fraud that leads to overall net income
and higher operating income. The schemes in these kinds of cases include: reporting cost of
goods sold as a non-operating expense so it does not adversely affect gross margin; capitalizing
operating expenses, so recording them as assets rather than expenses; and some expenses are left
out recording, or they are recorded in the wrong period. Red flags associated with these can be:
unexpected increase in assets, unusual increase in income, or allowances for sales returns,
warranty claims, and others that are reducing in percentage terms or are otherwise out of line
with the companies from the same industry (Ernst & Young 2009, 4).
This is another type of fraud. The schemes used are manipulating reserves, manipulating
the fair value of assets, and changing the useful lives of assets. The red flags associated with
these include: repeating negative cash flows, visible decrease in customer demand and increasing
business failure in the industry; or estimates on liabilities or assets, expenses and revenues are
based on high uncertainties. Some other schemes related to fraudulent financial reporting can
also relate to: smoothing of revenues, so overvaluing liabilities during good periods, and
storing away funds for future use; improper reporting of information, especially when it comes to
issues related to party transactions and loans to management; or implementing highly complex
This section will visualize the financial reports and identify the specific lines where the
most common types of fraud on financial statements have occurred. Example, the chapter will
examine reports presented by Lehman Brothers Holdings Inc. delivered to the US Securities and
Exchange Commission the same year the company filed for bankruptcy. First to note are some
examples from the Lehman Brothers quarterly income statement 2008, before the bankruptcy in
common types of fraud affecting financial statements. This is obvious in the income statement
under various headings, as highlighted above. Realized and unrealized losses or gains from
Financial instruments and other inventory positions owned and Financial instruments and other
inventory positions sold but not yet purchased, and the losses or gains from certain short-term
and long-term borrowing obligations, principally particular hybrid financial instruments, and
certain deposit liabilities at banks that the Company measures at fair value are revealed in
Principal transactions in the Consolidated Statement of Income (USSEC, 2008, 11). According
to this, it can be understood that many complicated transactions and financial instruments have
been used by the company, and thus, in this case, it has been able to mask something that should
Also, the balance sheet can be presented in a fraudulent way. As earlier discussed,
improper asset valuation is also a common type of fraud companies have used. The possible
fraudulent procedures can include manipulating reserves, changing the useful lives of assets, not
reporting down when needed, and manipulating the fair value of assets. Figure 2 presents some
of these points highlighted. For example, Lehman Brothers Notes on how the long-lived assets
Equipment, property, and leasehold improvements are recorded at historical cost, net of
method over the estimated useful lives of the assets. Buildings are depreciated up to a maximum
of 40 years. Leasehold improvements are amortized over the lesser of their useful lives or the
terms of the underlying leases, approximately 30 years. Understating expenses can also be used
in making the overall net income and operating income seems higher. In the Notes to the
statements, Lehman Brothers describes their revenue recognition policies, under Principal
transactions, as follows:
Developed for Internal Use, is capitalized and then amortized over the projected useful
life of the software, usually three years, with a maximum of seven years. The Company reviews
long-lived assets for impairment periodically and whenever changes in circumstances show the
carrying amounts of the assets may be impaired. If the likely future undiscounted cash flows are
less than the carrying amount of the asset, an impairment loss is identified to the extent the
carrying value of the asset exceeds its fair value (USSEC, 2008, 16.)
Figure 2 Lehman Brothers consolidated Assets, balance sheet (USSEC, 2008, 5).
Although in Lehmans case, there had not been any improper asset valuation, the balance
sheet and the Notes provide an example of where fraudulent reporting could occur. As the Notes
explain, the equipment, property, and leasehold improvements are valued at historical cost,
which for instance could mean that the inflation or other economic factors affecting the values
have not been taken into consideration. As a more detailed example, it mentions that buildings
statements that were produced fraudulently but was not caught, even by the auditors.
Many analysts have associated Lehmans collapse to risky real estate lending. The U.S.
subprime crisis was one of the main crises that had serious repercussion on the global banking
system, and still poses many threats to many banks, particularly those with investment banking
activities. Through securitization, the risks of sub-prime lending were transferred from mortgage
lenders to third-party investors (IFSL Research, 2008). Lehman's bankruptcy had caused some
price depreciation of commercial real estate. For instance, the liquidation of Lehmans $4.3
(CMBS) market.
