New Bookmarks
Year 2010 Quarter 1:  January 1 - March 31 Additions to Bob Jensen's Bookmarks
Bob Jensen at Trinity University

For earlier editions of New Bookmarks go to http://www.trinity.edu/rjensen/bookurl.htm 
Tidbits Directory --- http://www.trinity.edu/rjensen/TidbitsDirectory.htm 

Click here to search Bob Jensen's web site if you have key words to enter --- Search Site.
For example if you want to know what Jensen documents have the term "Enron" enter the phrase Jensen AND Enron. Another search engine that covers Trinity and other universities is at http://www.searchedu.com/.

Choose a Date Below for Additions to the Bookmarks File

2010
March 31, 2010

February 28

January 31

 March 31, 2010

Bob Jensen's New Bookmarks on  March 31, 2010
Bob Jensen at Trinity University 

For earlier editions of Fraud Updates go to http://www.trinity.edu/rjensen/FraudUpdates.htm
For earlier editions of Tidbits go to http://www.trinity.edu/rjensen/TidbitsDirectory.htm
For earlier editions of New Bookmarks go to http://www.trinity.edu/rjensen/bookurl.htm 

Click here to search Bob Jensen's web site if you have key words to enter --- Search Box in Upper Right Corner.
For example if you want to know what Jensen documents have the term "Enron" enter the phrase Jensen AND Enron. Another search engine that covers Trinity and other universities is at http://www.searchedu.com/

Bob Jensen's Blogs --- http://www.trinity.edu/rjensen/JensenBlogs.htm
Current and past editions of my newsletter called New Bookmarks --- http://www.trinity.edu/rjensen/bookurl.htm
Current and past editions of my newsletter called Tidbits --- http://www.trinity.edu/rjensen/TidbitsDirectory.htm
Current and past editions of my newsletter called Fraud Updates --- http://www.trinity.edu/rjensen/FraudUpdates.htm

Accountancy, Tax, IFRS, XBRL, and Accounting History News Sites  --- http://www.trinity.edu/rjensen/AccountingNews.htm

Accounting Professors Who Blog --- http://www.trinity.edu/rjensen/ListservRoles.htm

Cool Search Engines That Are Not Google --- http://www.wired.com/epicenter/2009/06/coolsearchengines

Accounting program news items for colleges are posted at http://www.accountingweb.com/news/college_news.html
Sometimes the news items provide links to teaching resources for accounting educators.
Any college may post a news item.

How to author books and other materials for online delivery
http://www.trinity.edu/rjensen/000aaa/thetools.htm
How Web Pages Work --- http://computer.howstuffworks.com/web-page.htm

Bob Jensen's essay on the financial crisis bailout's aftermath and an alphabet soup of appendices can be found at
http://www.trinity.edu/rjensen/2008Bailout.htm

Federal Revenue and Spending Book of Charts (Great Charts on Bad Budgeting) ---
http://www.heritage.org/research/features/BudgetChartBook/index.html

The Master List of Free Online College Courses --- http://universitiesandcolleges.org/

Free Online Textbooks, Videos, and Tutorials --- http://www.trinity.edu/rjensen/ElectronicLiterature.htm#Textbooks
Free Tutorials in Various Disciplines --- http://www.trinity.edu/rjensen/Bookbob2.htm#Tutorials
Edutainment and Learning Games --- http://www.trinity.edu/rjensen/000aaa/thetools.htm#Edutainment
Open Sharing Courses --- http://www.trinity.edu/rjensen/000aaa/updateee.htm#OKI
The Master List of Free Online College Courses --- http://universitiesandcolleges.org/

Bob Jensen's threads for online worldwide education and training alternatives ---
http://www.trinity.edu/rjensen/Crossborder.htm

"U. of Manitoba Researchers Publish Open-Source Handbook on Educational Technology," by Steve Kolowich, Chronicle of Higher Education, March 19, 2009 --- http://chronicle.com/wiredcampus/index.php?id=3671&utm_source=wc&utm_medium=en

Social Networking for Education:  The Beautiful and the Ugly
(including Google's Wave and Orcut for Social Networking and some education uses of Twitter)
Updates will be at http://www.trinity.edu/rjensen/ListservRoles.htm

Pete Wilson provides some great videos on how to make accounting judgments ---
http://www.navigatingaccounting.com/

FEI Second Life Video (thank you Edith) ---
If I Were an Auditor --- http://www.youtube.com/user/feiblog#p/a/u/0/Q-FR_fkTFKY

Bob Jensen's threads on accounting novels, plays, and movies ---
http://www.trinity.edu/rjensen/AccountingNovels.htm

  

Humor Between March 1 and March 31, 2010 --- http://www.trinity.edu/rjensen/book10q1.htm#Humor033110  

Humor Between February 1 and February 28, 2010 --- http://www.trinity.edu/rjensen/book10q1.htm#Humor022810 

Humor Between January 1 and January 31, 2010 --- http://www.trinity.edu/rjensen/book09q1.htm#Humor013110

Top Ten Things David Letterman Learned From Ten Area Accountants ---
http://www.youtube.com/watch?v=VWIlHl3j7CQ
These are so bad they will not change the public image of accountants
However, Richard Cohen talks about me

Fraud Updates have been posted up to December 31, 2009 ---
http://www.trinity.edu/rjensen/FraudUpdates.htm

Also see http://www.trinity.edu/rjensen/Fraud.htm

Humor Videos:  Pennsylvania Wants to Show CPAs Are Funny ---
http://www.webcpa.com/news/Pennsylvania-Wants-to-Show-CPAs-Are-Funny-53291-1.html
Bob Jensen's threads on accounting humor ---
http://www.trinity.edu/rjensen/FraudEnron.htm#Humor
 

"So you want to get a Ph.D.?" by David Wood, BYU ---
http://www.byuaccounting.net/mediawiki/index.php?title=So_you_want_to_get_a_Ph.D.%3F

Do You Want to Teach? ---
http://financialexecutives.blogspot.com/2009/05/do-you-want-to-teach.html

Jensen Comment
Here are some added positives and negatives to consider, especially if you are currently a practicing accountant considering becoming a professor.

Accountancy Doctoral Program Information from Jim Hasselback ---
http://www.jrhasselback.com/AtgDoctInfo.html 

Why must all accounting doctoral programs be social science (particularly econometrics) "accountics" doctoral programs?
http://www.trinity.edu/rjensen/theory01.htm#DoctoralPrograms

What went wrong in accounting/accountics research?
http://www.trinity.edu/rjensen/theory01.htm#WhatWentWrong

"The Accounting Doctoral Shortage: Time for a New Model,"
by Neal Mero, Jan R. Williams and George W. Krull, Jr. .
Issues in Accounting Education 24 (4)
http://aaapubs.aip.org/getabs/servlet/GetabsServlet?prog=normal&id=IAEXXX000024000004000427000001&idtype=cvips&gifs=Yes&ref=no

ABSTRACT:
The crisis in supply versus demand for doctorally qualified faculty members in accounting is well documented (Association to Advance Collegiate Schools of Business [AACSB] 2003a, 2003b; Plumlee et al. 2005; Leslie 2008). Little progress has been made in addressing this serious challenge facing the accounting academic community and the accounting profession. Faculty time, institutional incentives, the doctoral model itself, and research diversity are noted as major challenges to making progress on this issue. The authors propose six recommendations, including a new, extramurally funded research program aimed at supporting doctoral students that functions similar to research programs supported by such organizations as the National Science Foundation and other science-based funding sources. The goal is to create capacity, improve structures for doctoral programs, and provide incentives to enhance doctoral enrollments. This should lead to an increased supply of graduates while also enhancing and supporting broad-based research outcomes across the accounting landscape, including auditing and tax. ©2009 American Accounting Association

Bob Jensen's threads on accountancy doctoral programs are at
http://www.trinity.edu/rjensen/theory01.htm#DoctoralPrograms

"Understanding the Web of Learning: A Work-in-Process," by Rick Lillie, Thinking Outside the Box, November 22. 2009 ---
http://iaed.wordpress.com/2009/11/22/understanding-the-web-of-learning-a-work-in-process/

I enjoy moments where “dots connect”  and I realize how “connections” cause or influence other things.  Connecting the dots between books or articles that I read is sometimes pretty exciting.

For example, previously I read Friedman’s The World is Flat.  While I did not agree with all of his positions, Friedman helped me to better understand implications of globalization.  Currently, I am reading Bonk’s The World is Open:  How Web Technology Is Revolutionizing Education. A common thread (dot connector) between Friedman and Bonk is importance of the internet and Web 2.0 technologies in enabling worldwide connection and interaction.

Generally, my  blog postings focus on technology tools and their uses in teaching-learning processes.  This posting steps away from technology tools per se to  connecting dots between what Friedman and Bonk have to say about how technology is changing the ways we live, learn, communicate, and collaborate.

If you have not read these books, I suggest them to you.  I think you will enjoy the read and conclude the time well spent.

Rick Lillie (CalState San Bernardino)

Rick Lillie's education, learning, and technology blog is at http://iaed.wordpress.com/

Bob Jensen's threads on professors who blog ---
http://www.trinity.edu/rjensen/ListservRoles.htm

March 24, 2010 message to the AECM

I think professors who do not open share extensively on the Web miss the boat.
Selfishness has its own punishments, and generosity has its own rewards.
Scroll most of the way down in this message for an example from XXXXX

Will Yancey was a pioneer in open sharing on the Web ---
http://www.trinity.edu/rjensen/Yancey.htm
Will made a very good living consulting and found that open sharing pays back enormously, much better in his case than any kind of paid advertising. But if you would’ve known Will you would’ve also discovered that he shared openly out of the kindness of his big heart. I doubt that he even thought about payback when he commenced to open share so generously.

I was also an early-on open sharing professor and never once did so with the thought of payback in mind. However, I am forwarding the message below to show that once of the benefits of open sharing is payback ---
http://www.trinity.edu/rjensen/threads.htm

Once again, however, I stress that I would open share if there was not a penny of monetary payback. I open share because it makes me feel good to make a difference in the academy of professors and students.

When you do open share technical content, potential clients find your work using Google, Bing, and other Web crawlers.
I think professors who do not open share extensively miss the boat.
Selfishness has its own punishments, and generosity has its own rewards.

My threads on this type of problem are at
http://www.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm

My excel workbook contains an “Effective” spreadsheet at in the 133ex05a.xls file at
http://www.cs.trinity.edu/~rjensen/

I also provide a 133ex05a.wmv video at
http://www.cs.trinity.edu/~rjensen/video/acct5341/

Professors Who Blog ---
http://www.trinity.edu/rjensen/accountingnews.htm

How I made my money consulting ---
http://www.trinity.edu/rjensen/theory01.htm#ConsultingMoney

My Outstanding Educator Award Speech ---
http://www.trinity.edu/rjensen/000aaa/AAAaward_files/AAAaward02.htm

 Bob Jensen

From: XXXXX
Sent: Wednesday, March 24, 2010 4:26 PM
To: Jensen, Robert
Subject: Interest Rate Swap Valuation?

Hi Bob,

I found you on the internet. We are doing a Dec 31 2009 audit and our client obtained a mortgage loan in 2009, and entered into a fixed rate mortgage rate swap on the loans interest. I would like to get a fair value quote for the swap at Dec. 31,2009. Would you be available to consult with us on this valuation? Please advise interest and your fee?

Accounting Theory Courses

Accounting theory courses seem to vary across the board as do AIS courses in comparison to most other accounting courses that are structured largely by the CPA examination and relatively uniform textbooks in basic, intermediate, and advanced accounting courses.

Some programs gave up teaching accounting theory, in part because there really aren't any good new textbooks in accounting theory, and the older textbooks are outdated.
 

There are many bases from which accounting theory might be taught; Suggestions below are broad categories having considerable overlap:

 

·         Historical Base --- http://www.trinity.edu/rjensen/theory01.htm#AccountingHistory

Modern Science and Ancient Wisdom --- http://www.trinity.edu/rjensen/theory01.htm#AncientWisdom
 

"A Wisdom 101 Course!" February 15, 2010 ---
http://www.simoleonsense.com/a-wisdom-101-course/

"Overview of Prior Research on Wisdom," Simoleon Sense, February 15, 2010 ---
http://www.simoleonsense.com/overview-of-prior-research-on-wisdom/

"An Overview Of The Psychology Of Wisdom," Simoleon Sense, February 15, 2010 ---
http://www.simoleonsense.com/an-overview-of-the-psychology-of-wisdom/

 

·         Opposing Theories of Accounting Hall of Fame Theorists (not all were theorists) ---
http://fisher.osu.edu/departments/accounting-and-mis/the-accounting-hall-of-fame/membership-in-hall/

 

·         Creative Accounting Base       --- http://www.trinity.edu/rjensen/theory01.htm#Manipulation
                                       And  --- http://www.trinity.edu/rjensen/theory01.htm#OBSF2

 

•  Systemic Problems Base --- http://www.trinity.edu/rjensen/FraudConclusion.htm#BadNews
  
   

• Valuation Theory Base     --- http://www.trinity.edu/rjensen/theory01.htm#BasesAccounting
                             And      --- http://www.trinity.edu/rjensen/theory01.htm#FairValue
                             And      --- http://www.trinity.edu/rjensen/roi.htm
  
   

• Critical Research Base  --- http://www.trinity.edu/rjensen/theory01.htm#WhatWentWrong
  This is often the base in doctoral research seminars that are not as critical as me regarding accountics research
  
  "Why Bayesian Rationality Is Empty, Perfect Rationality Doesn’t Exist, Ecological Rationality Is Too Simple, and Critical Rationality Does the Job,"
  Simoleon Sense, February 15, 2010 --- Click Here
  http://www.simoleonsense.com/why-bayesian-rationality-is-empty-perfect-rationality-doesn%e2%80%99t-exist-ecological-rationality-is-too-simple-and-critical-rationality-does-the-job/
  
   

• Theoretical Problems of Validity Testing in Accounting Research --- http://www.trinity.edu/rjensen/TheoryTAR.htm
  
   

One course I would like to develop would relate the great theories of management and sociology to roles accounting might play under such theories:

• Great Minds in Management:  The Process of Theory Development --- http://www.trinity.edu/rjensen//theory/00overview/GreatMinds.htm
  
   

• Great Minds in Sociology ---
  http://www.sociosite.net/topics/sociologists.php
  Also see Also see http://www.sociologyprofessor.com/ 

I would also like to develop an accounting theory course on the interaction of accounting controls, stewardship accounting, and the evolution of fraud. The focus would be upon the theory of preventing fraud:

• http://www.trinity.edu/rjensen/FraudRotten.htm
  
   

• http://www.trinity.edu/rjensen/FraudConclusion.htm 
  
   

Added Later
Another topic I overlooked for a theory course would be focus on accounting for the “shadow economy” ---
http://www.trinity.edu/rjensen/theory01.htm#ShadowEconomy

And any accounting theory course should not overlook the huge problem of accounting for intangibles and contingencies ---
http://www.trinity.edu/rjensen/theory01.htm#TheoryDisputes
These are at the very center of the systemic and intractable problems of financial and managerial accounting.

 

Abe Briloff: Accounting Hall of Fame or Infame?

Yesterday the name of Abe Briloff was raised on the AECM.

I knew Abe personally. He’s one of my heroes in life. One of the reasons is that he wanted to make auditing more professional and conscionable without destroying private sector auditing in the process.
My Hero --- http://www.uic.edu/classes/actg/actg593/Readings/Investments/Life%20and%20career%20of%20Abe%20Briloff.pdf

What was wrong is the way the large auditing firms reacted with negativism and haughty arrogance rather than working with Abe to avoid what happened with Andersen and now the other big firms in the wake of the banking scandals of 2008. A better way for firms to have reacted to Briloff is to work with him on ways to improve their audits.

What is also tragic is that Abe Briloff has not yet been admitted to the Accounting Hall of Fame ---
http://fisher.osu.edu/departments/accounting-and-mis/the-accounting-hall-of-fame/membership-in-hall/

I will not speculate here as to what I guess (only a guess) is the main reason he’s not been inducted into the Hall of Fame. In my eyes, he’s one of the most deserving potential Hall of Famers. But he took the path less traveled among all Hall of Fame members to date. Abe’s writings are still models to behold on how to read financial statements with the skepticism of a true accountant.

Abe’s writings remain very good source material for students of financial accounting. When he talked (wrote) the capital markets listened. How many other accounting professors can say the same? George Foster questioned whether stock prices reacted more to what Briloff said or to the fact that Briloff said anything about a corporation’s financial statements.

For example an events study such as the discovery by George Foster that the publication of a Barrons' paper by Abe Briloff was highly correlated with a plunge in share prices of McDonalds Corporation tells us something about an association between Briloff's accounting publication and capital market events.  But correlation is not causation.  Foster's study could not really tell us if the accounting issue (dirty pooling) or the mere fact that Briloff said something negative about McDonalds in Barrons actually caused the plunge in share prices.

To find his best stuff, check to see if your college library has access to the archives of Barrons where he wrote his infamous columns. You might also check out such references as his book:
More Debits Than Credits: The Burnt Investor's Guide to Financial Statements

Additional examples have been provided over the years by Abe. The following is Table 1 from a paper entitled "Briloff and the Capital Markets" by George Foster, Journal of Accounting Research, Volume 17, Spring 1979 --- http://www.jstor.org/view/00218456/di008014/00p0266h/0

As George Foster points out, what makes Briloff unique in academe are the detailed real-world examples he provides. Briloff became so important that stock prices reacted instantly to his publications, particularly those in Barron's. George formally studied market reactions to Briloff articles.

Companies Professor Briloff criticized for misleading accounting reports experienced an average drop in share prices of 8%.

 Also see William Brighnti's 2+2 tribute
Accountants CPA Hartford CT William Brighenti CPA [accountantscpahartford@GMAIL.COM]
http://www.accountingweb.com/blogs/briggsie/barefoot-accountant/how-much-2-plus-2

March 23, 2010 reply from James R. Martin/University of South Florida [jmartin@MAAW.INFO]

I agree Bob, Briloff is a hero.

Here are a few more of Briloff's papers I copied from MAAW's bibliography.

For the JSTOR links go to http://maaw.info/BibliographyB.htm

Briloff, A. J. 1958. Price level changes and financial statements: A critical reappraisal. The Accounting Review (July): 380-388. .

Briloff, A. J. 1961. Price level changes and financial statements at the threshold of the new frontier. The Accounting Review (October): 603-607.

Briloff, A. J. 1964. Needed: A revolution in the determination and application of accounting principles. The Accounting Review (January):12-15.

Briloff, A. J. 1966. Old myths and new realities in accountancy. The Accounting Review (July): 484-495. (JSTOR link). (Discussion of three accounting myths related to: 1. The Gap in GAAP, 2. The communication Gap regarding the auditor's responsibility, and 3. The communication Gap related to management services and auditor independence).

Briloff, A. J. 1967. Dirty pooling. The Accounting Review (July): 489-496.

Briloff, A. J. 1967. The Effectiveness of Accounting Communication. Frederick A. Praeger, Inc. Review by T. J. Burns. (JSTOR link).

Briloff, A. J. 1972. Unaccountable Accounting. HarperCollins. Review by H.E. Milller.
See also Benston, G. J. 1974. Unaccountable accounting. Journal of Accounting Research (Autumn): 348-354. (JSTOR link).

Briloff, A. J. 1974. Prescription for change. Management Accounting (July): 63-65, 71.

Briloff, A. J. 1976. More Debits Than Credits: The Burnt Investor's Guide to Financial Statements. HarperCollins. 

Briloff, A. J. 1981. The Truth About Corporate Accounting. HarperCollins.

Briloff, A. J. 1995. Review of Strengthening the professionalism of the independent auditor, report to the public oversight board of the SEC practice section. Accounting Horizons (September): 125-130.

Briloff, A. J. 1996. America Online/ On a roll: A case study in investigative accounting. Behavioral Research In Accounting (8 Supplement): 1-11.

Briloff, A. J. 2002. Beyond the Brilovian critique: A Brilovian rejoinder.Accounting and the Public Interest (2): 94-96.

 

March 23, 2010 reply from Paul Williams [Paul_Williams@NCSU.EDU]

Bob, One of my heroes, too. His treatment by both the US accounting academy and the profession is nothing less than sordid. We all know that the powers that be tried to revoke his certification over a technical error in an engagement letter with a client of Abe's firm, which consists of one blind man and his daughter. An issue of Critical Perspectives on Accounting Vol. 12, No. 2, 2001 is devoted to the Briloff affair. The affair was a paper Abe wrote (originally titled Garbage In, Garbage Out) that was critical of the COSO report. It was submitted to Accounting Horizons and received less that respectful treatment. Subsequent events proved Abe was right -- Enron and Andersen were not small clients of small firms. Abe was prescient about what was to befall us two years after he wrote the paper. The stonewalling on that paper , the refusal to share data with Abe were not in the best traditons of scholarship. The Public Interest Section gave Abe our Exemplar Award many years ago. I agree he should be in the Hall of Fame. I could tell you some stories about his remarkable generosity, but will just leave it at, "He is a very generous person!" To paraphrase Pete Axthelm, "There are many men who are great accountants, but very few accountants who are great men." Abe is a great man.

March 23, 2010 reply from Dale Flesher [mailto:acdlf@olemiss.edu]

Bob:

I noticed your posting about Briloff. Have you seen the newly published biography by my former doctoral student Richard Criscione? See below.

Dale

Click Here
http://books.emeraldinsight.com/display.asp?K=9781848555884&cur=GBP&sf1=kword_index&sort=sort_date%2Fd&st1=Briloff&sf2=eh_cat_class&st2=E02&button_login=Go&m=1&dc=1

Synopsis
"Studies in the Development of Accounting Thought" works to inform readers of the historical foundations on which the profession is based, the historical antecedents of today's accounting institutions, the historical impact of accounting, as well as exploring the lives and works of pre-eminent individuals in the profession's history. Recent volumes have addressed: the founders of accounting in mid-nineteenth century and the origins of the Institute of Chartered Accountants of Scotland; the life and work of accountant Stuart Chase (1888-1985), and his concerns about waste, conservation, social action, justice, ethics and fairness; and the evolving nature of accounting regulation, looking at the overwhelming number of systems and checks that practising accountants face in the wake of modern management fraud. The series is edited by Gary J. Previts, Past President of the American Accounting Association and Professor at Weatherhead School of Management, Case Western Reserve University, and Robert Bricker, Professor and Ernst & Young Faculty Fellow at Weatherhead, CWRU.