Lehmans downfall gave rise to the drop in the Primary Reserve Fund. Lehman's
bankruptcy led to over $46 billion of its market value being wiped out. The collapse also served
as the catalyst for the acquisition of Merrill Lynch by Bank of America in an emergency deal
that was also publicized on September 15. The collapse of Lehman resulted in the loss of 70% of
$48 billion of receivables from derivatives that could have been relaxed (Valukas, 2010) and as
much as $75 billion in value was ruined (McCracken, 2008). Many countries, companies and
types of actors were also directly associated with Lehman and its bankruptcy. For instance, in
England, around 5,600 retail investors had bought Lehman-backed structured products for $160
million (Ross, 2009); while in Hong Kong, 43,000 individuals, many of them senior citizens, had
bought mini-bonds to a value of $ 1.8 billion. Famous cities and counties in the U.S lost more
than $ 2 billion (Caplan et.al, 2010). One public bank in Germany, Sachsen Bank, lost about half
a billion Euros (Kimberly, S. (2011). Pension funds, such as the New York State Teachers'
retirement plan had also suffered losses due to the collapse of Lehman (Bryan-Low, 2009). A
large number of hedge funds in London also had some $12 billion in assets frozen when Lehman
Internal control
follow objectives as: safeguard assets, promote operational efficiency, encourage employees to
follow company policy, ensure reliable, accurate, accounting records and comply with legal
requirements (Harrison et al. 2011, 237). COSO is one of the main sources providing guidance
and frameworks on enterprise risk management, internal control and fraud deterrence (COSO
2011). According to COSOs framework, internal control is an essential part of enterprise risk
management. The role of internal control is to manage risk, rather than to eradicate it (KPMG
1999, 14). Therefore, before discussing the concept of internal control, it is important to examine
conducted a study to provide better understanding of financial statement fraud cases. According
to the study, from 1998 to 2007 there were 347 cases of fraudulent financial reporting in US
public companies. The misappropriations accounted for nearly $120 billion in total of 300 fraud
cases. The most common type of fraud identified was improper revenue recognition, which
accounted for over 60% of the cases, following by the exaggeration of existing assets or
capitalization of expenses (Beasley et.al, 2010). The study revealed that fraud affects companies
no matter the size. The organizations involved had median revenue and total assets under $100
million in the period before committing fraud. The company sizes differed from startups to
companies with over $100 billion in revenues, so it can be supposed that fraud is not limited to
particular sized companies. 73% of the fraud companies common stock traded in over-the-
counter markets and were not listed in the American Stock Exchanges (Beasley et al. 2010, 2.)
One of the significant insights made by the study was that characteristics between audit
committees of fraud and no-fraud companies do not generally differ. For instance, nearly all of
the companies investigated in the study had audit committees. These committees were in both
company cases (fraud and no-fraud) groups of about three people and on average these groups
met around four times a year. So, it can be said, there is little proof that the characteristics of the
audit committees can be associated with fraudulent financial reporting. For what it comes to
external auditors, it appears as though fraud goes undetected by all types and sizes. 79% of the
companies that had committed fraudulent reporting were audited by the Big Four auditing firms
(Beasley et.al, 2010, 5). After the Lehman and Enron cases, in 2002 as a way to prevent
fraudulent financial reporting a new US legislation, called the SOX (Sarbanes-Oxley Act), was
set forth. As the timing of this study includes only five years of the Sarbanes-Oxley Act period, it
is hard to give any valid conclusions on how it has affected the possible fraud behavior of
companies. In specific interest is the Sarbanes-Oxley Act Section 404, which states internal
other entities with their internal control systems. In the recent years, the concern over fraud and
the focus on risk management have highly increased. COSO noticed an urgent need for a robust
framework to efficiently manage risk. Therefore, in 2001 it initiated a project, together with gent
management. In 2004 the framework was published, and COSO believes this updated framework
Enterprise Risk Management Integrated Framework fills the need. It expands on internal
control and offers a more broad focus on the whole subject of enterprise risk management. As
earlier mentioned, internal control and risk management are closely related, and according to
COSO internal control is integrated within the framework of risk management (COSO 2004).
The final assumption of enterprise risk management is that companies exist to offer value
for their stakeholders. All companies face uncertainty that presents both risks and opportunities.
One of the main challenges is to establish how much risk a company is ready to accept while
reaching for creating more value. Enterprise risk management should allow management to
efficiently deal with these uncertainties to create more value (COSO 2004, 1.)
The aim of the enterprise risk management (ERM) framework is to allow companies to
realize their objectives. According to the framework the objectives can be seen in the context of
four categories: strategic, operations, reporting and compliance. The final assumption of
enterprise risk management is that companies exist to offer value for their stakeholders. All
companies face uncertainty, which presents both opportunities and risks. One of the main
challenges is to define how much risk a company is willing to accept while reaching for creating
This refers to high-level goals, which should be aligned with and supporting the companys
mission.
2. Operations
3. Reporting
Reliability of reporting
4. Compliance
Compliance with appropriate law and regulations. This category makes it possible to have
focus on separate aspects and it addresses various company needs (COSO 2004, 3).
The ERM framework considers activities from all different levels of the company: enterprise
level, division or subsidiary and business unit processes (IIA 2004, 8.)
In front of the cube (figure 5) the eight pillars signify eight connected components of the
framework. These components derive from the way management runs a company and are
1. Internal Environment
This sets the tone of an organization, and is the foundation for how risk is viewed and
addressed by the employees. This includes the philosophy of risk management ethical values and
2. Objective Setting
Objectives are vital for an organization because management is able to identify possible events
affecting the companys accomplishments. The chosen objectives should align and support the
3. Event Identification
External and internal events affecting attainment of objectives need to be identified, and
4. Risk Assessment
The possibility and impact of risks are analyzed to determine how they should be managed.
5. Risk Response
Management needs to choose how to respond to the risks. This means developing a set of
actions to align risks based on the companys risk tolerances and risk appetite.
6. Control Activities
To ensure that risk responses are efficiently carried out, policies and procedures need to be
set out.
Relevant information needs to be identified and communicated in a way that employees can
carry out their responsibilities. Effective communication is as well flowing down, across, and up
the organization.
8. Monitoring
The companys whole enterprise risk management needs to be monitored, and if essential
modifications should be made when needed. The monitoring happens through management
activities and evaluations. All of the components mentioned above are correlated, where almost
every component influences another. The cube (figure 5) describes the correlation between the
eight components, the entitys units and the four objectives in a three dimensional matrix. The
objectives are symbolized in the vertical columns, the components in the horizontal columns and
For a company to have effective ERM the eight components need to be there and
operative. No material weaknesses can exist and all the risks need to be considered in the risk
appetite for the components to function correctly. However, one must keep in mind that the eight
components do not function identically in all organizations. For example, in smaller firms they
may be more informal and less structured, but still effective. Regardless of the benefits of ERM
certain limitations exist. As the operators of the system are just human, errors and mistakes are
to follow the principles set by COSO. For example, this part will examine one of the leading
auditing companies systems. The KPMG guide links the theoretical concepts a bit more into
practice, and hence beneficial to take a look at. As the business world is always changing, and
the companies live in a turbulent environment, a successful internal control system also needs to
be open for changes. Internal control and effective risk management therefore need regular
evaluation of the extent and nature of risks. The ultimate responsibility of the internal control
should be with the board. This also implies that the board should be the one sending a clear
message to the whole organization that the responsibility of internal control should be taken
In order to have an effective system of internal control, the board should consider the following
The categories and extent of risks that can be acceptable for the company to bear
The companys capacity to reduce the occurrence and impact on the risks that do
materialize.
The costs of operating specific controls relative to the benefit, thus managing the related
risks.
includes the same common elements to its system: control environment, identification and
evaluation of risks and control objectives, control activities, information and communication
processes, and processes for monitoring the effectiveness of the system of internal control.
Figure 6 below represents the five diverse components mentioned, with the board as the center
understand the context and nature of the control. First of all, as control should be able to respond
quickly to changing risks, it is important to get the control as close to the risk as possible. The
organization needs to have the capacity to adapt and respond to unexpected situations and risks,
and to make decisions despite having all the information. This is why the control needs to be
close to the related risks - the shorter the chain, the quicker the reaction (KPMG 1999, 22.)