Health-Care Taxes Put Spotlight on Tax-Exempt Municipal Bonds
The latest wrinkle in the muni-verse: the health-care reform legislation signed by President Barack Obama on Mar. 23. One widely discussed feature of the bill is a new Medicare tax that levies 3.8% on wages and other kinds of income, starting in 2013. The tax would not apply to interest on tax-exempt bonds and other forms of unearned income, such as any gain from the sale of a principal residence, that are excluded from gross income under the U.S. income tax code, according to a footnote in the Joint Committee on Taxation's Technical Explanation of the revenue provisions of the Reconciliation Act of 2010. That may seem like a no-brainer, but R.J. Gallo, senior portfolio manager for muni bonds at Federated Investors in Pittsburgh, says he's received calls from a few brokers asking whether munis would be exempt from the additional tax.
David Bogoslaw, “Health-Care Taxes Put Spotlight on Munis," Business Week, March 23. 2010 ---
http://www.businessweek.com/investor/content/mar2010/pi20100323_076507.htm?link_position=link1

"Health Care Reform Insights From Harvard Business School Faculty," by HBS Faculty Members, Harvard Business Review Blog, March 25, 2010 ---
http://blogs.hbr.org/cs/2010/03/health_care_reform_insights_fr.html?cm_mmc=npv-_-DAILY_ALERT-_-AWEBER-_-DATE

In the wake of the passage of sweeping health care reform legislation by the U.S. Congress, the political battle over the bill seems destined to continue. But what do Harvard Business School faculty experts, whose research applies a management lens to health care policy and delivery, think about the bill's content? And what are the next steps for improving patient care and containing costs?

Richard Bohmer Physician and Professor of Management Practice at Harvard Business School. Author of Designing Care: Aligning the Nature and Management of Health Care.

Insurance reform is a necessary but not sufficient component of U.S. health care reform. We need to think very hard as well about the optimal way of caring for a particular type of patient and then how to pay for that optimal way. For me, the optimal way is the function of a science: What is possible in terms of drugs, technology, devices, information technology, and personnel; then secondarily, consider the current regulations in place and the payment models.

There is an important set of discussions to be had around how we actually organize care, with all sorts of managerial and strategic decisions to be made at a policy and national level. Yet at ground zero, lots of interesting experiments are underway, with professionals trying different ways of configuring and managing services. On that list I include experiments with disease management programs, substituting nurse practitioners for physicians in certain circumstances, the in-store clinic model for treatment of simple diseases, and experiments with IT to enable precise electronic communication between patients and doctors so that real medical discussions can be had at a distance.

At the national level we don't hear much about these innovations; yet they present an equally important set of issues. We need to make a distinction between debating how it will be paid for and what the "it" is that is paid for.

Several factors are pushing us to change how we deliver care. Perhaps the most important of these is changing expectations. Patients are used to good service from other industries, and they expect higher performance than they see in the health care sector. They obviously worry a lot about whether their insurance will cover the medical services they need, but they are also concerned about the care they get — how accurate, reliable, and fail-safe it is, as well as how responsive and convenient. Employers expect better outcomes, and of course they and patients want fewer errors and fewer patients harmed by care that was intended to cure their disease. Finally, all health care's constituents expect better value.

As for innovation, our prevailing model has been that knowledge flows into medical and nursing practice from funded external research. In this model it is the role of provider organizations to bring knowledge published in the medical and nursing literatures to bear on individual patients by selecting the right therapies and the right way of implementing those therapies — a one-way flow of knowledge from the research community to the delivery community to each individual patient.

However, routine practice is itself a fertile source of innovations in care, in both what to do and how to do it. Medical knowledge and how to operationalize it can be learned through taking care of patients, and delivery organizations create knowledge for themselves. This is knowledge flow not from bench-side-to-bedside, but from bedside-to-bedside. New insights derived from practice can be brought to bear for the benefit of each subsequent patient.

Given the increased expectations of performance, we now need to design care by asking nitty-gritty design questions such as: How is care going to be delivered? Who will do what, when, where, and how? How will they hand over tasks and decision rights and accountability to the next person who will do what, when, where, and how? And how does technology support these decisions?

Hence, a lot of health care reform is a management problem. It can't be solved by policymakers acting at a distance. That is why we should help doctors understand the managerial issues related to their clinical practice. My involvement with the MD/MBA program at Harvard Business School is part of that belief. A not-for-profit institution deserves to be as well managed as a for-profit institution. In terms of health care delivery, the absence of a profit motive doesn't mean that people should tolerate poorly designed processes and symptoms, especially when organizational performance is a necessary component of realizing the best clinical outcomes for individual patients.

Adapted from the 11/23/09 HBS Working Knowledge article,"Management's Role in Reforming Health Care."

Bob Jensen's threads on health care --- http://www.trinity.edu/rjensen/health.htm

Denny Beresford finally got it through my thick skull that the billion-dollar write-offs of selected corporations are mandatory in FAS 106, leaving these corporations no choice with respect to write offs in the year the universal health care act was enacted.

March 28, 2010 message from Denny Beresford

Bob,

I'm amazed that you and others (apparently including this anonymous former "top executive in a Big Four accounting firm") apparently still seem to believe that the charges announced by AT&T and some other large companies are somehow voluntary or arbitrary - even opportunities for "cookie jar accounting." On Friday, KPMG issued its Defining Issues publication 10-16 (unfortunately I printed it out and then deleted the link so I can't reference here) which is titled, "New Health Care Legislation Creates an Income Tax Charge for Some Companies." I suspect that all of the firms will have publications on the street by early next week.

This is a fairly complex issue and it doesn't apply to too many companies. But for those it does affect, the charge is likely to be quite material. And it must be recorded in the period in which the legislation is enacted according to authoritative FASB guidance.

I apologize if I am misinterpreting either your views on this or your anonymous adviser (although it's hard to misinterpret his quoted words). But let's not confuse what companies have to do under generally accepted accounting principles with some other matters where they might be allowed to apply more management judgment.

Denny Beresford

Jensen Comment on this "Vast CEO Conspiracy"
Here’s the latest wisdom on this issue from the hallowed halls of the U.S. Congress.

"AT&T plans $1 billion write-down tied to health law : Telecom giant joins Caterpillar and Deere in outlining expense," by Jeffrey Bartash, The Wall Street Journal, March 26, 2010 ---
http://www.marketwatch.com/story/att-sees-1-billion-write-down-tied-to-health-law-2010-03-26?dist=afterbell 

Among its many changes, the new health-care law eliminated a tax deduction that companies used to cut the cost of drug-benefit programs for retired workers. President Obama signed the massive health-care overhaul into law earlier this week in a big victory for ruling Democrats.

News Hub: Health Costs for CompaniesThe health reform bill eliminated a subsidy for companies that operated as a double deduction. Companies such as John Deere and Caterpillar will face new costs up to $150 million, Ellen Schultz reports. Yet companies that still offer retiree drug benefits, mostly older industrial concerns or those with unionized employees, say the end of the deduction could force them to alter their benefit plans. In other words, they might curtail or even cancel them.

"As a result of this legislation, including the additional tax burden, AT&T will be evaluating prospective changes to the active and retiree health care benefits offered by the company," AT&T said in a filing with the government on Friday.

An AT&T spokesman declined to comment further on the filing.

Earlier this week, Verizon Communications sent a letter to employees suggesting that changes to their health-care plans could be afoot. AT&T and Verizon are the two largest phone companies in the U.S. and include a substantial number of unionized workers.

Several million retirees are estimated to receive drug benefits from a few thousand companies. If those retirees were shifted to the federal Medicare program, the government would to pick up the expense. Whether savings from elimination of the subsidy would offset those higher Medicare costs is unclear.

Under the old law, companies received a federal subsidy worth up $1,330 per retiree if they provided former workers with drug-care benefits. At the same time, however, companies could deduct the value of the subsidy from their taxable income. See blog on whether the new health care law already is hurting business

White House spokesman Robert Gibbs on Thursday said the government merely eliminated a tax loophole that effectively allowed a company to benefit twice from one law.

The AT&T announcement is sure to cause a ripple in Washington. Republicans have already assailed the administration for what they say are excessive costs saddled on business by the health-care law. The issue is sure to be part of their campaign against Democrats in the fall elections.

Democrats say the health-care law will become more popular over time and they point out that it also includes substantial new subsidies for business.

"There's $10 billion in health-care reform for support for businesses with early retirees," Gibbs said

Updates on Bifurcation Accounting for Embedded Derivatives

An example of an embedded derivative is the option in a mortgage contract that allows the borrower to pay off the mortgage before the maturity  date of the mortgage. Most embedded derivatives have underlyings that are “clearly and closely related” to the underlyings of the host contracts, as is usually the case with an embedded option to pay off the balance due on a note before its maturity date. However, there are many instances where embedded options do not meet the “clearly and closely related” tests of FAS 133. When these tests are not met, the embedded options must be bifurcated and accounted for as derivative contracts under FAS 133 and its amendments.

I provide some illustrations of bifurcation in my free FAS 133 examination materials at
http://www.cs.trinity.edu/~rjensen/Calgary/CD/ExamMaterial/PracticeQuestions/
Other examination helpers are at
http://www.cs.trinity.edu/~rjensen/Calgary/CD/

There have been some recent changes in both the U.S. and international standards.

First the IASB parted ways with the FASB by not requiring embedded derivative contracts to be bifurcated for any such embedded derivatives even if the underlyings are not at all clearly and closely related.

Second, the FASB has now taken a step closer to the IASB by not requiring that certain credit derivatives be bifurcated even if they are not clearly and closely related to their host contracts ---
http://accountingeducation.com/index.cfm?page=newsdetails&id=150909

Bob Jensen’s free tutorials and videos on accounting for derivative financial instruments and hedging activities are linked at
http://www.trinity.edu/rjensen/caseans/000index.htm

European Business Schools in 2010:  They're Soaring
Business Week ---
http://www.businessweek.com/globalbiz/europe/special_reports/20100317european_b-schools_report.htm?link_position=link1

Just the Facts!
"Tax Provisions of Health Care Reform Legislation Covered in Briefing by CCH," SmartPros, March 22, 2010 ---
http://accounting.smartpros.com/x69050.xml

Also read the CCH Special Tax Briefing on health care reform:
http://tax.cchgroup.com/Legislation/Final-Healthcare-Reform-03-10.pdf 
 

"EITF Reaches Five Final Consensuses (milestone method of revenue recognition)," KPMG Defining  Issues, March 2010 ---
http://www.us.kpmg.com/microsite/DefiningIssues/2010/di-10-15-eitf-reaches-five-final-consensuses.pdf

The FASB’s Emerging Issues Task Force reached five final Consensuses on the milestone method of revenue recognition, insurers’ accounting for majority-ownership interests in mutual funds owned through a separate account, casino base jackpot liabilities, the effect of a loan modification when the loan is part of a pool of acquired loans that deteriorated in credit quality prior to acquisition and the pool is accounted for as a single asset, and the effect of denominating the exercise price of a share-based payment award in the currency of the market in which the underlying equity security trades.1 Proposed Consensuses were reached on health care entity issues concerning the presentation of insurance claims and related insurance recoveries and measuring charity care for disclosure.

The Task Force also discussed revenue recognition for health care entities and deferred acquisition costs for insurance contracts.

 n a separate action, the SEC staff announced at the meeting temporary guidance related to Venezuelan foreign currency issues. The FASB is expected to ratify the new Consensuses at its March 31 meeting and, if it does, the Consensuses will become authoritative GAAP. The proposed Consensuses will be exposed for public comment if the FASB gives its approval at its March 31 meeting and will be considered at a future EITF meeting.

Milestone Method of Revenue Recognition (EITF 08-9)

EITF 08-9 provides guidance on applying the milestone method to milestone payments for achieving specified performance measures when those payments are related to uncertain future events. Under the final Consensus, the scope of this Issue is limited to transactions involving research or development if the milestone payment is to be recognized in its entirety in the period the milestone is achieved.

The milestone method should not be applied to transactions within the scope of other authoritative literature on revenue recognition (i.e., construction contract accounting).

Entities can make an accounting policy election to recognize arrangement consideration received for achieving specified performance measures during the period in which the milestones are achieved, provided certain criteria are met. Although the milestone method is an accounting policy election, other methods that would result in recognizing a milestone in its entirety during the period it was achieved would not be acceptable for milestones if the criteria are not met.

Under the EITF’s final Consensus, the milestone method is a valid application of the proportional performance model for revenue recognition if the milestones are substantive and there is substantive uncertainty about whether the milestones will be achieved. The Task Force agreed that whether a milestone is substantive is a judgment that should be made at the inception of the arrangement. To meet the definition of a substantive milestone, the consideration earned by achieving the milestone (1) would have to be commensurate with either the level of effort required to achieve the milestone or the enhancement in the value of the item delivered, (2) would have to relate solely to past performance, and (3) should be reasonable relative to all deliverables and payment terms in the arrangement. No bifurcation of an individual milestone is allowed. There can be more than one milestone in an arrangement.

A simplified example that Defining Issues has published before illustrates the revenue recognition question related to milestones. Assume that all other relevant revenue-recognition criteria are met and the only question is the pattern of revenue recognition. Bio agrees to perform research-and-development services on a new drug for Pharma and is to be reimbursed at a rate of $200 per hour. Pharma agrees to pay Bio an additional $5 million if clinical trials are successfully completed. The trials are expected to be completed by the expiration of approximately half of the project’s expected total of 50,000 hours. Bio performs 30,000 hours of services during the reporting period in which the agreement begins; clinical trials are successfully completed; and Bio continues to believe that 50,000 hours of service will be required to perform under the agreement. Pharma has paid Bio $11 million during the period: $6 million for the 30,000 hours of R&D service provided plus $5 million for successfully completing the clinical trials. An additional $4 million in fees is expected to be received as the remaining 20,000 hours of service are provided in future periods. What is the timing and amount of revenue that should be recognized? Assuming that the milestone was determined to be substantive, the $5 million milestone payment would be recognized as a performance bonus when the clinical trials are successfully completed.

Continued in article

EITF documents can be downloaded from http://www.fasb.org/jsp/FASB/Page/PreCodSectionPage&cid=1218220137031

Bob Jensen's threads on revenue recognition are at
http://www.trinity.edu/rjensen/ecommerce/eitf01.htm

History of Greed : Financial Fraud from Tulip Mania to Bernie Madoff ---
http://www.wiley.com/WileyCDA/WileyTitle/productCd-0470601809.html

In his new book, History of Greed, noted financial fraud expert David E. Y. Sarna posits that the major scandals that came to light in 2008, like most of those in the last two hundred years are just the superficial manifestations of a system that, at its core, is based on fraud, greed and dishonesty. The root cause of the markets’ malaise, in one word, is “greed.” In two words, it is “easy money.” The quest for easy money took many forms, and each greedy person involved in the financial world found his or her own lucrative niche.

Through anecdotal examples, History of Greed provides an in-depth, behind-the-scenes look at the world of financial fraud, large and small. Millions of dollars are made every day (mostly by promoters and insiders) and lost every day (mostly by innocent but greedy investors) in the markets for these smaller stocks. The market for smaller stocks is a giant casino in which the dice are loaded and the cards are marked. Unlike some of the more exotic greed strategies, like hard-to-comprehend complex derivatives, this one is easy for everyone to understand. Sarna looks at smaller cases of fraud and major financial panics and fruads such as AIG, Goldman Sachs, Enron, and Twentieth Century Ponzi schemes.

American History of Fraud ---
http://www.trinity.edu/rjensen/415wp/AmericanHistoryOfFraud.htm 

Derivative Financial Instruments History of Fraud ---
http://www.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds

Free Basic Financial Accounting Examination Samples
If you are interested in some free samples of financial accounting examinations, Joe Hoyle is in a sharing mood ---
http://joehoyle-teaching.blogspot.com/2010/03/second-test-in-financial-accounting.html

It’s No Joke on April 1 Fools Day
Joe Hoyle Schedules a Webinar on Engaging Your Financial Accounting Students
I will be doing a 60 Minute webinar for FlatWorldKnowledge at 2 p.m. on April 1, 2010. At that time, I will be discussing the challenge of "Engaging Your Financial Accounting Students." I want to share some of the ideas that I use in my own classs here at the University of Richmond. As all teachers know, if students are interested in the material, the learning process goes 100 times better. This presentation is being made in connection with the publication of my new Financial Accounting textbook (written with C. J. Skender of UNC).
Joe Hoyle, Teaching Financial Accounting Blog, March 25, 2010 ---
http://joehoyle-teaching.blogspot.com/2010/03/engaging-your-financial-accounting.html

If you would like to register for this program, go to https://www2.gotomeeting.com/register/950022658 .

What is not clear is what archive will be available following the Webinar. Since Joe seems to literally share everything about his teaching, I suspect he will also have a great deal to say about his April 1 Webinar later on in his blog ---
http://joehoyle-teaching.blogspot.com/

Joe open shares an updated and free financial  accounting textbook ---
http://www.trinity.edu/rjensen/electronicliterature.htm#Textbooks
Scroll down to Hoyle

Question
Will the big auditing firms survive the explosion in lawsuits stemming from questionable audits of failed firms in the wake of the 2008 economic collapse?

Where Were the Auditors? --- http://www.trinity.edu/rjensen/2008Bailout.htm#AuditFirms

Will the Largest International Auditing Firms Survive? --- http://www.trinity.edu/rjensen/2008Bailout.htm#Auditors

"For The Auditors Nothing’s Over Until It’s Over: Or Is It?" by Francine McKenna, re: The Auditors, March 23, 2010 ---
http://retheauditors.com/2010/03/23/for-the-auditors-nothings-over-until-its-over-or-is-it/

The leadership of the Big 4 audit firms – Deloitte, Ernst & Young, KPMG and PricewaterhouseCoopers – are scared witless. The auditors prefer to be Switzerland. That is, they prefer to remain neutral.  They don’t like the kind of attention that Ernst  & Young is getting.  They like the soft, managed, scripted kind of attention for Davos, diversity, charitable endeavors and support of higher education.

Until the Lehman Bankruptcy Examiner’ Report was issued on March 11th, the auditors had experienced a “good crisis.” No serious scrutiny of their behavior, no testimony before the various investigative committees of the US Congress and only a few lawsuits that had not yet come to trial.

October 2008, Gavin Hinks in Accountancy Age:

“Speaking at a meeting of accountants from across the world at the Mansion House yesterday, Paul Boyle said: ‘So far at least, auditing has had a good crisis.’
 

Detractors, Boyle added, had been vague in their complaints and had misunderstood the role of auditor, on the one hand, and corporate governance and financial services supervision, on the other. These statements are notable because Boyle is clearly sticking up for the profession. If he had thought the opposite he would presumably not addressed the subject during the speech. This is active backing for auditors.”

So much for that.

The Lehman Bankruptcy Examiner threw the word “fraud” into the financial crisis conversation.

The words “auditor malpractice’” followed.

It’s quite likely EY will be called before the US House Oversight Committee to testify about the Lehman bankruptcy. David Einhorn, a member of the much maligned “short club,” will probably be called to testify, too.

I criticized Ernst & Young in mid-2008 for not questioning Lehman’s CFO revolving door. Lehman had chosen another non-CPA CFO, the second one in less than three years. I was following the lead of another Cassandra, David Einhorn. Einhorn is now being heralded because he questioned Lehman’s accounting, in spite of being ridiculed and damned for it at the time. He’s getting almost as much applause as the “whistleblower” du jour, Matthew Lee.

Einhorn has also recently been vindicated in another case where he called foul and faced harsh criticism.

The SEC’s watchdog found that the agency failed to properly pursue serious allegations made against Allied Capital, a public company that invests in small to midsize businesses. But after heavy lobbying by Allied Capital, the agency aggressively pursued the hedge fund manager who had challenged the value of Allied’s investments…The case…began in 2002, when a hedge fund manager named David Einhorn explained in a speech that he bet against Allied Capital’s stock by short-selling it because he thought Allied overvalued its holdings.

Other investors proceeded to short Allied’s stock, which declined sharply in value.

About the same time, Einhorn began contacting the SEC by phone and letter to explain his skepticism about Allied Capital’s accounting techniques. Allied also worked behind the scenes to urge the SEC to investigate whether Einhorn was engaging in illegal behavior to undermine the company’s shares, according to the inspector general’s report.

Without any specific evidence of wrongdoing, Allied met with SEC investigators in June 2002 to urge them to investigate Einhorn. Shortly thereafter, the SEC opened a probe, questioning Einhorn about his trading activities, subpoenaing documents, and seeking his telephone records and a list of clients. Soon after investigators started looking at Einhorn, they concluded that he had done nothing wrong.

Sources tell me that the SEC Inspector General’s report on the Allied Capital investigation paints an even worse picture of the SEC than those involved ever expected.  For example, it was the SEC lawyer who grilled Einhorn that later became a lobbyist for Allied and was the one who hired private investigators to steal Greenlight Capital’s phone records. Allied Capital’s auditor is KPMG. They are not yet accused of any wrongdoing, but the report also discusses the mis-valuations that Allied was originally accused of by Greenlight.

Maybe it’s time to start listening to the “shorts” and the contrarians.

Many ask me if Ernst & Young will fail because of Lehman.  I have answered that in previous posts.

In short, not immediately.

Maybe E&Y won’t be the first of the remaining Big 4 to fail.  The leadership of the Big 4 are terrified because any one of them could be thrust into the harsh spotlight the way Ernst & Young has been. At any time.

Because they’re all on the brink.

Take KPMG.  When the New Century Trustee v. KPMG US and KPMG International lawsuit comes to trial, you can bet the media will suddenly remember there’s an auditor smoking gun there, too. Mr. Missal, the New Century bankruptcy examiner, found emails that uncovered the same kind of disregard for KPMG’s experts and their risk and quality gurus that we saw in Arthur Andersen’s handling of Enron. New Century is more like Enron for that reason than EY/Lehman is.  So far.  That we know of.

Depending on how well Steven Thomas tries it, the media will be all over the “KPMG will fail” scenario.  Losing the case carries a $1 billion dollar price tag for KPMG.  There’s also significant implications for the global network business model in addition to the enormous costs of KPMG defending themselves in the meantime.

Arthur Andersen’s partner ignored his own expert’s advice in Enron. KPMG is accused of doing the same in New Century. All for the sake of keeping a lucrative client. EY may have done the same to hold onto Lehman.  Certainly the long, lucrative relationship between EY and Lehman paints a similar picture of mercenary motivation.