Secondly, the costs of the control need to balance against the benefit of controlling the risk. As it
may occur that the cost of additional control becomes greater than the actual benefit arising from
the controlling of the risk. Thirdly, the control system needs to consist reporting procedures,
which communicate directly to the right management levels of any major control failings or
weaknesses that are identified. The reporting should also include details of the actions being
undertaken. This also implies that the philosophy of control should come from the top of the
Although control can minimize risks and errors, it cannot guarantee absolute assurance
that they will not happen. However, it would be important to include the control system in the
company is run by people, the control system is affected by people throughout the company, so
all the people in the company are accountable, the possibility of an effective control system is
increased (KPMG 1999, 22-24.) KPMG has developed a Risk Management Diagnostic, to
assists organizations follow whether all of the necessary components for an efficiently working
Behavior
Are those responsible for risk provided with suitable formal training?
Does the organization learn from the risk events when things go wrong rather than seek
retribution?
Performance appetite
Are action plans developed to move the organization to a more desired risk profile?
dependencies? Are management controls and actions identified and monitored for the risks?
KPMG believes that for any control model to work effectively and be pertinent to the
Philosophy and policy represents how the board should make the risk management
expectations clear. Employees must know what is expected from them and what is not.
Roles and responsibilities represent the significance of making all the responsibilities
Converting strategy to business objectives includes the idea of making strategic and
business objectives clear. This way the probability of overlooking significant risks will be
reduced, as the connection between business planning and strategy is a critical risk management
process.
Risk to delivering performance refers to how the significant business risks should be
officially identified by the board and this way show that they are aware of the likely risks.
In the left bottom of the pyramid KPMG has Performance appetite meaning that the
likelihood of the risk of occurring and of the impact of that risk should be analyzed. The cost and
should be monitored against targets; an evaluation of the effectiveness of the control should
periodically be provided to the board. This process has some indirectness, as monitoring may
lead to re-evaluating the companys control and objectives. Finally, the triangle has Behavior,
which represents shared moral values. These include responsibility, authority, values, integrity,
and accountability, should be established, communicated and implemented around the whole
organization (KPMG, 1999, 67-68). Some of the most common weaknesses in organizations
Roles and responsibilities the responsibilities are not clear throughout the organization
business objectives.
Risk to delivering performance a form of risk profiling, but usually differs from the
reality of doing business. In their paper, Lartey (2012) argues that the 2007-2008
financial crisis could have been evaded if the financial institutions adopted effective risk
management practices in their derivative trading. Before the collapse, Lehman had
invested so much in risky derivatives. The initial idea of derivatives was to help actors in
the real economy insure against risk but many derivatives trades have crossed the line of
Performance and risk effectiveness boards do not receive the right information, so
Although the international banking industry had witnessed numerous bankruptcies over
the past two decades, many experts believe that Lehman's collapse had huge consequences on the
economy in general, as it was that anaphylactic shock to the financial system that led to the
global economic downturn (The Independent, 2009). Lehmans collapse could have been
prevented if proactive measures were taken by senior management to guarantee effective risk
management in their operations. Just before its collapse, executives at Neuberger Berman sent e-
mail memos to Lehmans senior management proposing that Lehman Brothers' management
forgo multi-million dollar bonuses to send a strong message to both investors and employees that
management was not avoiding accountability for recent performance. Rather than waiting to
bailout banks in times of financial pain, many governments have adopted new strategies such as
directly investing into the capital of their banks. For instance, on October 8, 2010, the British
government declared that they would invest 400 billion pounds directly into the capital of their
banks; a quicker way of strengthening the banks rather than by buying up their toxic assets
(Swedberg, 2010).
There were many controversies surrounding the executives pay during the collapse. On
October 17, 2008, CNBC reported that some Lehman executives have been summoned in a case
relating to securities fraud. Lehman Brothers executive pay was reported to have increased
considerably before filing for bankruptcy. Most analysts were highly serious of Lehman's
executives, specifying that they should have done better. Valukas (2010) blamed Lehman
executives for worsening the firm's problems, resulting in financial fallout to shareholders and
creditors. According to Valukas (2010), the conduct of Lehmans executives "ranged from
serious but non-culpable errors of business judgment to actionable balance sheet manipulation."
The auditor's report criticizes Lehman's failure to disclose its use of the "Repo 105 accounting
tool. According to the report, accounting rules allowed Lehman to treat this transaction as sales
instead of financings, so as to exclude assets from the balance sheet (Wong & Smith, 2010).