When EY’s Lehman audit team ran into the growing use of Repo 105 transactions, or the declining market value of the CDOs, or the Archstone REIT or any of the other problematic accounting issues mentioned in the Examiner’s report, one of four scenarios took place:

• The audit team didn’t ask for advice from their technical GAAP and SEC reporting/disclosure specialists at EY headquarters. The team went along and did what had always been done in the past: They acquiesced to Lehman CFOs.  After all it was the  Lehman CFO Goldfarb, an EY alumni who designed the transactions and approved the accounting treatments.  When Sarbanes-Oxley outlawed the revolving door of audit partners moving into high level positions at clients, Dick Fuld chose non-accountants who didn’t know better, would not question and weren’t interested in accounting.
• Or…The audit team asked for advice from their technical GAAP and SEC reporting/disclosure specialists at EY headquarters.  The headquarters specialists blessed the existing treatment. After all it was Lehman CFOs who were EY alumni who had designed the transactions and approved the accounting treatments.
• Or…The audit team asked for advice from their technical GAAP and SEC reporting/disclosure specialists at EY headquarters. The audit team received advice that the problematic issues represented unacceptable treatments according to current standards.  And/or  the experts suggested disclosures to clarify Lehman’s position. When this answer was brought to the audit partners they dismissed it and acquiesced to the Lehman executives. That’s similar the KPMG/New Century scenario.
• Or…The audit team asked for advice from their technical GAAP and SEC reporting/disclosure specialists at EY headquarters. The audit team received advice that the problematic issues represented unacceptable accounting treatments according to standards.  When this answer was brought to the audit partners they raised the issue with Lehman executives, encouraged them to stop manipulating the balance sheet without disclosures using Repo 105 or to write down assets such as Archstone or the CDOs and were rebuffed.  Lehman executives threatened to fire them and replace them with another firm like KPMG and EY backed down.  We may never know if this happened unless or until EY partners are forced to settle  charges and flip on the Lehman executives.

Or take the massive Satyam fraud-related litigation facing PricewaterhouseCoopers.  When the courts in the Southern District of New York decide that PwC’s motions to dismiss are denied, PricewaterhouseCoopers will face a flood of lawsuits that will dwarf New Century v. KPMG. The publicity over EY/Lehman  should make it difficult for the court to accept any lame excuses from PwC. PwC’s argument is that the case should be tried in India but they are fighting in India to have the case dismissed.

New York courts will now hear age discrimination litigation that names PwC as a defendant because the courts agreed that decisions about PwC partnership are made in New York. That same theory can certainly be applied when it comes to PwC global leadership (elected to represent the interests of the owners of its largest member firms) and their control over a global client like Satyam. Satyam is a PwC client that was listed on the New York Stock Exchange. The global leadership exerted control over member firm India because it has significant strategic importance to the global leadership. The global leadership exerted that control using the PwC International Limited legal construct.

The Satyam saga is far from over.  The PCAOB recently sanctioned two fairly low-level PW India staff. (They are actually employees of local Indian member firm Lovelock and Lewes.)  These employees are now “barred from being an associated person of a [PCAOB] registered public accounting firm” because they would not cooperate in the Satyam investigation.

I asked PCAOB spokesperson Colleen Brennan if there was more to come. What about the Price Waterhouse India partners that were jailed?

The order says formal investigation started Jan 8, 2009.  It is now 14 months later and the outcome is that they wouldn’t talk to you.  What took so long? Generally speaking the investigative process requires getting relevant audit work papers and other documents and scheduling the testimony of witnesses.   Particularly in cases where witnesses are located abroad, which is the case here, the staff works with the witnesses and their counsel regarding an appropriate location for the testimony.  Depending on the location, different planning goes into scheduling the testimony.   Under the Board’s rules, witnesses are allowed to have counsel present during their testimony.  In this instance, the auditors obtained new counsel during the investigative process which led to a postponement of the original testimony.

Is this it on your Satyam activities?  What else is PCAOB doing to address the Satyam matter? The order mentions that the Board issued an order of formal investigation relating to the audits of Satyam.  We cannot comment further.

What are next steps for PCAOB on Satyam? The disciplinary proceedings as to these respondents are complete.  The Board does not comment one way or another about the specifics of its investigative inventory.  (We cannot confirm that we have an ongoing investigation because Section 105(b)(5)(A) of the Act. This is the first case where we barred someone only for non-cooperation with Enforcement.)

Has the Board charged any other Lovelock & Lewes personnel, or Lovelock & Lewes, the firm, in connection with the Satyam audit? We cannot comment on whether others have been or will be charged.  These orders only address the conduct of Messrs. Ravindernath and Prasad.

Are the Board’s investigation and disciplinary proceedings in connection with this matter completed? These disciplinary proceedings are completed as to Messrs. Ravindernath and Prasad.  The Board does not comment one way or another about the specifics of its nonpublic investigative inventory, or about any proceedings that may be in litigation before the Board, which are non-public as required by the Sarbanes-Oxley Act.

What prompted the Board to investigate the audits and reviews of Satyam’s financial statements? The orders disclose that Satyam filed a Form 6-K with the SEC on January 7, 2009, that its chairman had revealed that he had inflated key financial results, and the Board issued an order of formal investigation on January 8, 2009.

Is the SEC also investigating this matter? Do you expect the SEC also to take enforcement action against Satyam management, or the auditors in this matter? As a matter of policy, the Board does not comment on SEC investigations.

Don’t forget Deloitte has its own subprime/crisis litigation already on the docket.  They are named in lawsuits related to the acquisition of Merrill Lynch by Bank of America and the failure of Bear Stearns, as well as the bankruptcy of Washington Mutual.

Finally…

PwC, EY and KPMG are named in significant Madoff feeder fund litigation and it looks like those cases are starting to move through the courts.  There are billions of dollars in damages that will probably be paid.

Each of the largest global audit firms could take a hit of $1 billion if forced to.  They would find a way to come up with the cash.  But they don’t want to.  A $1 billion dollar settlement would make a significant impact on any of the firms.  A settlement or judgment, especially of that size, would make it very difficult to stay in business even if the firm remained technically viable.

But there are several $1 billion claims out there.  All four of the largest firms are suffocating under the weight of the potential claims and the cost to defend them as well as the distraction from normal business activities and the impact on morale.

The Big 4 feels the pain on a rotating basis, only for a short for a while, and only whenever a painful exposé such as the Lehman bankruptcy report surfaces or a case gets closer to trial. Then the media moves on. Very few cases against the auditors went to trial in the past.  There are many reasons for this.  But the sheer volume of cases filed given number of scandals, frauds and failures, is giving plaintiff’s lawyers and regulatory enforcement more practice than ever before.  The plaintiff’s lawyers, in particular are talking to each other, sharing information and getting better at their arguments with each filing.

The tide’s gone out and left the audit firms high and dry.

Which case will be the showcase trial of the new millennium? Which billion dollar case will make it to the jury first? Which case will force legislators and regulators to admit the business model for public accounting is irreparably broken?

Bob Jensen's threads on accounting firm litigation are at
http://www.trinity.edu/rjensen/fraud001.htm

The Financial Accounting Standards Board moved last year to close the loophole that Lehman is accused of using, Bushee says. A new rule, FAS 166, replaces the 98%-102% test with one designed to get at the intent behind a repurchase agreement. The new rule, just taking effect now, looks at whether a transaction truly involves a transfer of risk and reward. If it does not, the agreement is deemed a loan and the assets stay on the borrower's balance sheet.

Best Explanation to Date:
"Lehman's Demise and Repo 105: No Accounting for Deception," Knowledge@Wharton, March 31, 2010 ---
http://knowledge.wharton.upenn.edu/article.cfm?articleid=2464

The collapse of Lehman Brothers in September 2008 is widely seen as the trigger for the financial crisis, spreading panic that brought lending to a halt. Now a 2,200-page report says that prior to the collapse -- the largest bankruptcy in U.S. history -- the investment bank's executives went to extraordinary lengths to conceal the risks they had taken. A new term describing how Lehman converted securities and other assets into cash has entered the financial vocabulary: "Repo 105."

While Lehman's huge indebtedness and other mistakes have been well documented, the $30 million study by Anton Valukas, assigned by the bankruptcy court, contains a number of surprises and new insights, several Wharton faculty members say.

Among the report's most disturbing revelations, according to Wharton finance professor Richard J. Herring, is the picture of Lehman's accountants at Ernst & Young. "Their main role was to help the firm misrepresent its actual position to the public," Herring says, noting that reforms after the Enron collapse of 2001 have apparently failed to make accountants the watchdogs they should be.

"It was clearly a dodge.... to circumvent the rules, to try to move things off the balance sheet," says Wharton accounting professor professor Brian J. Bushee, referring to Lehman's Repo 105 transactions. "Usually, in these kinds of situations I try to find some silver lining for the company, to say that there are some legitimate reasons to do this.... But it clearly was to get assets off the balance sheet."

The use of outside entities to remove risks from a company's books is common and can be perfectly legal. And, as Wharton finance professor Jeremy J. Siegel points out, "window dressing" to make the books look better for a quarterly or annual report is a widespread practice that also can be perfectly legal. Companies, for example, often rush to lay off workers or get rid of poor-performing units or investments, so they won't mar the next financial report. "That's been going on for 50 years," Siegel says. Bushee notes, however, that Lehman's maneuvers were more extreme than any he has seen since the Enron collapse.

Wharton finance professor professor Franklin Allen suggests that the other firms participating in Lehman's Repo 105 transactions must have known the whole purpose was to deceive. "I thought Repo 105 was absolutely remarkable – that Ernst & Young signed off on that. All of this was simply an artifice, to deceive people." According to Siegel, the report confirms earlier evidence that Lehman's chief problem was excessive borrowing, or over-leverage. He argues that it strengthens the case for tougher restrictions on borrowing.

A Twist on a Standard Financing Method

In his report, Valukas, chairman of the law firm Jenner & Block, says that Lehman disregarded its own risk controls "on a regular basis," even as troubles in the real estate and credit markets put the firm in an increasingly perilous situation. The report slams Ernst & Young for failing to alert the board of directors, despite a warning of accounting irregularities from a Lehman vice president. The auditing firm has denied doing anything wrong, blaming Lehman's problems on market conditions.

Much of Lehman's problem involved huge holdings of securities based on subprime mortgages and other risky debt. As the market for these securities deteriorated in 2008, Lehman began to suffer huge losses and a plunging stock price. Ratings firms downgraded many of its holdings, and other firms like JPMorgan Chase and Citigroup demanded more collateral on loans, making it harder for Lehman to borrow. The firm filed for bankruptcy on September 15, 2008.

Prior to the bankruptcy, Lehman worked hard to make its financial condition look better than it was, the Valukas report says. A key step was to move $50 billion of assets off its books to conceal its heavy borrowing, or leverage. The Repo 105 maneuver used to accomplish that was a twist on a standard financing method known as a repurchase agreement. Lehman first used Repo 105 in 2001 and became dependent on it in the months before the bankruptcy.

Repos, as they are called, are used to convert securities and other assets into cash needed for a firm's various activities, such as trading. "There are a number of different kinds, but the basic idea is you sell the security to somebody and they give you cash, and then you agree to repurchase it the next day at a fixed price," Allen says.

In a standard repo transaction, a firm like Lehman sells assets to another firm, agreeing to buy them back at a slightly higher price after a short period, sometimes just overnight. Essentially, this is a short-term loan using the assets as collateral. Because the term is so brief, there is little risk the collateral will lose value. The lender – the firm purchasing the assets – therefore demands a very low interest rate. With a sequence of repo transactions, a firm can borrow more cheaply than it could with one long-term agreement that would put the lender at greater risk.

Under standard accounting rules, ordinary repo transactions are considered loans, and the assets remain on the firm's books, Bushee says. But Lehman found a way around the negotiations so it could count the transaction as a sale that removed the assets from its books, often just before the end of the quarterly financial reporting period, according to the Valukas report. The move temporarily made the firm's debt levels appear lower than they really were. About $39 billion was removed from the balance sheet at the end of the fourth quarter of 2007, $49 billion at the end of the first quarter of 2008 and $50 billion at the end of the next quarter, according to the report.

Bushee says Repo 105 has its roots in a rule called FAS 140, approved by the Financial Accounting Standards Board in 2000. It modified earlier rules that allow companies to "securitize" debts such as mortgages, bundling them into packages and selling bond-like shares to investors. "This is the rule that basically created the securitization industry," he notes.

FAS 140 allowed the pooled securities to be moved off the issuing firm's balance sheet, protecting investors who bought the securities in case the issuer ran into trouble later. The issuer's creditors, for example, cannot go after these securities if the issuer goes bankrupt, he says.

Because repurchase agreements were really loans, not sales, they did not fit the rule's intent, Bushee states. So the rule contained a provision saying the assets involved would remain on the firm's books so long as the firm agreed to buy them back for a price between 98% and 102% of what it had received for them. If the repurchase price fell outside that narrow band, the transaction would be counted as a sale, not a loan, and the securities would not be reported on the firm's balance sheet until they were bought back.

This provided the opening for Lehman. By agreeing to buy the assets back for 105% of their sales price, the firm could book them as a sale and remove them from the books. But the move was misleading, as Lehman also entered into a forward contract giving it the right to buy the assets back, Bushee says. The forward contract would be on Lehman's books, but at a value near zero. "It's very similar to what Enron did with their transactions. It's called 'round-tripping.'" Enron, the huge Houston energy company, went bankrupt in 2001 in one of the best-known examples of accounting deception.

Lehman's use of Repo 105 was clearly intended to deceive, the Vakulas report concludes. One executive email cited in the report described the program as just "window dressing." But the company, which had international operations, managed to get a legal opinion from a British law firm saying the technique was legal.

Bamboozled

The Financial Accounting Standards Board moved last year to close the loophole that Lehman is accused of using, Bushee says. A new rule, FAS 166, replaces the 98%-102% test with one designed to get at the intent behind a repurchase agreement. The new rule, just taking effect now, looks at whether a transaction truly involves a transfer of risk and reward. If it does not, the agreement is deemed a loan and the assets stay on the borrower's balance sheet.

The Vakulas report has led some experts to renew calls for reforms in accounting firms, a topic that has not been front-and-center in recent debates over financial regulation. Herring argues that as long as accounting firms are paid by the companies they audit, there will be an incentive to dress up the client's appearance. "There is really a structural problem in the attitude of accountants." He says it may be worthwhile to consider a solution, proposed by some of the industry's critics, to tax firms to pay for auditing and have the Securities and Exchange Commission assign the work and pay for it.

The Valukas report also shows the need for better risk-management assessments by firm's boards of directors, Herring says. "Every time they reached a line, there should have been a risk-management committee on the board that at least knew about it." Lehman's ability to get a favorable legal opinion in England when it could not in the U.S. underscores the need for a "consistent set" of international accounting rules, he adds.

Siegel argues that the report also confirms that credit-rating agencies like Moody's and Standard & Poor's must bear a large share of the blame for troubles at Lehman and other firms. By granting triple-A ratings to risky securities backed by mortgages and other assets, the ratings agencies made it easy for the firms to satisfy government capital requirements, he says. In effect, the raters enabled the excessive leverage that proved a disaster when those securities' prices fell to pennies on the dollar. Regulators "were being bamboozled, counting as safe capital investments that were nowhere near safe."

Some financial industry critics argue that big firms like Lehman be broken up to eliminate the problem of companies being deemed "too big to fail." But Siegel believes stricter capital requirements are a better solution, because capping the size of U.S. firms would cripple their ability to compete with mega-firms overseas.

While the report sheds light on Lehman's inner workings as the crisis brewed, it has not settled the debate over whether the government was right to let Lehman go under. Many experts believe bankruptcy is the appropriate outcome for firms that take on too much risk. But in this case, many feel Lehman was so big that its collapse threw markets into turmoil, making the crisis worse than it would have been if the government had propped Lehman up, as it did with a number of other firms.

Allen says regulators made the right call in letting Lehman fail, given what they knew at the time. But with hindsight he's not so sure it was the best decision. "I don't think anybody anticipated that it would cause this tremendous stress in the financial system, which then caused this tremendous recession in the world economy."

Allen, Siegel and Herring say regulators need a better system for an orderly dismantling of big financial firms that run into trouble, much as the Federal Deposit Insurance Corp. does with ordinary banks. The financial reform bill introduced in the Senate by Democrat Christopher J. Dodd provides for that. "I think the Dodd bill has a resolution mechanism that would allow the firm to go bust without causing the kind of disruption that we had," Allen says. "So, hopefully, next time it can be done better. But whether anyone will have the courage to do that, I'm not sure."

Bob Jensen's threads on the Lehman/Ernst controversies are at
http://www.trinity.edu/rjensen/fraud001.htm#Ernst

"Accounting firms facing rise in negligence claims amid credit crunch fallout," by Alex Spence, London Times, March 29, 2010 ---
http://business.timesonline.co.uk/tol/business/law/article7079418.ece

Leading accounting firms are facing more professional negligence claims as they are targeted by investors who lost money in the credit crunch.

There were 13 negligence cases against accountants in the High Court last year, according to research by Reynolds Porter Chamberlain, the City law firm, compared with four claims in the previous five years.

Although the number of claims last year was far lower than the 61 that reached the High Court in the wake of the dot-com collapse — when auditors were criticised for their their role in corporate scandals such as those involving Enron and WorldCom — lawyers predict that this is the beginning of a wave of cases that will emerge from the financial crisis.

“The sudden jump in professional negligence claims suggests that cases relating to the credit crunch have started to reach the courts,” Jane Howard, a partner of Reynolds Porter Chamberlain, said.

The big accounting firms are often regarded by investors as their best hope of recovering losses in the aftermath of a company failure, because they are perceived as having deep pockets and remain standing while other parties may have disappeared or been declared insolvent.

In 2005 Ernst & Young was sued for £700 million by Equitable Life, its former audit client, after the insurance company almost collapsed. The claim was dropped but could have bankrupted the accountant’s UK division if it had succeeded.

Further cases relating to the financial crisis have been filed against the big accounting firms in other countries. KPMG was sued for $1 billion by creditors of New Century, a failed American sub-prime lender, and PricewaterhouseCoopers has faced questions over its audit of Satyam, the Indian outsourcing company that was hit by an accounting fraud. Several firms are facing lawsuits relating to their auditing of the feeder funds that channelled investors into Bernard Madoff’s Ponzi scheme.

Ms Howard said that claims in the British courts would be likely to centre on allegations that accountants had failed to spot a fraud while auditing a company’s accounts or that they had overvalued a company’s assets.

The accountants’ tax practices may also face accusations of negligently mis-selling schemes intended to mitigate or defer income or capital gains tax, or of giving bad advice to clients about the risk of a successful challenge by the taxman.

The role of auditors in the financial crisis had received relatively little scrutiny until this month when Ernst & Young, one of the “big four”, was cast into the spotlight for its auditing of Lehman Brothers, the collapsed investment bank.

A strongly critical 2,200-page report by Anton Valukas, an examiner appointed by a federal bankruptcy court in New York, criticised Ernst & Young’s advice to Lehman as failing to measure up to professional standards. The firm, which has defended its work, could now face legal action by the bank’s creditors, although lawyers said that this was likely to take place in the United States rather than in the UK.

It is more difficult for investors to sue accountants successfully for negligence in Britain than in the United States, lawyers said, because the legal threshold for proving liability is higher.

“We’ve seen a lot of threats of credit crunch-related claims against accountants that are highly speculative and often fall by the wayside at the pre-action stage when firmly rebutted,” Ms Howard said.

Last year, in the most recent big negligence case against a City accountant, Britain’s law lords threw out a multimillion-pound claim against Moore Stephens, which had been accused of failing to uncover a £58 million fraud at Stone & Rolls, a commodity trader that it had audited from 1997 to 2001.

The case centred on whether Moore Stephens should have known that Stone & Rolls was allegedly being used by its managing director as a vehicle for defrauding banks through a letter-of-credit scam.

The law lords dismissed the claim on the ground that the company’s liquidators could not pursue the auditors for losses suffered as a result of the company’s own behaviour. However, the judges’ split decision provided less clarity about auditors’ liability for fraud than the industry had hoped for.

Although negligence cases can be difficult to win, accounting firms are worried about the threat of legal action. They can be held liable for the full amount of losses in the event that a business that they audit collapses, even if they were only partly to blame.

The accountants fear that a big lawsuit, such as that faced by Ernst & Young over Equitable Life, could put one of them out of business.

Led by the big four, the profession has lobbied the Government to encourage companies to cap their auditors’ liability. So far their efforts have failed.

Bob Jensen's threads on the clouded future of auditing firms ---
http://www.trinity.edu/rjensen/2008Bailout.htm#Auditors

A Lehman/Ernst Teaching Case

First of all I might note that an article in The Economist supports what I've been saying all along ---
that Lehman's Repo 105 contracts supported by their auditors had only one purpose --- to deceive the public
"Beancounters in a bind Banks’ professional advisers come under scrutiny," The Economist, March 20, 2010, Page 81 ---
http://www.economist.com/business-finance/displaystory.cfm?story_id=15721559

Some of its counterparty banks get a slap on the wrist for changing the terms of their collateral demands, for instance. But the strongest criticism of those who interacted with the flailing firm is reserved for Lehman’s auditor, Ernst & Young (E&Y), for failing to “question and challenge improper or inadequate disclosures”. The main “accounting gimmick” hidden from investors, but apparently known to the auditor, was called Repo 105. This technique helped the firm flatter its numbers by temporarily moving assets off its balance-sheet at the end of each quarter. Lawyers are also in the spotlight: unable to find an American law firm to approve the transaction as a “true sale” of assets, Lehman got the nod from Linklaters in London. Both E&Y and Linklaters deny any wrongdoing.

Although Repo 105 appears to have been in line with American accounting standards, its effect was to deceive.
The technique allowed Lehman to reduce its reported leverage substantially and thus avoid ruinous ratings downgrades as it fought for survival. Investors would like to think that auditors consider not just the letter of the rules but their spirit, too. The examiner concluded that there was enough evidence to support a case for malpractice against E&Y.

Continued in article"

From The Wall Street Journal Accounting Weekly Review on March 26, 2010
Note that Ernst & Young is disputing some portions of the Examiner's Report with regard to the whitleblower
http://www.trinity.edu/rjensen/fraud001.htm#Ernst

Lehman Insider's Letter Warned About Violating Code of Ethics
by: Michael Corkery
Mar 20, 2010
Click here to view the full article on WSJ.com

TOPICS: Bankruptcy, Business Ethics, Code of Ethics, Ethics, Financial Statement Fraud, Fraud, Internal Controls, Management Fraud, whistleblower

SUMMARY: Matthew Lee, a Lehman Brothers Holdings Inc. senior vice president, warned in a May 2008 letter that he believed "senior management" may have violated Lehman's internal code of ethics by misleading investors and regulators about the true value of the firm's assets. Mr. Lee's complaints echo those of many investors and analysts at the time, who questioned whether Lehman was delaying write-downs to avoid potentially crippling losses. Mr. Lee, a 14-year veteran who headed the firm's global balance-sheet and legal-entity accounting, said Lehman had "tens of billions of dollars of unsubstantiated balances, which may or may not be 'bad,' or non-performing assets." "I believe the manner in which the Firm is reporting [certain] assets is potentially misleading to the public and various governmental agencies," Mr. Lee wrote.