Lehman Brothers failed to be rescued by the government or a buyer bailout. It has been
recommended by many experts that public sources be used to capitalize banks and other key
financial institutions.
Preventive measures
The severity of Lehmans failure in international business has been labeled by financial
businesses globally (Aversa, 2008). Some believe Lehmans failure partly caused the 2007
economic meltdown (Murphy, 2008). A bulk of preventive measures has been attributed by
various analysts who if adhered to, would have prevented the collapse of Lehman Brothers.
According to Kimberly (2011), the collapse would have being prevented assuming management
had taken more proactive risk management actions than their reactive measures at a time the
company was almost collapsing. The indicators were written all over but management could not
find the correct solution to inhibit the crisis (Valukas, 2010). Significantly, credit agencies and
regulators cannot be exonerated from these failures. Company regulators were the right agencies
to have warned and guided Lehman to participate and operate within the confines of business
jurisdiction however; the regulators were reported on many occasions to have kept a blank eye
In an attempt to predict the failure of firms, Lehmans failure has exposed the weaknesses
in different models employed for this purpose. For example, in analyzing the financial health of
indicators are considered (Mensah, 2012) however; much weight is not placed on the cash flows
of those companies. A careful consideration of cash flow indicators could have prevented the
liquidity problems of the company. In view of the above measures, the inadequacies inherent the
auditing processes partially accounted for this failure. The assurance of a full disclosure by
external auditors in relation to the alleged financial statement fraud perpetuated by Lehmans
management could have helped in avoiding this huge catastrophe (Kimberly, 2011).
Conclusion
The international banking industry has undergone tremendous transformation across all
economies and markets over the past few years. Recent regulations and competition in the
banking industry have compelled many investment banks to pursue growth in sectors that
traditionally fell within the domain of other financial institutions such as commercial banks. This
exposes the banks to take on more risks, often leading to crisis. With regards to Lehmans
reaction to the subprime lending crisis and other economic events, some earlier decisions taken
by Lehmans management were questionable, although they fell within business judgment rule.
Most of the valuation procedures employed by Lehman were unreasonable for purposes of a
bankruptcy solvency analysis. The failure by Lehman to disclose the use of its Repo 105
accounting practice provided ample evidence of the loop-holes in their accounting system.
Again, there was a serious indictment for the inability of its external auditor, Ernst & Young to
meet professional standard in connection with the lack of disclosure of accounting and financial
statement frauds. The demands for collateral by Lehmans Lenders (J.P.Morgan and CitiBank)
had direct impact on Lehmans liquidity pool. While majority of Lehmans failures were from
within the companys own operations, many questions arose as to whether the interaction
between Lehman and the Government agencies that regulated and monitored Lehman
contributed to the collapse. Many analysts believed that Lehman's bankruptcy had set off a panic
that would end up by threatening not only the U.S. financial system but also the entire global
financial system. Subsequent to the demise of Lehman, many concerns have been raised as to
what led to the failure of the one-time leading investment bank in the U.S. The fact is that, these
questions are currently hard to answer, among other reasons because there is very little exact
place when the financial statements are deliberately misstated to make the financial position of
the company look better than it actually is. This often encompasses increasing reported revenues
and/or decreasing reported expenses. It could also comprise misrepresenting balance sheet
accounts to make ratios, such as the current or debt to equity ratios, look more favorable.
Reporting amounts different from what would have been reported under GAAP is also regarded
misrepresentation of financial statements is usually much more harmful to the company in the
long run. With misuse of assets it is hard to fraudulently misappropriate large amounts, while it
is much easier to just add large sums of money that never really existed to several accounts.