CLASSROOM APPLICATION: The Lehman bankruptcy court's report offers us a current-events case study in financial statement fraud, as well as whistleblowing law and companies' codes of ethics. This article also connects our course material with law and ethics, showing students that the things they are learning in various classes in the business school are connected. Educated business students need to see the connections and overlap that occurs.

QUESTIONS: 
1. (Introductory) What warnings did Mr. Lee include in his letter to Lehman officers? What were his concerns? What evidence did he offer?

2. (Advanced) What happened to Mr. Lee after he verbally complained? After he submitted his letter? What has happened to Lehman Brothers since then? Were Mr. Lee's concerns accurate or were they incorrect accusations?

3. (Introductory) What was "Repo 105"? Why did Lehman implement this plan? What are the problems with this plan? Point to specific rules in GAAP that Lehman violated with this plan. How should those transaction have been booked according to GAAP?

4. (Advanced) What is a whistleblower? What is the value of whistleblowing to the accounting profession and to society? What are the risks involved for employees who decide to whistleblow? What do you think whistleblowing laws should include? Why?

5. (Introductory) What was the ultimate resolution between Mr. Lee and Lehman Brothers? Which terms of the agreement are known? Why do you think Lehman made this decision? How would this settlement be booked?

6. (Advanced) How could this situation have been prevented? What could Lehman management have done when they heard Mr. Lee's complaints? Could the situation have been remedied at that point? Why or why not? Who was ultimately responsible for Lehman's problems and the treatment of Mr. Lee?

Reviewed By: Linda Christiansen, Indiana University Southeast

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"Lehman Insider's Letter Warned About Violating Code of Ethics:  Top Executives Told Firm Misled Investors on Assets; Problems in Mumbai," by by: Michael Corkery, The Wall Street Journal, March 20, 2010 ---
http://online.wsj.com/article/SB10001424052748704534904575132120222684184.html?mod=djem_jiewr_AC_domainid

Matthew Lee, a Lehman Brothers Holdings Inc. senior vice president, warned in a May 2008 letter that he believed "senior management" may have violated Lehman's internal code of ethics by misleading investors and regulators about the true value of the firm's assets.

View Full Image

Photo by Catherine Lee Matthew Lee's complaints echo those of investors and analysts at the time, who questioned whether Lehman was delaying write-downs to avoid potentially crippling losses.

Mr. Lee addressed his letter to then-Chief Financial Officer Erin Callan and Chief Risk Officer Chris O'Meara, among others, only days before he was ousted from the firm. Portions of the letter were excerpted in the U.S. Bankruptcy Court examiner's report on Lehman released last week. A full version of the letter was reviewed Friday by The Wall Street Journal. Ms. Callan didn't return a phone call seeking comment.

Mr. Lee's complaints echo those of many investors and analysts at the time, who questioned whether Lehman was delaying write-downs to avoid potentially crippling losses. Mr. Lee, a 14-year veteran who headed the firm's global balance-sheet and legal-entity accounting, said Lehman had "tens of billions of dollars of unsubstantiated balances, which may or may not be 'bad,' or non-performing assets."

"I believe the manner in which the Firm is reporting [certain] assets is potentially misleading to the public and various governmental agencies," Mr. Lee wrote.

On Friday, Senate Banking Committee Chairman Christopher Dodd (D., Conn.) asked the Justice Department to investigate alleged accounting manipulations that took place at Lehman and that were detailed in the 2,200-page examiner's report.

More

What Central Figures at Lehman Knew The Lehman Whistleblower's Letter In the May 18, 2008, letter, Mr. Lee specifically criticized the accounting controls in Lehman's Mumbai office. "There is a very real possibility of a potential misstatement of material facts being efficiently distributed by that office," Mr. Lee wrote.

At the time, one India investment was drawing scrutiny from Lehman critics, including David Einhorn of hedge fund Greenlight Capital Inc. Mr. Einhorn questioned why the Wall Street firm had written up the value of a power plant there, known as KSK Energy Ventures, during the first quarter of 2008. In a speech to investors on May 21, Mr. Einhorn, who was betting that Lehman's stock would decline, said the firm had booked a $400 million to $600 million gain in the first quarter by writing up the value of KSK Energy.

Lehman said in the spring of 2008 that it booked the gains because an investor had invested in the venture at a higher valuation than Lehman's investment. In his May 21 speech, Mr. Einhorn said Lehman later said that it valued KSK based on its "expected" pre-IPO financing, as well as other factors.

Mr. Lee's lawyer, Erwin Shustak, of San Diego, said his client had complained orally for several months to his boss, Martin Kelly, Lehman's former global financial controller, about many of the same issues he raised "formally" in his letter. Mr. Kelly declined to comment, through a Barclays PLC spokesman, where he now works. According to the examiner's report, Mr. Kelly had raised concerns to top executives about the firm's accounting tactic, known as "Repo 105," which temporarily moved billions of dollars off its balance sheet, according to the examiner's report. The Lehman bankruptcy estate declined to comment.

Mr. Shustak said his client was demoted about two months before he wrote the letter, which was drafted with help from the attorney. Mr. Lee was terminated a few days after he wrote the letter.

Lehman's auditors, Ernst & Young LLP, referred to the document as a "whistleblower letter" that was "pretty ugly," according to the examiner's report. In a statement, Ernst & Young said Lehman management determined that Mr. Lee's "allegations were unfounded."

"Mr. Lee believes he has been the victim of retaliation for bringing what he believed, in good faith, to have been ethical and securities law violations by Lehman to Lehman's managements' attention," Mr. Shustak wrote in a letter to Jack Johnson, a former member of the general counsel's staff, that was reviewed by The Wall Street Journal.

After being terminated in May, Mr. Lee was asked to return to Lehman on June 12 to be interviewed by Ernst & Young auditors about his complaints, his lawyer said. That is when Mr. Lee brought up his concerns about Lehman's use of Repo 105.

Mr. Shustak also wrote that Mr. Lee, who is now 56 years old, was considering filing a discrimination complaint because he was the "victim of age discrimination in what appears to be a company wide decision to replace more senior, higher paid employees, such as Mr. Lee, all over the age of forty years of age, with younger, less experienced and less expensive employees."

The letter added: "At time same time, Mr. Lee would prefer to resolve his dispute with Lehman amicably."

Mr. Lee and Lehman ultimately negotiated a severance agreement, which his lawyer said precluded him from filing a lawsuit or a whistle-blower complaint under the Sarbanes-Oxley Act.

Bob Jensen's threads on the Lehman/Ernst scandal are at
http://www.trinity.edu/rjensen/fraud001.htm#Ernst

March 30, 2010 message from Dennis Beresford [dberesfo@TERRY.UGA.EDU]

In the last day or so the SEC staff has sent the letter below to the CFO of 20 or so very large financial institutions including insurance companies.

Denny Beresford

Sample Letter Sent to Public Companies Asking for Information Related to Repurchase Agreements, Securities Lending Transactions, or Other Transactions Involving the Transfer of Financial Assets

In March 2010, the Division of Corporation Finance sent the following illustrative letter to certain public companies requesting information about repurchase agreements, securities lending transactions, or other transactions involving the transfer of financial assets with an obligation to repurchase the transferred assets.

March 2010

Name Chief Financial Officer XYZ Company Address

Dear Chief Financial Officer:

We are currently reviewing your Form 10-K for fiscal year ended ______. In our effort to better understand the decisions you made in determining the accounting for certain of your repurchase agreements, securities lending transactions, or other transactions involving the transfer of financial assets with an obligation to repurchase the transferred assets, we ask that you provide us with information relating to those decisions and your disclosure.

With regard to your repurchase agreements, please tell us whether you account for any of those agreements as sales for accounting purposes in your financial statements. If you do, we ask that you:

* Quantify the amount of repurchase agreements qualifying for sales accounting at each quarterly balance sheet date for each of the past three years. * Quantify the average quarterly balance of repurchase agreements qualifying for sales accounting for each of the past three years. * Describe _all_ the differences in transaction terms that result in certain of your repurchase agreements qualifying as sales versus collateralized financings. * Provide a detailed analysis supporting your use of sales accounting for your repurchase agreements. * Describe the business reasons for structuring the repurchase agreements as sales transactions versus collateralized financings. To the extent the amounts accounted for as sales transactions have varied over the past three years, discuss the reasons for quarterly changes in the amounts qualifying for sales accounting. * Describe how your use of sales accounting for certain of your repurchase agreements impacts any ratios or metrics you use publicly, provide to analysts and credit rating agencies, disclose in your filings with the SEC, or provide to other regulatory agencies. * Tell us whether the repurchase agreements qualifying for sales accounting are concentrated with certain counterparties and/or concentrated within certain countries. If you have any such concentrations, please discuss the reasons for them. * Tell us whether you have changed your original accounting on any repurchase agreements during the last three years. If you have, explain specifically how you determined the original accounting as either a sales transaction or as a collateralized financing transaction noting the specific facts and circumstances leading to this determination. Describe the factors, events or changes which resulted in your changing your accounting and describe how the change impacted your financial statements.

For those repurchase agreements you account for as collateralized financings, please quantify the average quarterly balance for each of the past three years. In addition, quantify the period end balance for each of those quarters and the maximum balance at any month-end. Explain the causes and business reasons for significant variances among these amounts.

In addition, please tell us:

* Whether you have any securities lending transactions that you account for as sales pursuant to the guidance in ASC 860-10. If you do, quantify the amount of these transactions at each quarterly balance sheet date for each of the past three years. Provide a detailed analysis supporting your decision to account for these securities lending transactions as sales. * Whether you have any other transactions involving the transfer of financial assets with an obligation to repurchase the transferred assets, similar to repurchase or securities lending transactions that you account for as sales pursuant to the guidance in ASC 860. If you do, describe the key terms and nature of these transactions and quantify the amount of the transactions at each quarterly balance sheet date for the past three years. * Whether you have offset financial assets and financial liabilities in the balance sheet where a right of setoff — the general principle for offsetting — does not exist. If you have offset financial assets and financial liabilities in the balance sheet where a right of setoff does not exist, please identify those circumstances, explain the basis for your presentation policy, and quantify the gross amount of the financial assets and financial liabilities that are offset in the balance sheet. For example, please tell us whether you have offset securities owned (long positions) with securities sold, but not yet purchased (short positions), along with any basis for your presentation policy and the related gross amounts that are offset.

Finally, if you accounted for repurchase agreements, securities lending transactions, or other transactions involving the transfer of financial assets with an obligation to repurchase the transferred assets as sales and did not provide disclosure of those transactions in your Management’s Discussion and Analysis, please advise us of the basis for your conclusion that disclosure was not necessary and describe the process you undertook to reach that conclusion. We refer you to paragraphs (a)(1) and (a)(4) of Item 303 of Regulation S-K.

As noted above, we seek to better understand the basis for your decisions and your disclosure. Please provide us with a written response to these questions within ten business days from the date of this letter or tell us when you will respond. Upon our review of your response to these questions, we may have additional comments that we will provide to you with any other comments we may have on your Form 10-K.

Please contact me if you have any questions.

Sincerely,

Senior Assistant Chief Accountant

/http://www.sec.gov/divisions/corpfin/guidance/cforepurchase0310.htm/

Far from going unnoticed, Lehman's Repo 105 transactions are destined to take a prominent place in the annals of accounting scandals — somewhere between Enron's infamous special-purpose entities and AIG's booby-trapped credit default swaps.
"SEC to CFOs: More Repo Disclosure:  In its latest "Dear CFO" letter, the SEC is seeking more information on why some repurchase agreements are being booked as sales" by Marie Leone, CFO.com, March 31, 2010 --- http://www.cfo.com/article.cfm/14487561/c_14487542?f=home_todayinfinance

The Securities and Exchange Commission is asking public-company CFOs for additional information about repurchase agreements, or repos, the transactions that Lehman Brothers used to make its balance sheet look healthier before the investment bank collapsed into bankruptcy.

The SEC wants companies to help the regulator "better understand" the accounting treatment used to record repos, and to provide details about how management determines whether to record repos as a sale or a collateralized financing. The commission would like to know, for example, how many repos qualified for sales accounting treatment each quarter for the past three years, whether those sales were concentrated with certain counterparties or countries, the business reason for structuring such transactions as sales, and whether a company has changed its original accounting treatment for any of the repos.

Issued in March in the form of a "Dear CFO" letter, the SEC's request for additional information seems "granular and broad at the same time," says Wallace Enman, a vice president and senior accounting analyst with Moody's Investor Services. He says that if companies were to use the letter as a guide, they would create "relatively robust" disclosures about repos. A sample letter was posted on the SEC's Website on Monday.

While SEC comment letters are usually directed at a single company, Dear CFO letters cover issues that affect a large swath of companies. But the repo letter "is not a typical Dear CFO letter where we provide companies with our views on accounting and disclosure matters they should consider," says SEC spokesman John Nester. "In this case, we are seeking very specific information from companies about repurchase agreements and similar transactions."

Nester says that based on company responses, the SEC could ask issuers to amend their filings or modify disclosures in future filings. But so far the commission has not concluded that any company has failed to comply with generally accepted accounting principles, violated any SEC rules, or failed to provide appropriate disclosures.

This isn't the first time the SEC has questioned companies about the way they apply asset-transfer accounting rules. Since 2004, the SEC has exchanged 171 comment letters with 93 different companies about whether agreements to transfer financial assets are treated as a sale or a temporary transaction under U.S. GAAP, according to research firm Audit Analytics.

For his part, Enman says the questions are the SEC's way of making sure that Lehman's so-called Repo 105 technique doesn't go unnoticed. Indeed, in an interview with CNBC this week, SEC Chairman Mary Schapiro said the commission is looking at all the issues surrounding Repo 105, both at Lehman and other financial institutions. "We want to make sure their accounting and disclosures are accurate when it comes to characterizing repurchases," said Schapiro.

One for the Books

Far from going unnoticed, Lehman's Repo 105 transactions are destined to take a prominent place in the annals of accounting scandals — somewhere between Enron's infamous special-purpose entities and AIG's booby-trapped credit default swaps.

Earlier this month, Anton Valukas, the court-appointed examiner in the Lehman bankruptcy case, released a 2,200-page report on the collapse of the investment bank, devoting more than 300 pages to Repo 105. While the report did not find that Lehman violated asset-transfer accounting rules, it said that the investment bank was not as forthcoming as it should have been in its financial-statement disclosures.

Valukas faulted Lehman for not revealing enough to investors about the purpose of Repo 105 transactions and how they affected the bank's leverage ratios. However, internal Lehman e-mail messages made public in the report quoted Lehman executives as describing the repos as balance-sheet "window dressing" and an "accounting gimmick."

In general, repos are used to buy and sell groups of securities, usually Treasury securities, in short-term transactions, typically overnight. The securities are put up as collateral by a borrower and in exchange, the borrower receives cash from counterparties that charge interest. Since the securities are treated as collateral and the agreement stipulates that the borrower has an obligation to pay back the cash in short order, the transaction is considered a financing for accounting purposes, and the transaction remains on the balance sheet.

In the case of Repo 105, however, Lehman overcollateralized the transactions by pledging $105 million for $100 million in cash. As a result, the investment bank — with the blessing of a legal opinion from UK law firm Linklaters — categorized Repo 105 as a sale for accounting purposes. The sales accounting treatment enabled Lehman to remove the securities from its balance sheet and use the cash from the "sale" to pay down other debt and improve its overall leverage ratios.

Lehman repeated the transaction again and again, including at the end of the last three quarters the bank was solvent. According to the Valukas report, "Lehman employed off-balance sheet devices . . . to temporarily remove securities inventory from its balance sheet, usually for a period of seven to ten days, and to create a materially misleading picture of the firm's financial condition in late 2007 and 2008." Then, a few days into the new quarter, Lehman would borrow funds to repay the repo borrowing plus interest, repurchase the securities, and restore the assets to its balance sheet.

"My Commentary Part 1: Ernst & Young’s Letter To Audit Committee Members," by Francine McKenna, re: The Auditors, March 31, 2010 ---
http://retheauditors.com/2010/03/31/my-commentary-part-1-ernst-youngs-letter-to-audit-committee-members/

"My Commentary Part 2: Ernst & Young’s Letter To Audit Committee Members," by Francine McKenna, re: The Auditors, April 4, 2010 ---
http://retheauditors.com/2010/04/04/my-commentary-part-2-ernst-young%e2%80%99s-letter-to-audit-committee-members/

Jensen Comment
Francine is not so impressed with the E&Y defense to date.

Bob Jensen's threads on the Lehman/Ernst Controversies are at
http://www.trinity.edu/rjensen/fraud001.htm#Ernst

Bob Jensen's threads on the Lehman/Ernst controversies are at
http://www.trinity.edu/rjensen/fraud001.htm#Ernst

Bob Jensen's threads on Repo 105 accounting are at
http://www.trinity.edu/rjensen/fraud001.htm#Ernst

"Lessons from the Lehman Autopsy:  The SEC can learn from Anton Valukas, the lawyer who led a probe into Lehman—and uncovered accounting chicanery that regulators largely ignored," by Paul M. Barrett, Business Week via the Young CPA Network, March 24, 2010 ---
http://ow.ly/1qJvx

In 2008, Anton R. Valukas, a trial attorney in Chicago, published a four-page stiletto thrust of an essay entitled "Arrogance: My Favorite Sin." The piece, included in a lawyers' guide to cross-examination, recounted Valukas' delight in using understated questioning to tempt executives into making implausible statements of the sort that reliably alienate jurors. "Frequently, the smartest witnesses—the most sophisticated and the most arrogant—are most susceptible to this type of examination," he wrote.

The piece reads today like a preamble to Valukas' voluminous autopsy of Lehman Brothers, which he performed as the court-approved bankruptcy examiner in the investment bank's formal unwinding. The 2,200-page Lehman report, released on Mar. 11, constitutes the single most penetrating document we have on the recent misbehavior on Wall Street. Valukas' earlier primer suggests why he did such an exemplary job: Although he heads a prestigious corporate law firm, Jenner & Block, the former federal prosecutor just plain resents dissembling by big shots in expensive suits. Not coincidentally, Jenner, a pillar of the Chicago business elite, sues Wall Street institutions as often as it defends them.

In the interest of preventing future Lehman disasters, we might ponder how to transplant Valukas' zeal into Washington's financial beat cops. That could help preclude the need to call him back again as corporate pathologist.

He'd be a hard man to clone. During a four-decade career, Valukas, 66, has represented all manner of white-collar rogues. When called to public service, he used his knowledge of the market's shadowy corners to prosecute well-heeled miscreants. In the late 1980s, as U.S. Attorney in Chicago, he sent agents disguised as commodity traders to clean up the futures exchanges. The probe protected investors and led to a slew of indictments. Some called him the Rudy Giuliani of the Midwest.

Unlike Giuliani, Valukas avoided elective politics and returned to his law firm. He prospered at Jenner, not least in his yearlong assignment as the Lehman examiner. Backed by colleagues from Jenner, he went over millions of pages of documents, interviewed scores of witnesses, and billed the Lehman estate $38.4 million. I'd say it was money well spent. His findings will provide the script for what's likely to be a theatrical airing in April, when Representative Barney Frank (D-Mass.) convenes his House Financial Services Committee to interrogate Lehman's former CEO, Richard S. Fuld Jr., and other participants in the debacle.

Dubious Behavior What Valukas brought to the endeavor was a no-nonsense lack of deference toward Wall Street game playing, says Francine McKenna, a former managing director at PricewaterhouseCoopers. "That's a Chicago thing," adds McKenna, herself a resident of the city. She now runs an investigative Web site called Re: The Auditors. "The mindset is: I've been around the block, I know how the game is played, and I'm not impressed by fancy names," she says.

As the Lehman examiner, Valukas doggedly unmasked the dubious behavior of executives once lauded as among Wall Street's conquering heroes. Fuld insisted to Valukas that he knew nothing about the accounting trickery called Repo 105, which was used to hide the bank's financial decline. Fuld's self-portrait—a veteran CEO blithely unfamiliar with the workings of his company—was not just implausible; it could support lucrative civil claims that he "was at least grossly negligent," as Valukas wrote. The examiner noted that Fuld's denials were undercut by evidence that he was thoroughly briefed on the chicanery.

Contacted by phone, Valukas declined to comment. Fuld's attorney, Patricia Hynes, has said her client told the truth and did nothing wrong.

"My Commentary Part 1: Ernst & Young’s Letter To Audit Committee Members," by Francine McKenna, re: The Auditors, March 31, 2010 ---
http://retheauditors.com/2010/03/31/my-commentary-part-1-ernst-youngs-letter-to-audit-committee-members/

Bob Jensen's threads on the Lehman/Ernst scandal are at
http://www.trinity.edu/rjensen/fraud001.htm#Ernst

"In Pari Delicto: Are Auditors Equally At Fault In The Big Fraud Cases?" by Francine McKenna, Re: The Auditors, March 9, 2010 ---
http://retheauditors.com/2010/03/09/in-pari-delicto-are-auditors-equally-at-fault-in-the-big-fraud-cases/

The phrase in pari delicto sounds like something dirty to me.  Maybe I’m still preoccupied with the accusation that I’m producing accounting pornography.

“…the etymology of the term [pornography] is: “Etymology: Greek pornographos, adjective, writing about prostitutes, from porn prostitute + graphein to write; akin to Greek pernanai to sell, porosjourney “

That implies accounting porn is writing about accounting prostitutes. That being the case, then Francine McKenna, Sam Antar, Tracy Coenen and Bob Jensen all engage in accounting porn. They write about the corporate executives and audit firm partners that prostitute their accounting reports in the search for fictitious profits and all too real unearned bonuses. In other words, accounting fraud is accounting prostitution…”

In pari delicto, for those of you not lawyers or legal argument junkies like me, is “Latin for “in equal fault”. It’s a legal term used to indicate that two persons or entities are equally at fault, whether we’re talking about a crime or tort. The phrase is most commonly used by courts when relief is being denied to both parties in a civil action because of wrongdoing by both parties. The phrase means, in essence, that since both parties are equally at fault, the court will not involve itself in resolving one side’s claim over the other, and whoever possesses whatever is in dispute may continue to do so in the absence of a superior claim.”

There are two active cases where this doctrine and defense is being employed by auditors trying to avoid liability for fraud.

In Teachers’ Retirement System of Louisiana v. PricewaterhouseCoopers LLP, No. 454, 2009 (Del. March 4, 2010), one of many AIG suits that PwC is involved in directly or indirectly, the Delaware Supreme Court used a procedure provided for under the New York Rules of Court  to certify a question of law to New York’s highest court, the New York Court of Appeals.This matter involves an appeal from the Delaware Court of Chancery regarding the oft-cited AIG case which denied a motion to dismiss claims against the top officials of AIG for breach of fiduciary duty based on Delaware law. However, the claims against the auditor, PwC, were dismissed based on New York law. The Plaintiff’s are appealing the Chancery Court’ decision regarding PwC. (Summary borrowed for accuracy from Francis Pileggi at Delaware Litigation.com who alerted me to this most unusual move by the Chancery Court.)