Once fraudulent financial reporting is revealed, share prices usually drop and companys true
Following the fall of Lehman Brothers, various reasons have been accredited to the
failure after full investigations were conducted by financial and non-financial analysts
(Kimberly, 2011). None of these analysts gave a single cause to this failure (Azadinmin, 2012);
but, a number of factors were revealed for their failure. The factors that accounted for this failure
were poor management choices together with unethical actions; liquidity crisis; repeal of the
Glass- Steagall Act of 1933; financial leverage; unsuccessful bail-out and take-overs, subprime
mortgage crisis, excessive losses; Repos 105, massive credit default swaps, and complex capital
The supporters of the Glass-Steagall Act of 1933 blamed the whole US financial crisis on
the enactment of the Gramm-Leach-Biley Act of 1999 to replace the Glass-Steagall Act
(LaRoche, n.d). To eradicate or reduce possible conflict of interest, the Glass-Steagall Act of
1933 was ratified to separate commercial banking from investment banking after the great
depression (Tabarrok, n.d). During the great depression, 9,000 banks were described to have
failed (Lartey, 2012). This Act was revised and replaced in 1999 to permit commercial banks
carry investment banking activities. The replacement of the 1933 Glass-Steagal Act of 1933 saw
many commercial banks merging with investment banks. Financial analysts attributed this
change on the failure of Lehman. In their pursuit to compete with commercial banks which has
high leverage positions, Lehman merged and acquired many investment and commercial banks
(Valukas, 2008). The unethical merging activities exposed them to many risks leading to their
In their quest to achieve their expansion strategy and other objectives, managers of
Lehman chose to use various suspicious mechanisms, obnoxious accounting practice coupled
with their obvious disregard for prudent corporate governance practices (Caplan et al, 2012).
According to Gasaparino (2008), Lehman used window dressing presentation facilitating the
altered picture of the company. This was verified by the application of charges against their
auditors Ernst &Young by the Attorney General for helping Lehman Brothers in perpetrating
financial statement fraud (Valukas, 2010). Lehman further used Repos 105 transactions to
improve the companys financial health at the end of the financial year.
accounting scandals were dubious transactions, and Lehman employed (Repos 105 to alter the
financial statement of the company (Morin & Maux, 2011). According to Kimberly (2011), the
Lehman balance sheet in June 2008 was fabricated with window-dressing method popularly
referred to as Repos 105. This action led to the removal of $50 billion in pledge from their
financial statement (Morin & Maux, 2011). Nevertheless the unethical employment of Repos 105
by Lehman, it is lawful for banks to engage in Repos 105 transactions (Wilchins & DaSilva,
2010). Basically, repurchase agreement has been traditionally used by banks to manage their
short-term cash liquidity (Mensah, 2012). This involves the pledging of short- term low risk
instruments or government bonds in return for short-term funds (Casu et al, 2006). Traditional
Repos involves the agreement between two or more financial institutions in which one of these
institutions decides to dispose of its short-term security for cash with the condition that after a
some agreed time, the seller will buy it back at a prearranged rates and date (Mensah, 2012;
Agyemang, 2012).
The apparent security disposed by the seller serves as security (Jeffers, 2011). These
short-term securities will then return back to the seller after paying the cash received in addition
to the interest thereon. In case the seller fails to pay on the due date, the buyer may dispose of the
pledged securities for reimbursement (Casu et al, 2006). In a nutshell, Repos 105 is just a
measure employed by firms to raise short-term funds by pledging their long-term financial assets
to improve their liquidity position. To account for Repos 105, the bank pledging its securities for
cash reports it as a loan with security (Jeffers, 2011). To support their unethical practices,
Lehman instead failed to use the right accounting method to report Repos 105 thus failing to
disclose it to credit agencies investors, the government, and its own board of directors (Morin &
Maux, 2011). According to Wilchins and DaSilva (2010), Lehman extended this practice by
obtaining government bond from another bank using one of its special units in the U.S. Just
before the end of the quarter, Lehman transfers these bonds to their London affiliates (Lehman
Brothers International). Their London affiliate then transfers the bonds to another bank for cash
with a pledge to buy it back at a higher rate (105 percent of the price). The cash received is then
transferred to the Lehman Brothers US to pay off a large amount of liabilities therefore reducing
the firms liabilities to show healthier quarterly reports and improve investors confidence,
Prior to the successive quarter, Lehman Brothers will then borrow more at other lending
institutions to purchase back the securities from their London affiliates at 105% of the initial
price. The financial statement will then return back to its initial unhealthy position after such
practices making Lehman worse-off because they want their financial position to look healthy in
the eyes of the government, investors, and regulators. This practices amount to financial
statement fraud (COSO, 2005) and one of the factors that led to its collapse (Valukas, 2010). By
extension, the external auditors of Lehman cannot be acquitted from this terrible crime (Carcello
Liquidity crisis
Central to the failure of Lehman was their failure to meet short term obligation (Valukas,
2011). Despite its high asset base, Lehman was experiencing erratic liquidity problems. As a
result, Lehman was losing its market confidence; evidently, most banks withdrew their credit
lines and services to Lehman Brothers (DArcy, 2009). At this point, the confidence level of
customers and lenders halted; rendering Lehman unpleasant in the eyes of investors and
prospective investors (Mensah, 2012). To address this challenge, Lehman reduced their gross
asset base $147 billion to improve their liquidity position$45 billion (Valukas, 2011).