The Court of Chancery held that the claims against PwC were governed by New York law, and that based on the allegations of the Complaint, AIG’s senior officers did not “totally abandon[]” AIG’s interests—as would be required under New York law to establish the “adverse interest” exception to imputation.  Accordingly, the Court of Chancery held that the wrongdoing of AIG’s senior officers is imputed to AIG.3  The Court of Chancery concluded that, once the wrongdoing was imputed to AIG, AIG’s claims against PwC were barred by New York’s in pari delicto doctrine and by the related Wagoner line of standing cases in the United States Court of Appeals for the Second Circuit.

This Court hereby certifies the following question to the New York Court of Appeals:

Would the doctrine of in pari delicto bar a derivative claim under New York law where a corporation sues its outside auditor for professional malpractice or negligence based on the auditor’s failure to detect fraud committed by the corporation; and, the outside auditor did not knowingly participate in the corporation’s fraud, but instead, failed to satisfy professional standards in its audits of the corporation’s financial statements?

The other case where the in pari delicto defense has tied the litigation into knots and caused some stops and starts is in Kirschner v. KPMG LLP et al., case number 09-2020, in the U.S. Court of Appeals for the Second Circuit which is about the Refco fraud. The Second Circuit certified the questions about an exception to the in pari delicto defense.  Now they have two high profile cases against auditors to consider. From Law360.com:

Not one to go down easy, the bankruptcy trustee for Refco Inc. brought his suit implicating Mayer Brown LLP, KPMG LLP and other corporate giants in the massive Refco fraud to a federal appeals court…The U.S. Court of Appeals for the Second Circuit found Monday that trustee Marc S. Kirschner’s fight to revive his claims against the clutch of corporate insiders raised critical unresolved questions concerning the bankruptcy trustee’s standing under New York law to sue third parties for Refco’s fraud.

The trustee alleges outside counsel Mayer Brown, auditors Ernst & Young LLP, [Grant Thornton] PricewaterhouseCoopersLLP, Banc of America Securities LLC and several other insiders are liable for defrauding Refco’s creditors, namely by helping the defunct brokerage conceal hundreds of millions of dollars in uncollectible debt.

Steve Jakubowski, a local Chicago lawyer who writes the Bankruptcy Litigation Blog, sponsored a guest post in January by Catherine Vance, one of the fiercest critics of the “expansive” use of the in pari delicto defense.  He introduces her post this way:

Whatever you may think about the fact that Refco’s outside corporate counsel, Joe Collins, was convicted on 5 criminal counts and sentenced today to 7 years in prison, one has to wonder how the system got so turned upside down on the civil side that while the law firm’s lead lawyer is torched in criminal court, his firm is summarily dismissed from a civil case for precisely the same conduct on a simple motion to dismiss (based on a theory that the Refco trustee lacked standing to bring suit to recover for damages arising from a fraudulent scheme devised and carried out by Refco’s own senior management).  One could argue that this result is unique to the Second Circuit (and the Seventh) because of the Wagoner decision and its progeny (which are not followed in the First, Third, Fifth, Eighth, or Eleventh Circuits).  Even in those circuits, however, management’s wrongful conduct has been imputed to the corporation under the in pari delicto doctrine to just as effectively knock the props out from civil actions involving some of the most spectacular commercial frauds of the century.

Ms. Vance wrote an article entitled, In Pari Delicto, Reconsidered, in which she posited–as none had before–that the in pari delicto doctrine is being inappropriately used by federal courts to supplant traditional tort law defenses that derive from state, not federal, law.

The way I see it, the in pari delicto doctrine is being used like a pair of needle nosed pliers by audit firm defense lawyers to diffuse a bomb – huge liability for some of the biggest frauds in history. The in pari delicto doctrine attempts to pull the auditors’ tails from the fire by excusing any of their guilty acts due to the approval of those acts by potentially equally guilty executives. The law allows these executives to continue to “stand in the shoes” of the shareholder plaintiffs even after their guilt has been determined. The theory is that the executives perpetrated the fraud for the benefit of the corporation and never “totally abandoned” it, as would be required for the “adverse interest” exception.

Auditors who should otherwise be tested on their fulfillment of their public duty are instead getting reprieves because courts have been unwilling to impose the “adverse interest” exception as expansively as they have the in pari delicto defense itself.  How can executives who are successfully sued, been subject to regulatory sanctions or, in the case of the Refco executives, plead guilty to criminal activities, still be considered representatives of the corporation’s interests? They should forfeit the right to stand in the shoes of the corporation’s shareholders in derivative suits and therefore to shield other potentially guilty or negligent parties.

The situation gets complicated in a bankruptcy case such as Refco since, traditionally according to Section 541 of a decision called In re PSA, Inc, “property of the bankruptcy estate consists of all legal or equitable interests of the debtor, including causes of action, as of the commencement of the bankruptcy case. A bankruptcy estate’s causes of action, therefore, as well as the attendant defenses thereto, transfer to the bankruptcy trustee frozen and fixed as they existed at the commencement of the bankruptcy case.  As a result, an “innocent” bankruptcy trustee “stands in the shoes” of the pre-petition debtor and may be unable to prevail on estate causes of action where the pre-bankruptcy debtor participated or was complicit in the wrongful acts upon which the estate attempts to sue.”

A trustee in bankruptcy must have standing to sue anyone on behalf of the creditors and other injured parties.  Unfortunately, this habit of allowing guilty parties to continue to drive the bankruptcy bus by having the actions of the guilty officers “imputed” to the corporation and, therefore, in bankruptcy to the trustee potentially threatens the trustee’s ability to sue “co-conspirators.”

It’s just nuts.

Akin Gump summarizes critics of this line of reasoning this way:

The purpose of the in pari delicto defense, they argue, is to prevent a party who is complicit in wrongdoing from prevailing against their joint actors.  In their view, the intercession of an innocent trustee whose duty it is to maximize the value of the estate for the debtor’s creditors purges the taint of the debtor’s wrongdoing, and that to hold otherwise would simply elevate the legal fiction of section 541 over the purpose of the in pari delicto defense.

Ms. Vance reminds us in her treatise that in pari delicto was ushered into modern bankruptcy jurisprudence as a part of the deepening insolvency discussion. I’ve written about deepening insolvency many times as it relates to the auditors who, by continuing to provide false and negligent clean audit opinions, allow a company to go deeper and deeper into debt and ruin, thereby significantly diminishing any remaining value for stakeholders once the gig is up.

The deepening insolvency arguments have been shot down by no less than Judge Posner whose pernicious pragmatism forces him to engage in the self-delusion that helping companies remain “viable” via fraud doesn’t hurt anyone.  This fantasy presupposes the company to be a person and not the embodiment of the goals and objectives, hopes and dreams, faith and trust of the shareholders, employees, creditors, and community that count on it to continue legally and honorably instead.   I suppose a Supreme Court that allows corporations to donate money to political campaigns in an exercise of their inalienable constitutional rights would not find this idea so strange.

Continued in article

"My Commentary Part 1: Ernst & Young’s Letter To Audit Committee Members," by Francine McKenna, re: The Auditors, March 31, 2010 ---
http://retheauditors.com/2010/03/31/my-commentary-part-1-ernst-youngs-letter-to-audit-committee-members/

Bob Jensen's threads on auditor fraud and negligence are at
http://www.trinity.edu/rjensen/fraud001.htm

Adding Videos to PowerPoint Slides

March 11, 2010 message from XXXXX

Bob,

I am wondering if you know of any websites where I can gain access to watch camtasia-style (or narrated powerpoints) videos/lectures of upper level accounting instruction?

My Dean asked me to look into creating an asynchronous, distance/hybrid accounting program. I want to get an idea of what is out there. I think the classes I need are:

AIS Cost Intermediate 1 and 2 Tax Auditing Advanced GNP or NFP Any other advanced accounting, like advanced cost.

Thank you,

XXXXX

March 11, 2010 reply from Bob Jensen

Firstly, I would begin with the asynchronous way basic accounting is taught at BYU almost entirely with variable-speed videos even to resident students living on campus ---
http://www.trinity.edu/rjensen/000aaa/thetools.htm#BYUvideo

Next I would enter a number of search terms into YouTube --- http://www.youtube.com/
Examples include:
Accounting Information Systems
Accounting Ethics
Intermediate accounting
Advanced accounting
Governmental accounting
Hedge accounting
Cost Accounting
Managerial Accounting
Fair Value Accounting
Auditing
SAP or ERP
XBRL

 

I have a few accounting theory Camtasia videos at
http://www.cs.trinity.edu/~rjensen/video/acct5341/
Links to my other online materials (including PowerPoint presentations) are at
http://www.trinity.edu/rjensen/caseans/000index.htm
http://www.trinity.edu/rjensen/fraud001.htm

 

My PowerPoint presentations and Excel workbooks are linked at
http://www.cs.trinity.edu/~rjensen/Calgary/CD/

I suggest you contact my good friend Amy Dunbar about how she uses Camtasia videos in her online tax courses ---
Amy.Dunbar@business.uconn.edu

In the future U.S. accounting programs will be building in more and more IFRS. Here there’s a heck of a lot of free educational material available ---
http://www.trinity.edu/rjensen/theory01.htm#IFRSlearning
There are some good cases available, especially from the Big Four.

There is also a lot of free XBRL material, including some good videos --- http://www.xbrl.org/Home/
Click on “Education and Training”

The AICPA has a library of both fee and free videos --- http://www.aicpa.org/
Enter the search term “video”

Other organizations have some deals on videos for courses, including the IIA, Certified Fraud Examiners, etc.

There’s a ton of free material on ethics and fraud.

The OKI --- http://www.okiproject.org/view/html/site/oki
MIT’s Open Courseware Links --- http://ocw.mit.edu/OcwWeb/web/home/home/index.htm
Click on the Sloan School for accounting, finance, and other business open courseware materials
 

MIT’s Video Lecture Browser (better for the sciences than business) --- http://web.sls.csail.mit.edu/lectures/

"MIT's Management School Shares Teaching Materials (Cases) Online," by Steve Kolowich, Chronicle of Higher Education, January 27, 2009 ---
Click Here

Though some business schools charge for the “case studies” they develop as teaching aids, the Massachusetts Institute of Technology announced today that it is making a set of teaching materials available free online.

MIT’s Sloan School of Management has unveiled a set of case studies, videos, interactive teaching tools, and teacher’s notes on a new Web site called MIT Sloan Teaching Innovation Resources --- https://mitsloan.mit.edu/MSTIR/IndustryEvolution/Pages/default.aspx

The announcement comes eight years after MIT created its OpenCourseWare project, which makes instructional materials for courses available online for free.

Other open sharing materials provided by prestigious universities can be found at
http://www.trinity.edu/rjensen/000aaa/updateee.htm#OKI

Oh my Gosh!

I forgot to mention the AAA Commons where there’s now a great deal of available, including syllabi, tutorials, course materials, videos, and textbook recommendations --- http://commons.aaahq.org/pages/home

Soon many of the AAA Commons pages will be available to the world in general and not just AAA members. Among other things this makes the resources available to all of your students

Bob Jensen

Bob Jensen's threads on distance education and training alternatives are at
http://www.trinity.edu/rjensen/crossborder.htm

Roger Collins shows why you may maybe would prefer to become a rocket scientist---
 http://www.sos.ca.gov/business/corp/pdf/mergers/corp-mergerintr.pdf

Another one from that Ketz guy

"Iffiness of IFRS," by J. Edward Ketz, SmartPros, March 2010 ---
http://accounting.smartpros.com/x69096.xml

On February 24, the SEC issued its "Statement in Support of Convergence and Global Accounting Standards." Curiously, while the SEC did indeed affirm its "strong commitment" to IFRS, it may have unwittingly given voice to the concerns of dissidents. Finally!

The report begins with a documentation of the SEC’s commitment to a set of high-quality accounting standards.  Quite naturally, this history includes a discussion of its own report on a principles-based accounting system.  The reader should recall that this previous study merely provides a list of unproven assertions about principles-based accounting, including greater comparability for investors and lowered costs of capital for corporations.  Rather than providing evidence, the SEC merely enumerates these articles of faith.

At least this time around the SEC adopted a go-slow policy and hoped that the IASB would improve its IFRS in six areas.  These concerns question whether IFRS is the Holy Grail it is portrayed to be primarily because of various implementation and administrative issues.  Let’s turn to these issues.

First, the SEC says that IFRS must be sufficiently developed to apply the system to the U.S. reporting system.  The SEC then indicates there are concerns with respect to the comprehensiveness, the auditability and enforceability, and the consistent and high-quality application of IFRS.  The SEC staff notes that commentators have criticized IFRS because they allow savvy managers significant wiggle room to manipulate accounting numbers and disclosures and thwart efforts by auditors to perform high-quality audits.  Indeed, some wonder whether principles-based annual reports are even capable of being audited.  Another issue raised by the SEC is whether standards will be uniformly enforced around the globe—the answer is of course not.  The real questions are how divergent will this enforceability be and what will be its significance.

Second, the SEC probes the independence of the IASB, especially since much of its operating funds comes from corporate donations.  Do you think that maybe, just maybe, corporate donors want something in return?  Whether the board is free from undue influence won’t require much research since economic theory posits that managers have huge incentives to gain control over the IASB.  As an aside, many have criticized the FASB for moving at the pace of a tortoise.  Do they realize that the IASB will make the FASB seem like a hare?

Third, will investors understand IFRS?  The SEC staff promises to empirically assess the current knowledge of investors about the IFRS.  I wouldn’t waste the resources.  Except for institutional investors, the answer is they don’t understand IFRS, and they won’t have any incentives to learn until the change is imminent.  More importantly, as the costs for learning IFRS are large, we probably shouldn’t worry about investors.  Let them depend on the skills and independence of financial statement researchers and analysts.

Fourth, IFRS could have unknown effects in areas other than investments, the domain of the SEC.  For example, financial statements are used by industry and anti-trust regulators and federal and state taxing agencies.  Will an adoption of IFRS have a perverse effect on national and state policies?

Fifth, the SEC speculates about the impact of adopting IFRS on issuers, including changes to accounting information systems, implications for contracts that depend on accounting numbers, and concerns about corporate governance.  My short response is that it’s about time the SEC started thinking about these issues.  It is fairly clear to me that the adoption of IFRS will require many issuers to keep dual systems for several years.  Annual reports are utilized for too many things to move wholly to IFRS.  In turn this will add to the costs of adoption and to its complexity.

Sixth, the SEC mentions human capital readiness.  Except for the Big Four and some of the largest corporations, is anybody ready for the transition?  If the IASB opened up its data base and supplied users with free training materials, then maybe managers and analysts and accountants could prepare themselves for the transition—unless the banking industry or Congress decides to introduce new and worse problems for the business community.

As I survey this list, I again marvel at the rush to IFRS.  The benefits do not appear to match or exceed the costs of the adoption.  Nonetheless, I suppose we shall find ourselves employing IFRS within a decade.  Hopefully this pause by the SEC will address some of the most glaring challenges.

Of all the issues listed, the most important is this: whether IFRS statements can be audited and what will happen in the courtroom after a firm experiences severe declines in its stock price.  I predict that principles-based accounting will become rules as judges and juries fill in the details left out by the accounting profession and create accounting case law.  And then where will the benefit be?

This essay reflects the opinion of the author and not necessarily the opinion of The Pennsylvania State University.

An analysis of the Ketz editorial, by David Albrecht ---
http://profalbrecht.wordpress.com/2010/03/29/ed-ketz-a-beacon-of-sound-reason-about-ifrs/

Bob Jensen's threads on IFRS are at http://www.trinity.edu/rjensen/theory01.htm#MethodsForSetting

January 2010 IFRS Update from Ernst & Young ---
http://commons.aaahq.org/files/7d1fad745e/January_2010_IFRS_outlook.pdf

January 2010 Comparison of US GAAP versus IFRS from Ernst & Young
http://commons.aaahq.org/files/2ddee9578c/IFRS_Basics_Novemberr2009_BB1856.pdf

Bob Jensen's threads on free IFRS learning resources (including real-world cases) ---
http://www.trinity.edu/rjensen/theory01.htm#IFRSlearning

March 24, 2010 message from Roger Collins [Rcollins@TRU.CA]

http://business.timesonline.co.uk/tol/business/industry_sectors/engineering/article7073658.ece 

"The investigation was sparked by auditors at KPMG Fides Peat in Switzerland working for the Swiss Federal Banking Commission in 2004 after they stumbled upon documents detailing the transfer of €20 million by Alstom into various shell companies, according to The Wall Street Journal".

Roger

Roger Collins
TRU School of Business & Economics

Bob Jensen's Fraud Updates are at
http://www.trinity.edu/rjensen/fraudUpdates.htm

"The Two-Part CMA Exam for 2010," by James Martin, MAAW's Blog, March 20, 2010 ---
http://maaw.blogspot.com/2010/03/new-two-part-cma-exam-2010.html

Also see http://maaw.info/ArticleSummaries/ArtSumBrauschWhitney2010.htm

Bob Jensen's threads on management accounting are at
http://www.trinity.edu/rjensen/theory01.htm#ManagementAccounting

"Top Five: Secrets of a CPA Start-Up," by Rick Telberg, CPA Trendlines, March 8, 2010 --- Click Here
http://cpatrendlines.com/2010/03/08/top-five-secrets-of-a-cpa-start-up/?utm_source=feedburner&utm_medium=email&utm_campaign=Feed%3A+cpatrendlines%2FtPxN+%28CPA+Trendlines%29

Together, Brian and Darren Wendroff are working to innovate every aspect of how an accounting firm works. Take just five examples of their leading edge strategies:

1. Adopting flexible and supportive human resources policies — The firm’s tele-work policy was put in place to support a healthy work-life balance and to attract and retain the best talent for the money. But it also came in handy during the “snowpocalypse” that hit Washington in February, which otherwise might have ground their tax season to a halt.
    
2. Pursuing Web- and cloud-based business solutions — The firm is a pioneer in QuickBooks Online and sits on an Intuit advisory board. Their CRM system, Highrise, is all SaaS. And they manage many firm processes through Google Docs.
    
3. Aggressive experimentation with social media marketing — Twitter has yielded five new clients in the last year, billing about $14,000 annually. And the firm picked up two more in January. The last time I checked @wendroffcpa, they had over 13,000 followers. By comparison, @PwC_LLP, representing the largest accounting firm on the planet, had about 3,700.
    
4. Ruthless dedication to changing with client criticism — The firm sends out a client satisfaction survey twice a year, which is unusual enough. But they use the super-simple Net Promoter Score developed in part by Bain & Co. And they follow up with a memo to their client base baring the results and sharing their plans to improve.
    
5. Practicing the “sow-before-you-reap” verse is the new age marketing Bible — The firm offers free “Ask-a-CPA” Webinars on basic accounting or tax tips for clients and non-clients alike.  For business owners with at least $2 million in annual turnover, Wendroff & Associates organizes CEO peer-to-peer groups. “It’s a group where C-Level executives or business owners can talk frankly about issues affecting their organizations,” Darren says. “We wanted to join a group like this, and couldn’t find one, so we created ours.” The meetings are invitation-only, highly structured, single-topic and followed by a memo to all, which actually reads more like a Harvard Business School case study than minutes from a meeting.

It wasn’t always this way. When Brian first started the firm, he admits his fees were set too low and he was attracting the wrong clients. Today, fees are set to cover overhead and salaries, plus enough to plow back into the business. And the firm is now getting the right kind of clients — the kinds who want more than just bookkeeping or tax prep, but want and need strategic services.

The proof? Wendroff says, “Nearly every company we worked with last year grew through the recession.”

Derivative Financial Instruments and Their Fraud Timeline ---
http://www.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds

March 24, 2010 message from Miklos A. Vasarhelyi [miklosv@ANDROMEDA.RUTGERS.EDU]

Does anyone understand how the derivative contracts goldman create for Greece obfuscated its financial conditions?
how much is this a problem today for banks and industrials?

miklos

March 24, 2010 reply from Bob Jensen

Hi Miklos,

Especially note Titlos PLC ---
http://www.cs.trinity.edu/~rjensen/Calgary/CD/DerivativesTitlosPLC.pdf

Note the relatively early date on the article below (and especially note the comments that follow the article)
"Open Source Inquiry Opportunity: Some of Goldman's Greece Swaps ," Naked Capitalism, February 15, 2010  Click Here
http://www.nakedcapitalism.com/2010/02/open-source-inquiry-opportunity-some-of-goldmans-greece-swaps-made-public.html

In a New York Times op-ed late last year, Bill Black, Frank Partnoy, and Eliot Spitzer called for an open source investigation:

we know where the answers are. They are in the trove of e-mail messages still backed up on A.I.G. servers, as well as in the key internal accounting documents and financial models generated by A.I.G. during the past decade. Before releasing its regulatory clutches, the government should insist that the company immediately make these materials public. By putting the evidence online, the government could establish a new form of “open source” investigation.

Once the documents are available for everyone to inspect, a thousand journalistic flowers can bloom, as reporters, victims and angry citizens have a chance to piece together the story. In past cases of financial fraud — from the complex swaps that Bankers Trust sold to Procter & Gamble in the early 1990s to the I.P.O. kickback schemes of the late 1990s to the fall of Enron — e-mail messages and internal documents became the central exhibits in our collective understanding of what happened, and why.

Now it is worth noting that the emphasis in the Black/Partnoy/Spitzer argument was to get a lot of eyeballs on a large stash of source material that is presumably pretty accessible to the public, namely, e-mails.

But there is a second line of potential open-source inquiry that would be at least as valuable: getting people who have expertise in certain types of documentation to look probe transaction documentation for deals that were deceptive or had significant negative outcomes. Even with more and more investigators of various sorts getting their noses into various suspect-looking activities, a lot of the destructive behavior took place in the form of transactions that industry participants at the time would argue fell within normal, accepted practice. Understanding what was deficient about prevailing practice is therefore key to developing durable reforms.

For instance, one of the requirements in the FDIC’s proposed securitization reforms is to have the participants disclose their motivations and intentions as well as their fees. That means that parties like Goldman and Deutschebank, who teed up CDOs for the purpose of them taking a short position would have had to disclose that objective under the proposed regulations.

Reader Nick has provided a link to one of the now-infamous Goldman-Greek government swaps, which served to camouflage the magnitude of its fiscal deficits from the EU. His comments:

I came across the prospectus for the 5.1bn Euro Titlos PLC Asset Backed Notes which Goldman arranged for Greece in 2008.

This was the restructuring of a controversal 2005 swap, which, in turn, related to the infamous
“Aeolos” deal in 2001. Aeolos was the SPV which GS and the “Hellenic Civil Aviation Authority” used
to enable the Greeks to hide its borrowing and enter the EU under false pretenses.