Their liquidity redemption strategy further saw the reduction in their commercial mortgage
exposure by 20% and leverage from a factor of 32 to about 25 (Lartey, 2012). Unlike their rivals
Bear Beach Stearn which suffered the same fate in March 2008, Lehmans liquidity crisis was
not liberated by their proposed strategy and bailout. Bear Beach Stearns was rescued by
In their effort to take advantage of opportunities in the real estate market, Lehman
Brothers before the collapse were reported to have engaged into some unnecessary and risky
investments (Murphy, 2008). According to Kimberly (2011), RLWs (Residential Whole Loans)
was also reported to have accounted to the failure of Lehman Brothers. RWLs are residential
mortgages that is usually traded and pooled during the process of securitization and subsequently
change into RMBS (Residential-Mortgaged Backed Securities) (Lartey, 2012). As at May 2008,
Lehmans consolidated market value of RWLs amongst its subsidiaries amounted to about $8.3
billion (Valukas, 2010). According to Murphy (2008), Lehman lacked a healthy product control
process to account for residential whole loans combined with misstatement in assets further
worsening their position. To capitalize on speculative opportunities and reducing its exposure to
credit risk in the financial market, Lehman entered the derivative market. This is intended to
manage the volatility of their exposure and assets. As at the time of filling their bankruptcy,
Lehman had in its books an approximated estimated derivative to the tune of $35 trillion in their
portfolio (Kimberly, 2011) and held over 900,000 derivative positions worldwide (Valukas,
2010).
These derivative instruments enable firms to derive the value of investment from the
changes in the price and value of other underlying assets such as stocks or commodities
(Buchanan, 2000). Most of these derivatives were credit default swaps; evidently, the property
prices crashed in the financial market during the global economic crisis leading to repossession
of assets, Lehman was reported to have written its credit default swaps (CDS) by $2.5 billion
(DArcy, 2009). Credit derivatives such as mortgages, loans, and other forms of loans are the
main underlying assets CDS. CDOs (Collateralized Debt Obligations) also accounted for the
losses in the securities market during the global financial crisis of 2007 (Lang & Jagtiani, 2010).
CDOs are derivative instruments which involves the accumulation of both prime and subprime
securities planned to be sold to a special purpose vehicle in a low-tax jurisdiction (Wilks, 2008).
The buyer then repackages the loans and issues them as bonds or equity to other interested
investor. Between the period 2006 and 2007, half of Lehmans CDOs projected at $431 billion
had experienced defaults by November 2008 (Valukas, 2010). The decline in the values of CDOs
Leveraging
The high borrowing approach of Lehman to finance their assets terminated into high
leverage position (Lartey, 2012). A companys financial leverage is its ability to finance a
portion of its assets with securities bearing fixed rate of interest with the confidence of increasing
the final returns to the equity shareholders (Keown et al, 2005). As at 2007, Lehmans high
leverage ratio has augmented from 20 in 2004 to 44 to 1 shareholders equity (DArcy, 2008). By
effect, for every $1 of cash and other available financial resources, Lehman would lend $44
which was too high a leverage ratio to maintain (Valukas, 2010). The impact of the global
financial crisis that saw prices decreasing coupled with increased interest rates, Lehmans
financial position were harmfully impacted leading to their bankruptcy (DArcy, 2009).
As a result of having to cope with doing business in over 3,000 different legal entities,
Lehman Brothers was confronted with issues about capital structure (Steinberg & Snowdon,
2009). As difficulties arose due to their expansion strategy culminating into a significant growth,
the growth was alleged to have contributed to the high degree of capital structure complexity.
Many financial analysts identified this phenomenon as a key factor that contributed to the failure
of Lehman.