See page 47 of the pdf file (page 43 of the document) under “Use of Proceeds”. I’m curious that no mention of Greece’s real motivation to do this deal — or previous ones — is mentioned. (Maybe it’s in the doc, but I sure couldn’t find it.)

Will the final net result of these derivative trades be a transfer from German and French taxpayers to Greece along with $300mm or so to GS?

Yves here. Per the remarks above on the FDIC, I’m not surprised at all regarding the lack of disclosure. And Nick’s comment raises a more basic point: how the use of forms and mechanisms from regulated markets have served to lull investors and issuers into a false sense of security.

Now here, Greece presumably knew exactly what it was doing. The whole point of this deal was to allow it to hide its failure to live up to its Maasricht obligations.

But even though I have looked at various types of deal documents for decades, something that should have been blindingly obvious occurred to me only tonight. This document, like all of its cousins, says very clearly that the securities (in this case, notes) will not be registered with the SEC, but will be listed on the Luxembourg stock exchange. So this one at least is subject to certain disclosure requirements. But as Nick points out, you sure couldn’t tell what the real motivation for the note deal was from this prospectus (as in the stated aim, while not necessarily untrue, was not the real driver).

But investors have over the course of decades come to expect that documents like this make a full and fair disclosure. The use of this particular form of presentation conveys the message (among others) that everything you need to know to invest is here. It may be somewhat obscured by clever lawyering or the relegation of key facts to financial footnotes, but the belief surrounding documents like this is that the investors have been told what they needed to know.

But we now know they weren’t. The SEC has a key notion in its disclosure rules, that failure to state a material fact is a no-no. It isn’t just that what a prospectus says has to be accurate, it also must not omit to state any material fact that would make the statements in the disclosure documents false or misleading.

And where did the chicanery that led to the crisis take place? Not in areas subject to the full force of SEC regulations, but areas completely outside its reach (derivatives) or where much weaker rules were operative (the rule 3a-7 exemption for asset backed securities).

In case readers think I am making overmuch of this process, consider: propaganda similarly suborns existing channels, in this case, the media. Most people believe that the press and TV tell them what they need to know, both in the sense that what they say is accurate, and anything they fail to cover must not be newsworthy. And even though we have had some stark evidence to the contrary, that the media can be used by the state for its own ends (witness the Creel Commission in World War I, as well as the run-up to the Iraq war) as well as influenced by powerful private interests, the conditioning, which is to trust the media, remains very much intact.

So as much as I welcome and encourage reader comments on the document that Nick pointed out, I’d also welcome reader input on where they think disclosure fell short, and why.

 

More on this topic (What's this?)

Greece Is Too Small? Really? (Random Roger's Big Picture, 2/9/10)

Greece: Trojan Horse or Triple Crown Winner? (Oxbury Publishing, 2/17/10)

REUTERS – GREECE TO BE BAILED OUT (THE PRAGMATIC CAPITALIST, 2/9/10)

Open Source Investing in Greece Wikinvest

Bob Jensen's free tutorials on derivatives and accounting for derivative financial instruments and hedging activities are at
http://www.trinity.edu/rjensen/caseans/000index.htm

What is the world is going to happen to private sector versus public sector auditing?

The big difference between private sector auditors versus government auditors is that we can sue the private sector auditors over and over and over until they make serious efforts to get it right. Virtually nothing is being done to make the government’s auditors get it right.

What my inside contacts in the large firms are telling me is that more than ever efforts are now being made to make their auditors independent to a point where they will stand up to their largest and most lucrative clients and demand that there be better GAAP and GAAS conformance ---
Advancing Quality through Transparency Deloitte LLP Inaugural Report --- 
http://www.cs.trinity.edu/~rjensen/temp/DeloitteTransparency Report.pdf  

I think the PCAOB audit reviews have contributed in a small but marked way to improve audits. But there’s a long way, miles and miles, to go before we sleep --- http://www.trinity.edu/rjensen/fraud001.htm

It’s Market Versus the Government!
The question is what’s the alternative? Those that want a Government’s Central Planning Board to allocate resources in the economy (in place of markets) are aiming the world economy for disaster, confusion, and disruption. And who keeps the government honest? At the moment the GAO declares that it’s impossible to audit our largest government agencies like the Pentagon, the IRS, etc. Government accountability, accounting, and auditing are in much worse shape than our far less-than-perfect private sector accountability, accounting, and auditing.
The Sad State of Government Accounting --- http://www.trinity.edu/rjensen/theory01.htm#GovernmentalAccounting
The Sad State of Private Sector Accounting --- http://www.trinity.edu/rjensen/fraud001.htm

No Resource Allocation System Can Exist Without Accountability, Accounting, and Auditing
Accountability, accounting, and auditing are necessary under any type of resource stewardship and resource allocation system. At one extreme we have markets, investors, and creditors who rely upon audits and stewardship accounting of the private sector market participants. The FASB and the IASB do indeed, in my viewpoint, focus on the information needs of those investors and creditors. The auditing firms, however, are faced with what Tom Selling calls a “broken model” where those being audited choose their auditors and negotiate the audit fees. This is certainly problematic if not completely broken.

The Government’s resource allocation system brought us the Jack Murtha Airport with its full security system, air controller system, six flights a day to only one destination, and less than 50 passengers a day. It’s a taxpayer cash flow black hole.

At the other extreme we have the government auditors who cannot get any type of  handle on how to audit the enormous agencies to a point with the auditors have just given up on total system audits. Nobody audits the Pentagon after the GAO declared it “unauditable.”
http://www.trinity.edu/rjensen/theory01.htm#GovernmentalAccounting

The world is not perfect, and certainly financial and commodities markets were manipulated by Enron, Lehman, Merrill, etc. Andersen’s audits were among the worst in the history of the world, and Andersen got its just dessert for not enforcing quality control of its audits. Government is the land of corrupt resource allocation that usually leads to even less efficient resource allocations than the market-based resource allocations.

I think auditing of banks has been a sham by virtually all the auditing firms, and these firms will soon pay a heavy price in court for certifying fiction of bank accounting for the thousands of banks that recently went “bank”rupt. Unless the large auditing firms overcome their sham audits of banks, they too will bite the dust.

The question is whether the professionalism/independence recovery efforts of all the large auditing firms can save them is still open to question. After all these years since Andersen imploded, I think the Wall Street bank audits indicate that the big auditing firms, in Art Wyatt’s wording, “still didn’t get it.” Art Wyatt was the lead executive research partner for Andersen. After Andersen imploded, Art observed the lack of professionalism in the surviving auditing firms and concluded that “They Still Don’t Get It” ---
http://aaahq.org/AM2003/WyattSpeech.pdf 
But the real problem in my viewpoint is not the mixing of consulting and auditing nearly as much as it is the "too big to lose" clients (read that as auditing firms being unwilling to quit the audit after spending so much time and money gearing up for the big-client audit).

Can you hear us now?
The question is whether the auditing firms, in the wake of the banking collapse and bailout, are more seriously listening and, more importantly, finally doing the right thing. Investors are amazingly tolerant of the cycles of scandal and promised reforms in the capital markets. The Dow remained amazingly high during all the recent Wall Street scandals and bailouts. And investors and creditors will have their day in court when they bring the bankers and their auditors to the dock ---
http://www.trinity.edu/rjensen/2008Bailout.htm#AuditFirms

But nobody is bringing the broken government accounting and auditing system to the dock. You can’t usually sue the government. Many of the recent frauds could’ve been prevented or mitigated by the SEC, but the SEC is not being held accountable for its huge failures, especially under an incompetent political hack named Chris Cox.

Question

What’s the big difference between Soviet Union Accounting in 1960 and accounting in the U.K. and the U.S. in 2010?

Answer
In the Soviet Union the public could not haul the sham auditors into court. Accounting in the Soviet Union really was fiction writing at all levels of enterprise. In the Soviet Union there could never be a Prem Sikka, an Abe Briloff, a Frank Partnoy, a Mark Lewis, a Lynn Turner, or a CBS Sixty Minutes. Why does Prem Sikka now want to destroy our market system and model us after the Soviet Union? Perhaps I’m being unfair to Prem. He tears at the foundations of markets without ever suggesting what he thinks should take their place for an economy’s resource allocation system. Others like Partnoy, Lewis, and Turner want to “make markets be markets” with better accountability and auditing”
"Make Markets Be Markets"
 "Bring Transparency to Off-Balance Sheet Accounting," by Frank Partnoy, Roosevelt Institute, March 2010 ---
 http://www.rooseveltinstitute.org/policy-and-ideas/ideas-database/bring-transparency-balance-sheet-accounting
 Watch the video!

Why aren’t we hauling the GAO and the SEC and government watchdogs in general into court and demanding that they make at least as much effort at reform as the private sector accountants and auditors?

The big difference between private sector auditors versus government auditors is that we can sue the private sector auditors over and over and over until they make serious efforts to get it right. Virtually nothing is being done to make the government’s auditors get it right.
http://www.trinity.edu/rjensen/fraud001.htm

Absolutely Must-See CBS Sixty Minutes Videos
You, your students, and the world in general really should repeatedly study the following videos until they become perfectly clear!
Two of them are best watched after a bit of homework.

Video 1
CBS Sixty Minutes featured how bad things became when poison was added to loan portfolios. This older Sixty Minutes Module is entitled "House of Cards" --- http://www.cbsnews.com/video/watch/?id=3756665n&tag=contentMain;contentBody
This segment can be understood without much preparation except that it would help for viewers to first read about Mervene and how the mortgage lenders brokering the mortgages got their commissions for poisoned mortgages passed along to the government (Freddie Mack and Fannie Mae) and Wall Street banks. On some occasions the lenders like Washington Mutual also naively kept some of the poison planted by some of their own greedy brokers.
The cause of this fraud was separating the compensation for brokering mortgages from the responsibility for collecting the payments until the final payoff dates.

First Read About Mervene --- http://www.trinity.edu/rjensen/2008Bailout.htm#Sleaze

Then Watch Video 1 at http://www.cbsnews.com/video/watch/?id=3756665n&tag=contentMain;contentBody

Videos 2 and 3
Inside the Wall Street Collapse (Parts 1 and 2) first shown on March 14, 2010

Video 2 (Greatest Swindle in the History of the World) --- http://www.cbsnews.com/video/watch/?id=6298154n&tag=contentMain;contentAux

Video 3 (Swindler's Compensation Scandals) --- http://www.cbsnews.com/video/watch/?id=6298084n&tag=contentMain;contentAux

My wife and I watched Videos 2 and 3 on March 14. Both videos feature one of my favorite authors of all time, Michael Lewis, who hhs been writing (humorously with tongue in cheek) about Wall Street scandals since he was a bond salesman on Wall Street in the 1980s. The other person featured on in these videos is a one-eyed physician with Asperger Syndrome who made hundreds of millions of dollars anticipating the collapse of the CDO markets while the shareholders of companies like Merrill Lynch, AIG, Lehman Bros., and Bear Stearns got left holding the empty bags.

The major lessons of videos 2 and 3 went over the head of my wife. I think that viewers need to do a bit of homework in order to fully appreciate those videos. Here's what I recommend before viewing Videos 2 and 3 if you've not been following details of the 2008 Wall Street collapse closely:

• Read about Mervene if you did not already do so for Video 1 ---  http://www.trinity.edu/rjensen/2008Bailout.htm#Sleaze
  
   
• Be able to define a CDO and relate a poisoned CDO to Mervene's mortgage (particularly the bit Wall Street bankers slicing and dicing Mervene's hopeless mortgage into multiple CDOs in an effort to diversify repayment risk among various international buyers of this diversified poison)..
  CDO --- http://en.wikipedia.org/wiki/Collateralized_debt_obligation
  How CDOs brought down the banks --- http://www.trinity.edu/rjensen/2008Bailout.htm#Sleaze
   

This is not necessary to Videos 2 and 3, but to really appreciate what suckered the Wall Street Banks into spreading the poison, you should read about how they all used the same risk diversification mathematical function --- David Li's Gaussian Copula Function:

Can the 2008 investment banking failure be traced to a math error?
Recipe for Disaster:  The Formula That Killed Wall Street --- http://www.wired.com/techbiz/it/magazine/17-03/wp_quant?currentPage=all
Link forwarded by Jim Mahar ---
http://financeprofessorblog.blogspot.com/2009/03/recipe-for-disaster-formula-that-killed.html 

Some highlights:

"For five years, Li's formula, known as a Gaussian copula function, looked like an unambiguously positive breakthrough, a piece of financial technology that allowed hugely complex risks to be modeled with more ease and accuracy than ever before. With his brilliant spark of mathematical legerdemain, Li made it possible for traders to sell vast quantities of new securities, expanding financial markets to unimaginable levels.

His method was adopted by everybody from bond investors and Wall Street banks to ratings agencies and regulators. And it became so deeply entrenched—and was making people so much money—that warnings about its limitations were largely ignored.

Then the model fell apart." The article goes on to show that correlations are at the heart of the problem.

"The reason that ratings agencies and investors felt so safe with the triple-A tranches was that they believed there was no way hundreds of homeowners would all default on their loans at the same time. One person might lose his job, another might fall ill. But those are individual calamities that don't affect the mortgage pool much as a whole: Everybody else is still making their payments on time.

But not all calamities are individual, and tranching still hadn't solved all the problems of mortgage-pool risk. Some things, like falling house prices, affect a large number of people at once. If home values in your neighborhood decline and you lose some of your equity, there's a good chance your neighbors will lose theirs as well. If, as a result, you default on your mortgage, there's a higher probability they will default, too. That's called correlation—the degree to which one variable moves in line with another—and measuring it is an important part of determining how risky mortgage bonds are."

I would highly recommend reading the entire thing that gets much more involved with the actual formula etc.

The “math error” might truly be have been an error or it might have simply been a gamble with what was perceived as miniscule odds of total market failure. Something similar happened in the case of the trillion-dollar disastrous 1993 collapse of Long Term Capital Management formed by Nobel Prize winning economists and their doctoral students who took similar gambles that ignored the “miniscule odds” of world market collapse -- -
http://www.trinity.edu/rjensen/FraudRotten.htm#LTCM  

The rhetorical question is whether the failure is ignorance in model building or risk taking using the model?

 

• You should understand how the Wall Street Banks used the big credit rating agencies to give AAA ratings to sell CDO bonds that should've instead been rated as junk bonds. Michael Lewis in Video 2 seems to think the credit rating agencies were just naive and were manipulated by the Wall Street bankers. I'm more inclined to think the CRAs were knowingly and greedily part of the frauds ---  http://www.trinity.edu/rjensen/2008Bailout.htm#Sleaze
  CRA --- http://en.wikipedia.org/wiki/Credit_rating_agency
  
   
• You should also understand what a credit default swap (CDS) is and how Video 2 above keeps calling it unregulated credit "insurance." Essentially, this is how some banks, particularly Goldman Sachs was "insuring" against the value collapse of the poisoned CDOs they were creating and selling. The "insurance" company brokering the AIG credit default swaps was AIG.
  CDS --- http://en.wikipedia.org/wiki/Credit_default_swap
  Here's how they worked ---  http://www.trinity.edu/rjensen/2008Bailout.htm#Sleaze
  
   
• Understand how some Wall Street Banks were better connected in the Treasury Department and Federal Reserve than other banks. In particular, Goldman Sachs alumni were practically in charge while Hank Paulson (former Goldman Sachs CEO) was U.S. Treasury Secretary. Why did Paulson save Goldman Sachs and let others watch their shareholders get wiped out like Lehman Bros., Bear Stearns, Merrill Lynch, etc.? Understand why saving Goldman Sachs with TARP money entailed saving AIG since saving AIG was crucial to paying off the CDS insurance.
  
   
• For the above three videos it is not necessary to understand the lack of professionalism (at best) among the bank auditors that never provided any warning that thousands of banks that failed had badly underestimated bad debts and overvalued poisoned loan portfolios. The above videos do not get into the failings of the CPA auditors in this regard, but you can read about these failings at
  http://www.trinity.edu/rjensen/2008Bailout.htm#AuditFirms

For more on the inside track of all of this I highly recommend Janet Tavakili's great book entitled Dear Mr. Buffett (Wiley, 2009). Videos 1-3 will help you understand some of the technicalities in her fantastic and very depressing book.

Here are some of the take-aways from the three CBS videos above:

• The root cause of the 2008 meltdown of Wall Street was really the failings on Main Street where the poison was first added to mortgages by Main Street brokers who were willing to broker mortgages (including re-financings) that were bound to be defaulted. Note that the problem was not just in brokering mortgages for poor people (Barney's Rubble). Poisoned mortgages were also being written for higher income people who were borrowing beyond their means for those four-car garage dream houses with swimming pools and marble floors. In other words the root cause was the ability to broker a poisoned mortgage and then sell it to Freddie Mack, Fannie Mae, and the Wall Street Banks.
  
   
• The next cause of the 2008 meltdown was David Li's risk diversification formula that all the Wall Street banks were using on the theory that default risk of mortgage investments could be diversified by crumbling mortgage cookies into crumbs that were reassembled into thousands of CDOs (each CDO having only a small crumble of each mortgage's poison). With the blessings of credit rating agencies, these CDO bonds were then sold as AAA-rated when in fact they were worse than junk.
  
   
• Videos 2 and 3 above stress how the underlying cause of allowing a one-eyed physician with Asperger Syndrome make hundreds of millions dollars by detecting the collapse of the CDO values way in advance of the Wall Street pros is that the Wall Street pros were paid not to look for the CDO risks. And the bank CDO sellers who perhaps did understand the risks were willing to screw their eimployers (such as Lehman, Bear Stearnes, etc.) because it was so easy to steal hundreds of millions from these employers who were even willing and still are willing to pay them bonuses in spite of their thefts.
  
   
• After the government bailed them out, the Wall Street banks that survived because of the government's bailout are still paying out billions in bonuses. One of my favorite quotes in Video 2 goes something like:
  
  "If Goldman does not pay its best people billions in bonuses they will quit and go to JP Morgan, and if JP Morgan does not pay its best people billions in bonuses they will quit and go to Goldman." Meanwhile the taxpayers got screwed out of nearly a trillion dollars.
  
   
• Video 2 leaves us with the impression that Wall Street is no longer a value-added part of U.S. economy. The TARP in reality is truly the Greatest Swindle in the History of the World --- http://www.trinity.edu/rjensen/2008Bailout.htm#Bailout
  Meanwhile the surviving swindlers and their credit rating agencies and their auditors are still thriving as if nothing has happened. Opps! I forgot that the credit rating agencies and auditing firms still have some multi-billion shareholder lawsuits pending that do threaten their survival. But a lot of big swindlers still have their yachts thanks to Hank and Ben and Tim.

I highly recommend the outstanding and often humorous books of both Michael Lewis and Frank Partnoy.
My timeline of these books and the scandals they write about can be found at
http://www.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds

Rotten to the Core --- http://www.trinity.edu/rjensen/FraudRotten.htm

Related CBS Sixty Minutes videos are as follows:

• Video:  Strong ARM of Mortgage Bubble is Building to Burst: 
  "Second Financial Economic Crash Coming - Huge & Soon," CBS Sixty Minutes --- http://www.youtube.com/watch?v=JKlBJavw_X4
  
   

• CBS Sixty Minutes on June 14, 2009 ran a rerun that is devastatingly critical of the SEC. If you’ve not seen it, it may still be available for free (for a short time only) at http://www.cbsnews.com/video/watch/?id=5088137n&tag=contentMain;cbsCarousel
  The title of the video is “The Man Who Would Be King.”
  Also see http://www.fraud-magazine.com/FeatureArticle.aspx
  
   

• Financial WMDs (Credit Derivatives) on Sixty Minutes (CBS) on August 30, 2009 ---
  http://www.cbsnews.com/video/watch/?id=5274961n&tag=contentBody;housing
  
   

• CBS Sixty Minutes on June 14, 2009 ran a rerun that is devastatingly critical of the SEC ---
  http://www.cbsnews.com/video/watch/?id=5088137n&tag=contentMain;cbsCarousel
  The title of the video is “The Man Who Would Be King.”
  Also see http://www.fraud-magazine.com/FeatureArticle.aspx
  
   

• David Walker's Wake Up Call ---
  http://www.cbsnews.com/video/watch/?id=2532398n&tag=mncol;lst;8

I also recommend watching all the David Walker videos on YouTube.
Watch them and weep.

I also recommend watching all the David Walker videos on YouTube.
Watch them and weep.

March 16, 2010 reply from Paul Williams [Paul_Williams@NCSU.EDU]

Bob, I concur -- I watched 60 Minutes last night and the interview with Michael Lewis was spellbinding. What emerges from Lewis descriptions is just how much of the financial crisis can be laid at the feet of modern finance theory -- that which emerged out of Chicago and such places back in the late fifties and sixties. As Keynes remarked about practical men (the remainder of that familiar observation is even more prescient, "Mad men in authority who hear voices in the air distill their particular frenzy from some academic scribbler of a few years back.").

In modern finance theory (starting with portfolio theory of Markowitz, then the CAPM) asset prices became simply a function of other asset prices and financial markets were made into a closed system The fixation on betas make asset prices a function of other asset prices within that market and become theoretically disconnected from the real economy that purportedly underlies the value of everything. There is a book that just came out titled, The Quants," about the takeover of Wall Street by the math types (PhDs in physics that could make more money as "analysts" than as physicists).

The tragedy in every Greek tragedy has its origins in hubris and modern finance theory has contributed more to the hubris that Lewis decribed than anything else. Lewis observation about capitalism being destroyed by the capitalists brings to mind Alan Wolfe's observation that throughout history it has always been capitalism's critics that have saved it from itself.

 This time it may not happen because financial reform seems to have no traction. Recalling an earlier photo, circulated on AECM, taken on Wall Street, if the F... won't jump on his own, maybe he needs a little push.

Ah, the innocence of youth.
What really happened in the poisonous CDO markets?

The Senior Thesis
"The Story of the CDO Market Meltdown: An Empirical Analysis," by Anna Katherine Barnett-Hart, Harvard University, March 19, 2010 ---
http://www.hks.harvard.edu/m-rcbg/students/dunlop/2009-CDOmeltdown.pdf

I previously mentioned three CBS Sixty Minutes videos that are must-views for understanding what happened in the CDO scandals. Two of those videos centered on muckraker Michael Lewis. My friend, the Unknown Professor, who runs the Financial Rounds Blog, recommended that readers examine the Senior Thesis of a Harvard student.