Describing the events prior to their liquidation, Lehman Brothers tried different measures
to redeem their operations. This was compelled by the massive losses recorded in 2008 and their
failed attempt to dispose of some of their subsidiaries. In their second financial quarter alone, the
company reported losses of $2.8 billion which hastened the disposal of $6 billion worth of their
assets due to the low rated mortgage in their subprime position (Anderson, 2008). By September
10, 2008, the firm announced a loss of $3.9 billion in their attempt to sell-off their majority
confidence continued to erode when their stock prices lost nearly half of its value, thus, S&P 500
dipped by 3.4%. This incidence further saw the Dow Jones losing about 300 points the same time
on investors perception about the security of the bank (Yandel, 2009). Their situation was
worsened by the US governments announcement plan not to assist any financial crisis that
emerged at Lehman (Anderson, 2009). In their enactment to turn-around the fortunes of Lehman
after the governments announcement; Lehman Brothers reported a possible take-over deal with
organizations in the US and the world. In the US alone, Lehmans failure led to depreciation in
price of commercial real estates, an extinguishing 70% of $48 billion of receivables from
derivatives, and $46 billion of its market value (McCracken, 2008). The hedge market was not
spurred since over 1000 hedge funds used Lehman as the leading broker and mostly depended on
the firm for funding. Freddie Macs exposure to Lehman in relation to single-family home loans
was valued at $400 million (Murphy, 2008). Lehmans collapse also led to the writing-off of $48
million debts owed to the Federal Agricultural Corporation in September (Bryce, 2008).
Constellation Energy was also reported to have its stock falling to 56 percent on the New York
Stock Exchange halting trading of Constellation Energy culminating into it buy-out by Mid-
American Energy (Maurna, 2008). The international community was not completely exonerated
from the significant impact of Lehmans failure. Insurers and Japanese banks reported a possible
loss of 249 billion yen ($2.4 billion) while a counsel from the Royal Bank of Scotland Group is
reported to be facing dues between $1.5 billion and $1.8 billion with respect to an unsecured
guarantee from Lehman Brothers (Emily, 2008). In England, about 5,600 investors had invested
in Lehmans backed-structured product totaling $160 million (Ross, 2009). In Germany, a state-
owned bank lost approximately 500,000 euros (Kirchfeld & Simmons, 2008) whereas hedge
funds amounting to over $12 million were frozen in England as a result of Lehmans bankruptcy
(Spector, 2009). The validation of these losses in the US and the international business
The collapse of Lehman clearly demonstrates the connection between regulations and
action management systems. The failures exposed the deficiency in the regulatory system thus
requiring urgent need for strict supervision of specific performance indicators such as a solvency,
liquidity position, and profitability. Policy makers such as the International Financial Reporting
Standards, SEC, etc. must initiate strict policies to address Lehman failure to prevent any future
occurrence. Firms must also be required to abide to good corporate governance practice to
restore investors confidence. Sound ethical standards and practices must adhere to and
Lehmans failure provides very vital lessons. First, regulators of financial institutions
should remove the gaps in their financial regulatory framework that allows complex, large,
In September 2008, no government agency had adequate authority to compel Lehman to operate
in a sound and safe manner and in a way that did not pose dangers to the whole financial system.
There is also the need for a new resolution regime, similar to that already established for failing
banks, to avoid having to choose in the future between bailing out a failing, systemically critical
firm or permitting its disorderly bankruptcy. Such a regime, according to many experts in the
global banking industry, would both protect the economy and improve market discipline by
guaranteeing that the failing firm's creditors and shareholders take losses and its management is
replaced.
Conclusion
The current competition in the banking industry has led to most banks engaging in
fraudulent and risky exposures. The collapse of Lehman is a clear sign of this phenomenon. The
failure could be attributed to a multiplicity of factors ranging from dubious accounting practices,
unethical management practices, over investment in risky unsecured investments, laxity on the
part of regulators (Morin & Maus, 2011). External auditors also played a major part in this
failure by not discovering these financial statement malpractices by the Lehman managers.
According to Greenfield (2010), the main indicators of fraud could be detected in the financial
statement apparently; the external auditors could not discover this activity. It must however be
noted that the collapse of Lehman had not impacted on the US economy only but the world as a
whole thus; firms ought to avoid unnecessary business strategies, strict supervision of existing
formulation of practical and alternative financial failure prediction regulations and models of the
derivative market. The international business community must ensure that businesses hold high
standards and ethical culture which to a large extent necessary in avoiding collapse of firms in