"Michael Lewis’s ‘The Big Short’? Read the Harvard Thesis Instead," by Peter Lattman, The Wall Street Journal, March 20, 2010 ---
http://blogs.wsj.com/deals/2010/03/15/michael-lewiss-the-big-short-read-the-harvard-thesis-instead/tab/article/

Deal Journal has yet to read “The Big Short,” Michael Lewis’s yarn on the financial crisis that hit stores today. We did, however, read his acknowledgments, where Lewis praises “A.K. Barnett-Hart, a Harvard undergraduate who had just written a thesis about the market for subprime mortgage-backed CDOs that remains more interesting than any single piece of Wall Street research on the subject.”

While unsure if we can stomach yet another book on the crisis, a killer thesis on the topic? Now that piqued our curiosity. We tracked down Barnett-Hart, a 24-year-old financial analyst at a large New York investment bank. She met us for coffee last week to discuss her thesis, “The Story of the CDO Market Meltdown: An Empirical Analysis.” Handed in a year ago this week at the depths of the market collapse, the paper was awarded summa cum laude and won virtually every thesis honor, including the Harvard Hoopes Prize for outstanding scholarly work.

Last October, Barnett-Hart, already pulling all-nighters at the bank (we agreed to not name her employer), received a call from Lewis, who had heard about her thesis from a Harvard doctoral student. Lewis was blown away.

“It was a classic example of the innocent going to Wall Street and asking the right questions,” said Mr. Lewis, who in his 20s wrote “Liar’s Poker,” considered a defining book on Wall Street culture. “Her thesis shows there were ways to discover things that everyone should have wanted to know. That it took a 22-year-old Harvard student to find them out is just outrageous.”

Barnett-Hart says she wasn’t the most obvious candidate to produce such scholarship. She grew up in Boulder, Colo., the daughter of a physics professor and full-time homemaker. A gifted violinist, Barnett-Hart deferred admission at Harvard to attend Juilliard, where she was accepted into a program studying the violin under Itzhak Perlman. After a year, she headed to Cambridge, Mass., for a broader education. There, with vague designs on being pre-Med, she randomly took “Ec 10,” the legendary introductory economics course taught by Martin Feldstein.

“I thought maybe this would help me, like, learn to manage my money or something,” said Barnett-Hart, digging into a granola parfait at Le Pain Quotidien. She enjoyed how the subject mixed current events with history, got an A (natch) and declared economics her concentration.

Barnett-Hart’s interest in CDOs stemmed from a summer job at an investment bank in the summer of 2008 between junior and senior years. During a rotation on the mortgage securitization desk, she noticed everyone was in a complete panic. “These CDOs had contaminated everything,” she said. “The stock market was collapsing and these securities were affecting the broader economy. At that moment I became obsessed and decided I wanted to write about the financial crisis.”

Back at Harvard, against the backdrop of the financial system’s near-total collapse, Barnett-Hart approached professors with an idea of writing a thesis about CDOs and their role in the crisis. “Everyone discouraged me because they said I’d never be able to find the data,” she said. “I was urged to do something more narrow, more focused, more knowable. That made me more determined.”

She emailed scores of Harvard alumni. One pointed her toward LehmanLive, a comprehensive database on CDOs. She received scores of other data leads. She began putting together charts and visuals, holding off on analysis until she began to see patterns–how Merrill Lynch and Citigroup were the top originators, how collateral became heavily concentrated in subprime mortgages and other CDOs, how the credit ratings procedures were flawed, etc.

“If you just randomly start regressing everything, you can end up doing an unlimited amount of regressions,” she said, rolling her eyes. She says nearly all the work was in the research; once completed, she jammed out the paper in a couple of weeks.

“It’s an incredibly impressive piece of work,” said Jeremy Stein, a Harvard economics professor who included the thesis on a reading list for a course he’s teaching this semester on the financial crisis. “She pulled together an enormous amount of information in a way that’s both intelligent and accessible.”

Barnett-Hart’s thesis is highly critical of Wall Street and “their irresponsible underwriting practices.” So how is it that she can work for the very institutions that helped create the notorious CDOs she wrote about?

“After writing my thesis, it became clear to me that the culture at these investment banks needed to change and that incentives needed to be realigned to reward more than just short-term profit seeking,” she wrote in an email. “And how would Wall Street ever change, I thought, if the people that work there do not change? What these banks needed is for outsiders to come in with a fresh perspective, question the way business was done, and bring a new appreciation for the true purpose of an investment bank - providing necessary financial services, not creating unnecessary products to bolster their own profits.”

Ah, the innocence of youth.

The Senior Thesis
"The Story of the CDO Market Meltdown: An Empirical Analysis," by Anna Katherine Barnett-Hart, Harvard University, March 19, 2010 ---
http://www.hks.harvard.edu/m-rcbg/students/dunlop/2009-CDOmeltdown.pdf

 A former colleague and finance professor at Trinity University recommends following up this Harvard student’s senior thesis with the following:

Bob Jensen’s threads on the CDO and CDS scandals ---
http://www.trinity.edu/rjensen/2008Bailout.htm#Sleaze

Legal Research References and Links --- http://www.trinity.edu/rjensen/fraud001.htm

March 13, 2010 message from David Albrecht [albrecht@PROFALBRECHT.COM]

I know that most Big4 lawsuits are settled out of court. Is there anyplace on the web a listing of Big 4 lawsuits?

Although it might be argued that settling is a business decision, I think a settlement is a symbolic defeat by the CPA firm.

David Albrecht

March 14, 2010 reply from Bob Jensen

Hi David,

Lawyers are going to use their very expensive legal research databases. A list of sources in the U.S. is provided in
http://en.wikipedia.org/wiki/Legal_Research

I know of no free Web reference that records all criminal and civil actions where a Big Four firm is a defendant.
Big Four lawsuits can arise in over 100 nations (recently one of the largest actions in history was filed in Hong Kong, where the Ernst & Young partner in charge was actually jailed) --- http://www.trinity.edu/rjensen/fraud001.htm#Ernst

The Audit Analytics database has a lot of the auditor lawsuits classified by year ---
http://www.auditanalytics.com/
Examples for 2006 are at http://www.trinity.edu/rjensen/AuditingFirmLitigationNov2006.pdf

In the U.S. there are both state and federal jurisdictions. And there can be individual or class action lawsuits brought by plaintiffs. One of the better sources for federal securities class action lawsuits is the Stanford University Law School Federal Class Action Clearinghouse ---
http://securities.stanford.edu/
But this by no means covers most of the lawsuits against large auditing firms. In fact, the database has surprisingly few hits for Big Four firms. Many of the SEC lawsuits are not in this database.

Keep in mind that auditors are usually secondary in lawsuits with their clients being the primary defendants. Most of the lawsuits are probably filed in the state where a corporate client is licensed as a corporation, which gives Delaware a lot of lawsuits.

For the past ten years I’ve tried to keep tidbits on the highly publicized lawsuits involving large auditing firms ---
http://www.trinity.edu/rjensen/fraud001.htm
Interestingly, auditing firms sometimes win in courts, as recently happened when Ernst & Young emerged as a winner.

For lawsuits dealing with derivative financial instruments I also have a tidbit timeline at
http://www.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds

Of course the lawyers are going to use their very expensive legal research databases. A list of sources in the U.S. is provided in
http://en.wikipedia.org/wiki/Legal_Research

I don’t have time at the moment, but it would be interesting to see how much PwC provides in the Comperio database. Since this database is heavily used by clients, my guess is that Comperio is not a good source for searching auditor lawsuits.

There are also instances where an auditing firm is a plaintiff, usually where it is suing a former client.

There can also be criminal cases like the recent case where the managing partner of PwC in England was charged with stealing money from PwC to pay for the luxurious tastes of his mistress ---
http://www.trinity.edu/rjensen/fraud001.htm#PwC

Bob Jensen

 March 14, 2010 reply from Orenstein, Edith [eorenstein@FINANCIALEXECUTIVES.ORG]

Some limited data regarding litigation for the six largest audit firms (U.S. data only, as of 2007) was provided by the Center for Audit Quality (CAQ) - an affiliate of the AICPA, in reports to the U.S. Treasury Advisory Committee on the Auditing Profession (ACAP).

For example, among CAQ's  reports to ACAP, CAQ's Jan. 23, 2008 report to ACAP included a section on Litigation. A caveat in the CAQ report states:

"Information regarding litigation is highly sensitive, because of the risk that the data could be used

unfairly against a firm in litigation. For these reasons, the data presented in this report were gathered from the six audit firms and aggregated (the data relate only to claims against the six U.S. firms and do not include claims in U.S. courts against any non-U.S. firms that are members of the same networks). To prevent "reverse engineering" of the data to tie specific facts to a specific lawsuit or firm, the data have been grouped - for example, aggregating data from several different years. The litigation data discussed in this report do not include information relating to government inquiries, investigations, or enforcement actions.31"  [Footnote 31 in the CAQ report states: "2007 litigation data in this report reflect submissions by five firms of information as of December 20, 2007 and by one firm of information as of November 30, 2007."]

Additionally, CAQ's Second Supplement to ACAP (4/16/08) included data on private actions and shareholder class actions.

Treasury's ACAP published its final report  in 2008; here is related summary in FEI blog.

Edith Orenstein
Director of Accounting Policy Analysis and Communications
Financial Executives International (FEI)
1250 Headquarters Plaza, West Tower, 7th Floor
Morristown, NJ  07932
(973) 765-1046
eorenstein@financialexecutives.org
web: www.financialexecutives.org
blog: www.financialexecutives.blogspot.com
twitter: www.twitter.com/feiblog

---

 

March 14,2010 message from Francine McKenna [retheauditors@GMAIL.COM]

Dave,

I try to keep up as best I can on litigation against the auditors. It's not easy since I am not an attorney and do not have access to their databases.  I depend of the "kindness of lawyer strangers" to help me often.  

It's not easy since auditors are often one of many defendants in a class action lawsuit , for example. Often news reports or other blog posts do not include all the defendants if auditors are not the focus of the story.  Which they are often not.  Which is why my site is useful.

 I look at the lists compiled by Kevin LaCroix on his site DandODiary.com of securities litigation and class action suits, Francis Pileggi of DelawareLitigation.com also mentions suits against or by auditors (as in the Deloitte suit against their own Vice Chairman ) when they make it to Delaware Chancery Court. They both keep an eye out for me now and it was Frans=cis who alerted me to both the judgement against Deloitte's Flanagan and the recent "in pari delicto" case against pwC.

I also use a site called Justia to look for all other suits against the firms, often focused on suits in Federal Courts.  

http://dockets.justia.com/

The Stanford Law School database is also useful for getting the actual filings and documents. http://securities.stanford.edu/

Interestingly PwC does a great job tracking everyone else's 10b-5 litigation  - except their own.  You will never see auditor litigation broken out in their report.

http://10b5.pwc.com/public/Default.aspx

Bob is right to say that there's a whole slew of suits, at times very large and important that are outside of the US, such as the ones in Hong Kong against EY.  For that I count on Google Alerts (and my blog readers) to alert me, sometimes at odd hours of the night, of new developments.

http://retheauditors.com/category/auditor-litigation/

http://retheauditors.com/2009/07/11/mckenna-on-auditor-litigation-securities-dockets-mid-year-update/

fm

Repo105 --- http://en.wikipedia.org/wiki/Repo_105

Thanks XXXXX for the heads up!

 Dear Bob,

Please don't forward this email with my name, but I thought you may find the info below of interest, you may (or may not) want to cut/paste info below to share with others; if you do share it, please don't attribute the comments to me, it can just be someone who prefers to be anonymous). Thank you!

www.repo105.com strikes me as possibly being a spam site, maybe even authored by someone overseas, due to some misspellings on their site including "Bernie Maddof" and "Dick Chaney."

Moreover, it looks like the site may have been set up to get attention of people looking for info on "Repo 105" but drives them to their own business which apparently is selling FX or gold trading, e.g. this para. on their website:    

"Financial markets may well roil in the throws of this latest revelation, especially if the practice is shown to be widespread

From

XXXXX

Jensen Comment
An evolving site that might one day be quite good for Repo 105 information might be
http://en.wikipedia.org/wiki/Repo_105
Currently I think my links below will be more useful on this accounting controversy.

Bob Jensen’s threads on the Lehman/Ernst Repo 105 mess will soon be available at
http://www.trinity.edu/rjensen/fraud001.htm#Ernst

Also see http://www.trinity.edu/rjensen/2008Bailout.htm#AuditFirms

Former employees of Big Four firms (alumni) have a blog that is generally upbeat and tends not to be critical of their former employers
However, with respect to the impact of the Lehman Bankruptcy Examiners Report, this Big Four Blog is unusually critical of Ernst and Young and predicts a very tough time for E&Y in the aftermath.

The next few days will reveal how the regulators, erstwhile shareholders of Lehman and other stakeholders will move against E&Y. Valukas’ statement that there is sufficient evidence to show that E&Y was negligent is enough to spur a whole host of law suits. E&Y is in a very tough spot now, and while it may escape an imploding collapse like Andersen, the long tail of Lehman is sure to create a strong whiplash with painful monetary, reputational and punitive
"Ernst and Young Found Negligent in Lehman Report, Tough Consequences," The Big Four Blog, March 17, 2010 ---
http://bigfouralumni.blogspot.com/2010/03/ernst-and-young-found-negligent-in.html

There’s been so much press on the recently released report on the spectacular failure of Lehman Brothers by Anton Valukas, so we’ll just focus on the key elements which involve Lehman’s auditor Ernst & Young.

Valukas is highly critical of E&Y’s work, claiming that they did not perform the due diligence needed by audit firms, the ultimate watchdog of investors’ interests. He believes there is a case of negligence and professional malpractice against the firm. Though in a very limited sense Lehman perhaps followed standard accounting principles, and this is the basis on which E&Y signed off on their annual and quarterly filings, they wrongly categorized a repo as a sale to knowingly report a lower leverage ratio, they exceeded internal limits on the infamous Repo 105, and they found a loophole in the British system to execute these transactions, and keep them off the public eye.

Lehman was clearly at fault and grossly fraudulent in hiding this from investors, and then obfuscating answers to clear questions from analysts. Is Ernst and Young equally culpable?

E&Y should have been more rigorous in pursuing this issue, knowing that it was material, being misrepresented and highly abused. With full knowledge of its usage, and then signing off on SEC documents is definitely negligent.

E&Y is now being investigated by the FRC in the UK and very likely in due course by the SEC. The Saudi government has already cancelled E&Y’s security license in the kingdom. The law suits are yet to hit the wires, but they are coming. The key is whether a criminal indictment of the firm is likely, recall that this is what brought down Andersen. Dealing with civil suits is only a matter of money, but a criminal charge is going to send clients away in droves. The critical question is whether the industry can withstand the loss of a $20 billion accounting giant, the consequences of a Big Three are quite hard to imagine.

E&Y was recently hit with a $8.5 million fine by the SEC for its involvement with Bally Fitness, and in that settlement E&Y agreed to tighten internal procedures and refrain from audit abuse. So the SEC is unlikely to look favorably on this.

The next few days will reveal how the regulators, erstwhile shareholders of Lehman and other stakeholders will move against E&Y. Valukas’ statement that there is sufficient evidence to show that E&Y was negligent is enough to spur a whole host of law suits.

E&Y is in a very tough spot now, and while it may escape an imploding collapse like Andersen, the long tail of Lehman is sure to create a strong whiplash with painful monetary, reputational and punitive consequences.

Bob Jensen's threads on the Examiner's Report aftermath can be found at
http://www.trinity.edu/rjensen/fraud001.htm#Ernst

Lehman/Ernst Teaching Case on the Largest Bankruptcy in History
March 18, 2010 message from Bob Jensen

Dear Jim,

The Repo 105 issue was more like having a poisoned CDO bond worth $1 that you sell for $1,000 with a guaranteed buyback in a week for $1,005. That way you report a sale for $1,000, an asset of $0 in the balance sheet for a “sold investment,” and $0 for the liability to buy it back. Sounds like a bad economic deal and a great OBSF ploy. Of course it’s not necessarily boosting earnings if you paid more than $1,000 for the CDO cookie crumbles in the first place in the first place.

But it sure beats writing investments down from $1,000 to a $1.

Ernst and Young claims using these contracts to keep billions of dollars of poison investments and unbooked debt out of the financial statements result fairly present the financial status of sales and liabilities in the financial statements.

Do our Accounting 101 and Auditing 101 students concur?
God help this profession if our students side with Ernst & Young!

Frank Partnoy and Lynn Turner contend that Wall Street bank accounting is an exercise in writing fiction:
Watch the video! (a bit slow loading)
Lynn Turner is Partnoy's co-author of the white paper."Make Markets Be Markets"
"Bring Transparency to Off-Balance Sheet Accounting," by Frank Partnoy, Roosevelt Institute, March 2010 ---
http://www.rooseveltinstitute.org/policy-and-ideas/ideas-database/bring-transparency-balance-sheet-accounting
Watch the video!

Bob Jensen

Lehman/Ernst Teaching Case on the Largest Bankruptcy in History
From The Wall Street Journal Accounting Weekly Review on March 19, 2010

Examiner: Lehman Torpedoed Lehman
by: Mike Spector, Susanne Craig, Peter Lattman
Mar 11, 2010
Click here to view the full article on WSJ.com

TOPICS: Advanced Financial Accounting, Debt, Degree of Operating Leverage, Disclosure, Revenue Recognition

SUMMARY: "A federal judge released a scathing report on the collapse of Lehman Brothers Holdings Inc. that singles out senior executives, auditor Ernst & Young and other investment banks for serious lapses that led to the largest bankruptcy in U.S. history...." The report focuses on the use of "repos" to improve the appearance of Lehman's financial condition as it worsened with the market declines beginning in 2007. "Mr Valukus, chairman of law firm Jenner & Block, devotes more than 300 pages alone to balance sheet manipulation..." through repo transactions. As explained more fully in the related articles, repurchase agreements are transactions in which assets are sold under the agreement that they will be repurchased within days. Yet, when Lehman exchanged assets with a value greater than 105% of the cash received for them, the company would report it as an outright sale of the asset, not a loan, thus reducing the firms apparent leverage. These transactions were based on a legal opinion of the propriety of this treatment made for their European operations, but the company never received such an opinion letter in the U.S., so Lehman transferred assets to Europe in order to execute the trades. The second related article clarifies these issues. Of course, this was but one significant problem; other forces helped to "tip Leham over the brink" into bankruptcy including J.P. Morgan Chases' "demands for collateral and modifications to agreements...that hurt Lehman's liquidity...."

CLASSROOM APPLICATION: The questions ask students to understand repurchase agreements and cases in which financing (borrowing) transactions might alternatively be treated as sales. The role of the auditor, in this case Ernst & Young, also is highlighted in the article and in the questions in this review.

QUESTIONS: 
1. (Introductory) What report was issued in March 2010 regarding Lehman Brothers? Summarize some main points about the report.

2. (Advanced) Based on the discussion in the main and first related articles, describe the "repo market'. What is the business purpose of these transactions?

3. (Advanced) How did Lehman Brothers use repo transactions to improve its balance sheet? Note: be sure to refer to the related articles as some points in the main article emphasize the impact of removing the assets that are subject to the repo agreements from the balance sheet. The main point of your discussion should focus on what else might have been credited in the entries to record these transactions.

4. (Introductory) Refer to the second related article. What was the role of Lehman's auditor in assessing the repo transactions? What questions have been asked of this firm and how has E&Y responded?

Reviewed By: Judy Beckman, University of Rhode Island

RELATED ARTICLES: 
Lehman Maneuver Raises Accounting Question.
by David Reilly
Mar 13, 2010
Online Exclusive

 

"Examiner: Lehman Torpedoed Lehman," by: Mike Spector, Susanne Craig, Peter Lattman, The Wall Street Journal, Mar 11, 2010 ---
http://online.wsj.com/article/SB10001424052748703625304575115963009594440.html?mod=djem_jiewr_AC_domainid

A scathing report by a U.S. bankruptcy-court examiner investigating the collapse of Lehman Brothers Holdings Inc. blames senior executives and auditor Ernst & Young for serious lapses that led to the largest bankruptcy in U.S. history and the worst financial crisis since the Great Depression.

In the works for more than a year, and costing more than $30 million, the report by court-appointed examiner Anton Valukas paints the most complete picture yet of the free-wheeling culture inside the 158 year-old firm, whose chief executive Richard S. Fuld Jr. prided himself on his ability to manage market risk.

The document runs thousands of pages and contains fresh allegations. In particular, it alleges that Lehman executives manipulated its balance sheet, withheld information from the board, and inflated the value of toxic real estate assets.

Lehman chose to "disregard or overrule the firm's risk controls on a regular basis,'' even as the credit and real-estate markets were showing signs of strain, the report said.

In one instance from May 2008, a Lehman senior vice president alerted management to potential accounting irregularities, a warning the report says was ignored by Lehman auditors Ernst & Young and never raised with the firm's board.

The allegations of accounting manipulation and risk-control abuses potentially could influence pending criminal and civil investigations into Lehman and its executives. The Manhattan and Brooklyn U.S. attorney's offices are investigating, among other things, whether former Lehman executives misled investors about the firm's financial picture before it filed for bankruptcy protection, and whether Lehman improperly valued its real-estate assets, people familiar with the matter have said.

The examiner said in the report that throughout the investigation it conducted regular weekly calls with the Securities and Exchange Commission and Department of Justice. There have been no prosecutions of Lehman executives to date.

Several factors helped to tip Lehman over the brink in its final days, Mr. Valukas wrote. Investment banks, including J.P. Morgan Chase & Co., made demands for collateral and modified agreements with Lehman that hurt Lehman's liquidity and pushed it into bankruptcy.

Lehman's own global financial controller, Martin Kelly, told the examiner that "the only purpose or motive for the transactions was reduction in balance sheet" and "there was no substance to the transactions." Mr. Kelly said he warned former Lehman finance chiefs Erin Callan and Ian Lowitt about the maneuver, saying the transactions posed "reputational risk" to Lehman if their use became publicly known.

In an interview with the examiner, senior Lehman Chief Operating Officer Bart McDade said he had detailed discussions with Mr. Fuld about the transactions and that Mr. Fuld knew about the accounting treatment.

In an April 2008 email, Mr. McDade called such accounting maneuvers "another drug we r on." Mr. McDade, then Lehman's equities chief, says he sought to limit such maneuvers, according to the report. Mr. McDade couldn't be reached to comment.

In a November 2009 interview with the examiner, Mr. Fuld said he had no recollection of Lehman's use of Repo 105 transactions but that if he had known about them he would have been concerned, according to the report.

Mr. Valukas's report is among the largest undertaking of its kind. Those singled out in the report won't face immediate repercussions. Rather, the report provides a type of road map for Lehman's bankruptcy estate, creditors and other authorities to pursue possible actions against former Lehman executives, the bank's auditors and others involved in the financial titan's collapse.

One party singled out in the report is Lehman's audit firm, Ernst & Young, which allegedly didn't raise concerns with Lehman's board about the frequent use of the repo transactions. E&Y met with Lehman's Board Audit Committee on June 13, one day after Lehman senior vice president Matthew Lee raised questions about the frequent use of the transactions.

"Ernst & Young took no steps to question or challenge the nondisclosure by Lehman of its use of $50 billion of temporary, off-balance sheet transactions," Mr. Valukas wrote.

In a statement, Mr. Fuld's lawyer, Patricia Hynes, said, "Mr. Fuld did not know what those transactions were—he didn't structure or negotiate them, nor was he aware of their accounting treatment."

An Ernst & Young statement Thursday said Lehman's collapse was caused by "a series of unprecedented adverse events in the financial markets." It said Lehman's leverage ratios "were the responsibility of management, not the auditor."

Ms. Callan didn't respond to a request for comment. An attorney for Mr. Lowitt said any suggestion he breached his duties was "baseless." Mr. Kelly couldn't be reached Thursday evening.

As Lehman began to unravel in mid-2008, investors began to focus their attention on the billions of dollars in commercial real estate and private-equity loans on Lehman's books.

The report said that while Lehman was required to report its inventory "at fair value," a price it would receive if the asset were hypothetically sold, Lehman "progressively relied on its judgment to determine the fair value of such assets."

Between December 2006 and December 2007, Lehman tripled its firmwide risk appetite.

But its risk exposure was even larger, according to the report, considering that Lehman omitted "some of its largest risks from its risk usage calculations" including the $2.3 billion bridge equity loan it provided for Tishman Speyer's $22.2 billion take over of apartment company Archstone Smith Trust. The late 2007 deal, which occurred as the commercial-property market was cresting, led to big losses for Lehman.

Lehman eventually added the Archstone loan to its risk usage profile. But rather than reducing its balance sheet to compensate for the additional risk, it simply raised its risk limit again, the report said.

Bob Jensen's threads on the Lehman financial and accounting fraud are at
http://www.trinity.edu/rjensen/fraud001.htm#Ernst

Where Were the Auditors?
http://www.trinity.edu/rjensen/2008Bailout.htm#AuditFirms

Lehman, Ernst, and Andersen Questions for Your Students
Why didn't FAS 121, FAS 142, and SAS 85 apply to the poisoned CDOs with severely impaired values in Lehman?
Why didn't FAS 121 and SAS 85 apply to the poisoned SPEs of Enron?

Hint
First read about FAS 121 and FAS 142 at http://www.cogentvaluation.com/pdf/AssetImpairmentTransitioningUnderFAS142.pdf

In any event, Andersen does not appear to have applied the GAAP requirement to recognize asset impairment (FAS 121). From our reading of the Powers Report, the put-options written by the SPEs that, presumably, offset Enron's losses on its merchant investment, were not collectible, because the SPEs did not have sufficient net assets. (Details on the SPEs' financial situations should have been available to Andersen.) GAAP (FAS 5) also requires a liability to be recorded when it is probable that an obligation has been incurred and the amount of the related loss can reasonable be estimated. The information presently available indicates that Enron's guarantees on the SPEs and Kopper's debt had become liabilities to Enron. It does not appear that they were reported as such.
"ENRON: what happened and what we can learn from it," by George J. Benston and Al L. Hartgraves, Journal of Accounting and Public Policy, 2002, pp. 125-137:

In any event, Andersen does not appear to have applied the GAAP requirement to recognize asset impairment (FAS 121). From our reading of the Powers Report, the put-options written by the SPEs that, presumably, offset Enron's losses on its merchant investment, were not collectible, because the SPEs did not have sufficient net assets. "ENRON: what happened and what we can learn from it," by George J. Benston and Al L. Hartgraves, Journal of Accounting and Public Policy, 2002, pp. 125-137:

3.3 Independent public accountants (CPAs)

The highly respected firm of Arthur Andersen audited and unqualifiedly signed Enron's financial statements since 1985. According to the Powers Report, Andersen was consulted on and participated with Fastow in setting up the SPEs described above. Together, they crafted the SPEs to conform to the letter of the GAAP requirement that the ownership of outside, presumably independent, investors must be at least 3% of the SPE assets. At this time, it is very difficult to understand why they determined that Fastow was an independent investor. Kopper's independence also is questionable, because he worked for Fastow. In any event, Andersen appears, at best, to have accepted as sufficient Enron's conformance with the minimum specified requirements of codified GAAP. They do not appear to have realized or been concerned that the substance of GAAP was violated, particularly with respect to the independence of the SPEs that permitted their activities to be excluded from Enron's financial statements and the recording of mark-to-market-based gains on assets and sales that could not be supported with trustworthy numbers (because these did not exist). They either did not examine or were not concerned that the put obligations from the SPEs that presumably offset declines in Enron's investments (e.g., Rhythms) were of no or little economic value. Nor did they require Enron to record as a liability or reveal as a contingent liability its guarantees made by or though SPEs. Andersen also violated the letter of GAAP and GAAS by allowing Enron to record issuance of its stock for other than cash as an increase in equity. Andersen also did not have Enron adequately report, as required, related-party dealings with Fastow, an executive officer of Enron, and the consequences to stockholders of his conflict of interest.

4.1 GAAP

We believe that two important shortcomings have been revealed. First, the US model of specifying rules that must be followed appears to have allowed or required Andersen to accept procedures that accord with the letter of the rules, even though they violate the basic objectives of GAAP accounting. Whereas most of the SPEs in question appeared to have the minimum-required 3% of assets of independent ownership, the evidence outlined above indicates that Enron in fact bore most of the risk. In several important situations, Enron very quickly transferred funds in the form of fees that permitted the 3% independent owners to retrieve their investments, and Enron guaranteed the SPEs liabilities. Second, the fair-value requirement for financial instruments adopted by the FASB permitted Enron to increase its reported assets and net income and thereby, to hide losses. Andersen appears to have accepted these valuations (which, rather quickly, proved to be substantially incorrect), because Enron was following the specific GAAP rules.

Andersen, though, appears to have violated some important GAAP and GAAS requirements. There is no doubt that Andersen knew that the SPEs were managed by a senior officer of Enron, Fastow, and that he profited from his management and partial ownership of the SPEs he structured. On that basis alone, it seems that Andersen should have required Enron to consolidate the Fastow SPEs with its financial statements and eliminate the financial transactions between those entities and Enron. Furthermore, it seems that the SPEs established by Fastow were unlikely to be able to fulfill the role of closing put options written to offset losses in Enron's merchant investments. If this were the purpose, the options should and would have been purchased from an existing institution that could meet its obligations.

Andersen also seems to have allowed Enron to violate the requirement specified in FASB Statement 5 that guarantees of indebtedness and other loss contingencies that in substance have the same characteristics, should be disclosed even if the possibility of loss is remote. The disclosure shall include the nature and the amount of the guarantee. Even if Andersen were correct in following the letter, if not the spirit of GAAP in allowing Enron to not consolidate those SPEs in which independent parties held equity equal to at least 3% of assets, Enron's contingent liabilities resulting from its loan guarantees should have been disclosed and described.

In any event, Andersen does not appear to have applied the GAAP requirement to recognize asset impairment (FAS 121). From our reading of the Powers Report, the put-options written by the SPEs that, presumably, offset Enron's losses on its merchant investment, were not collectible, because the SPEs did not have sufficient net assets. (Details on the SPEs' financial situations should have been available to Andersen.) GAAP (FAS 5) also requires a liability to be recorded when it is probable that an obligation has been incurred and the amount of the related loss can reasonable be estimated. The information presently available indicates that Enron's guarantees on the SPEs and Kopper's debt had become liabilities to Enron. It does not appear that they were reported as such.

GAAP (FAS 57) specifies that relationships with related parties "cannot be presumed to be carried out on an arm's-length basis, as the requisite conditions be competitive, free-market dealings may not exist". As Executive Vice President and CFO, Fastow clearly was a "related party". SEC Regulation S-K (Reg. §229.404. Item 404) requires disclosure of details of transactions with management, including the amount and remuneration of the managers from the transactions. Andersen does not appear to have required Enron to meet this obligation. Perhaps more importantly, Andersen did not reveal the extent to which Fastow profited at the expense of Enron's shareholders, who could only have obtained this information if Andersen had insisted on its inclusion in Enron's financial statements.

4.2 GAAS

SAS 85 warns auditors not to rely on management representations about onset values, liabilities, and related-party transactions, among other important items. Appendix B to SAS 85 illustrates the information that should be obtained by the auditor to review how management determined the fair values of significant assets that do not have readily determined market values. We do not have access to Andersen's working papers to examine whether or not they followed this GAAS requirement. In the light of the Wall Street Journal report presented above of Enron's recording a fair value for the Braveheart project with Blockbuster Inc., though, we find it difficult to believe that Andersen followed the spirit and possibly not even the letter of this GAAS requirement.

SAS 45 and AICPA, Professional Standards, vol. 1, AU sec. 334 specify audit requirements and disclosures for transactions with related parties. As indicated above, this requirement does not appear to have been followed.

An additional lesson that should be derived from the Enron debacle is that auditors should be aware of the ability of opportunistic managers to use financial engineering methods, to get around the requirements of GAAP. For example, derivatives used as hedges can be structured to have gains on one side recorded at market or fair values while offsetting losses are not recorded, because they do not qualify for restatement to fair-value. Another example is a loan disguised as a sale of a corporation's stock with guaranteed repurchase from the buyer at a higher price. If this subterfuge were not discovered, liabilities and interest expense would be understated. Thus, as auditors have learned to become familiar with computer systems, they must become aware of the means by which modern finance techniques can be used to subvert GAAP.

 

"What Is Accounting Pornography?" by David Albrecht, The Summa, March 9, 2010 ---
http://profalbrecht.wordpress.com/2010/03/09/what-is-accounting-pornography/

Jensen Comment
The courts cannot define "pornography" except as it depicts nude children and/or eroticism featuring underage children.

Hence if David's definition of "accounting pornography" is to stand court tests it must feature children in accounting acts like dirty debits or childish credits.

Hi David,

Accounting Pornography breaks down in to three categories --- solos, couples, and groupies.

At the end of her blog post Francine suggests that Repos 105 OBSF ploys should perhaps fall under the Groupie Category (her word is Fraternité).

“Liberté, Egalité, Fraternité: Big Lehman Brothers Troubles For Ernst & Young,” By Francine McKenna, re; The Auditors, March 15, 2010 ---
http://retheauditors.com/2010/03/15/liberte-egalite-fraternite-lehman-brothers-troubles-for-ernst-young-threaten-the-big-4-fraternity/

Begin Quote (about how top financial executives at Lehman were former E=&Y auditors of Lehman)
That kind of comfort and confidence in your client and their technical competence comes from a long, lucrative relationship.  But it must have been more than that. It could not have possibly come from confidence in the CFO suite, given its revolving door and the lack of accounting interest and aptitude in later years.

No.

Ernst and Young’s confidence in Lehman’s CFO leadership was rooted in fraternity.  Both Christopher O’Meara and David Goldfarb, his predecessor who was CFO from 2000 to 2004, are Ernst and Young alumni.  Prior to joining Lehman Brothers in 1994, Mr. O’Meara worked as a senior manager in Ernst & Young’s Financial Services practice.  Prior to joining Lehman Brothers in 1993, Mr. Goldfarb served as the Senior Partner of the Ernst & Young’s Financial Services practice, where he worked from 1979 to 1993.

Mr. Goldfarb, the former EY Senior Partner, was the Lehman CFO who created the Repo 105  transactions.

End Quote

Jensen Comment
But the Lehman-E&Y Fraternity was merely a local chapter of the larger National Fraternity. The National Fraternity appears to have been among the FASB, the Credit Rating Agencies (read that Moody’s)  and Big Four alumni working in all the troubled Wall Street Banks. When drowning in the poison of AAA-rated CDO Bond Investments that should’ve been rated as junk, the Repo 105 wash sale ploys were invented to keep the poisoned bond investments off the balance sheet at fair values along with the wash sale debt obligation to buy them back about a week after a Wall Street bank’s books closed for the year.

Frank Partnoy and Lynn Turner proclaim these fiction transactions are all part of the “fiction” balance sheets of Wall Street banks ---
http://www.rooseveltinstitute.org/sites/all/files/Off-Balance Sheet Transactions.pdf
The video is at
http://www.rooseveltinstitute.org/policy-and-ideas/ideas-database/bring-transparency-balance-sheet-accounting

Fraternity brothers at the FASB apparently joined in this groupie by making FAS 140 mushy enough to make Repo 105 deceptive sales appear to be legitimate. Lehman could sell a poisoned CDO bond the day before the books closed as long as the Repo 105 sales contract had an iron-clad clause to buy the poisoned CDO bond back at a higher price in about a week. This was a costly Hail Mary effort to hide the poisoned CDO bonds from the balance sheet and “pretend” with an orgiastic gasp that the poisoned bonds were sold at a phony price immensely greater than true fair value of junk.

And yet the FASB continues to stand before the congregation and preach the virtues of “Fair Value Accounting.”

The FASB makes a huge deal in FAS 133 and FAS 157 about booking financial contracts at fair value, but in FAS 140 allows its fraternity brothers on Wall Street (and their Big Four auditors) not to even have to disclose billions in Repo 105 buy-back obligations. Even an Accounting 101 student can tell the FASB that this wasn’t really a sale, and even if it was a sale the obligation to buy it back should’ve been booked as debt.

Francine had the right idea about this being a groupie. But she only hints at a local chapter of the groupie. I take that back. She does provide the slightest hint of a National Chapter of that fraternity.

“Liberté, Egalité, Fraternité: Big Lehman Brothers Troubles For Ernst & Young,” By Francine McKenna, re; The Auditors, March 15, 2010 ---
http://retheauditors.com/2010/03/15/liberte-egalite-fraternite-lehman-brothers-troubles-for-ernst-young-threaten-the-big-4-fraternity/

Begin Quote (actually she’s quoting the Examiner’s Report)
Lehman initiated its Repo 105 program sometime in 2001, soon after SFAS 140 took effect in September 2000 Lehman’s outside auditors and lawyers participated in the firm’s review of SFAS 140. Indeed, Lehman vetted the concept of a SFAS 140 repo transaction with its outside auditor, before the firm formalized a Repo 105 accounting policy and approved Repo 105 transactions for use by firm personnel.
(Bankruptcy Examiner’s Report V3, page 765)
End Quote

What’s ironic is that Lehman could not even find a shyster law firm in the U.S. to bless its Repo 105 transactions. If you can’t get a U.S. law firm to lie for you it must really be a rotten lie.  Lehman and E&Y had to go all the way to England to find a shyster law firm.

"Repos Played a Key Role in Lehman's Demise:  Report Exposes Lack of Information And Confusing Pacts With Lenders," by Suzanne Craig and Mike Spector, The Wall Street Journal, March 13, 2010 ---
http://online.wsj.com/article/SB20001424052748703447104575118150651790066.html#mod=todays_us_money_and_investing

The rare look into the repo market embedded in the report comes 18 months after Lehman Brothers collapsed in the U.S.'s largest bankruptcy filing. While top Lehman executives were quick to blame the real-estate market for their woes, the exhaustive report singles out senior executives and auditor Ernst & Young for serious lapses.

The report exposed for the first time what appears to be an accounting slight of hand known as a Repo 105 transaction, where Lehman was able to book what looked like an ordinary asset for cash as an out-and-out sale, drastically reducing its leverage and making its financial picture look better than it really was. The transactions often were done in flurries in a financial quarter's waning days, before Lehman reported earnings.

Four days prior to the close of the 2007 fiscal year, Jerry Rizzieri, a member of Lehman's fixed-income division, was searching for a way to meet his balance-sheet target, according to the report. He wrote in an email: "Can you imagine what this would be like without 105?"

A day before the close of Lehman's first quarter in 2008, other employees scrambled to make balance-sheet reductions, the report said. Kaushik Amin, then-head of Liquid Markets, wrote to a colleague: "We have a desperate situation, and I need another 2 billion from you, either through Repo 105 or outright sales. Cost is irrelevant, we need to do it."

Marie Stewart, the former global head of Lehman's accounting policy group, told the examiner the transactions were "a lazy way of managing the balance sheet as opposed to legitimately meeting balance-sheet targets at quarter end."

Lehman's use of this accounting technique goes back to the start of the decade when Lehman business units from New York and London met to discuss how the firm could manage its balance sheet using accounting rules that had taken effect in September 2000. Lehman soon created the "Repo 105" maneuver: Because assets the firm moved amounted to 105% or more of the cash it received in return, Lehman could treat the transactions as sales and remove securities inventory that otherwise would have to be kept on its balance sheet.

Because no U.S. law firm would bless the transaction, Lehman got an opinion letter from London-based law firm Linklaters. That letter essentially blessed using the maneuver for Lehman's European broker-dealer under English law. If one of Lehman's U.S. entities needed to engage in a Repo 105 transaction, the firm moved the securities to its European arm to conduct the deal on the U.S. entity's behalf, the report found. That is likely why the counterparties on the repo transactions were largely a group of seven non-U.S. banks. These included Germany's Deutsche Bank AG, Barclays PLC of the U.K. and Japan's Mitsubishi UFJ Financial Group.

In a statement, a Linklaters spokeswoman said the report "does not criticize" the legal opinions it gave Lehman "or suggest or say they were wrong or improper." The law firm said it was never contacted during the investigation.

Jensen Comment
Although Lehman could not find a shady U.S. law firm to "bless the transaction," Ken Lay at Enron managed to find a shady U.S. law firm to bless the Raptors' transactions after Sherron Watkins (an Enron executive) sent her infamous whistle blowing memo to both Ken Lay and to Andersen executives in Chicago.---
http://www.trinity.edu/rjensen/FraudEnron.htm

Yogi Berra says Lehman following Enron bankruptcies this is “Déjà vu all over again.”

Francine Does Her Homework
"Send Lawyers, Guns And Money… The Big 4 And Their Litigation," by Francine McKenna, re:  The Auditors, March 2, 2010 ---
http://retheauditors.com/2010/03/02/send-lawyers-guns-and-money-the-big-4-and-their-litigation/

Following the big lawsuits against the audit firms is fairly easy.  Updates on subprime and financial crisis suits typically hit my Google Alerts.  There area few more like the Banco Espiritu Santo v. BDO Seidman case and the case against PwC re: Satyam that have their very own customized alerts.  And Kevin LaCroix can be counted on to pick up the odd securities class action suit naming an auditor for sport and he also tracks all of the Madoff related filings.  Every once and a while I depend on the kindness of handsome strangers to catch the latest update like when Francis Pileggi told us the what happened in Delaware Chancery Court with Deloitte’s suit against accused inside trader and their own ex-Vice chairman Tom Flanagan.

The big lawsuits – the ones that accuse the firms of accounting malpractice or various federal securities law violations – have been chronicled on this site and by fellow writers such as James Peterson ad infinitum.  The accounting industry’s response to these threats is to ask for liability caps.  As if we don’t have enough moral hazard in the financial system with “too big to fail,” the auditors want to institutionalize their insulation from accountability to their clients, the shareholders, with a policy of “too few to pay for their mistakes.”

If only the lawsuits claiming lack of audit prowess were the only ones they had to worry about.  Unfortunately for them, and for their “partners” who go along for the ride leaving the management of “matters” up to senior leadership acting as caretakers for the 5-10 years they are at the top of the heap, there are so many more suits that just show what lousy managers they are.

Here are some of the more interesting lawsuits and legal matters facing each of the Big 4.

Deloitte

DOJ Defends Document Request Targeting Deloitte

The U.S. Department of Justice has turned to a federal appeals court in Washington, D.C., in the hope of forcing the accounting firm Deloitte LLC to turn over tax-related documents that government lawyers say are not protected by the work product privilege…As part of a civil tax suit in federal district court in Louisiana, the government is seeking certain documents that Dow turned over to Deloitte during the firm’s audit of the company.

[DOJ Tax Division lawyer Judith] Hagley on Friday argued that the work product privilege does not apply to the documents Dow turned over to Deloitte because the documents were prepared during what Hagley said was the ordinary course of business 
– and not prepared for litigation purposes.

Ex-Deloitte Exec Settles Insider Trading Charges

A former Deloitte tax professional has agreed to pay approximately $144,000 to settle insider trading charges with the Securities and Exchange Commission.

The SEC filed settled insider trading charges against four individuals, including John A. Foley, who served as an employee benefits specialist at Deloitte between July 2005 and May 2007. The others who settled the SEC charges were Aaron M. Grassian, Timothy L. Vernier, and Bradley S. Hale. They were accused of participating in insider trading in the securities of four public companies — Crocs, Inc., YRC Worldwide, Inc., Spectralink Corporation and SigmaTel, Inc. — over a 22-month period, yielding illegal profits totaling $210,580.62.

As GoingConcern.com told us:

Despite the high standard that Deloitte holds you to — higher than the SEC, PCAOB, and the AICPA, we might add — this happened, “Based on our own reviews and that of the PCAOB, we believe compliance with our independence policies is not what it should be, and the PCAOB has, in fact, questioned our commitment to adhere to our own policies. This is clearly not acceptable.”

Our contributor Francine McKenna reminded us that Deloitte didn’t think too much of the PCAOB’s report from last year, “They [are] the same firm that famously responded to the PCAOB’s latest inspection report, ‘How dare you second guess us?‘”

Although Deloitte won a preliminary victory against Flanagan, they obviously still have a lot of work to do to improve their independence compliance function and are still subject to PCAOB and SEC enforcement actions and potential sanctions.

In the meantime, they did settle Parmalat, but now they’re named in several suits related to the Merrill Lynch acquisition by Bank of America and the Bear Stearns failure.  Deloitte is the only Big 4 firm to have escaped any Madoff feeder fund exposure even though they are supposedly the number one choice of hedge funds.

Ernst & Young

Ernst & Young has its own inside trader case to go along with the ones we saw a few months ago and the rest of the SEC sanctions they’re collecting.

A former Ernst & Young LLP partner was sentenced to a year and a day in prison on Monday after he was convicted last year of fraud charges in an insider-trading scheme where he allegedly tipped a Pennsylvania broker about pending corporate takeovers.

At a hearing, U.S. District Judge Miriam Goldman Cedarbaum in Manhattan sentenced James Gansman, a lawyer who resigned from Ernst & Young in October 2007. He was convicted of six counts of securities fraud, but acquitted of conspiracy and three securities fraud counts in May 2009.

Ernst & Young Auditors Accused in Investment Case

The Securities and Exchange Commission has instituted public administrative proceedings against two former Ernst & Young auditors who failed to uncover the misappropriation of client funds by an investment advisor they were auditing.

The proceedings were instituted against two CPAs: Gerard A.M. Oprins, 50, who had been a partner in Ernst & Young’s financial services practices group since 1995; and Wendy McNeely, 33, a former audit manager in E&Y’s financial services group who now works for another firm.

In addition to the myriad of suits relating to the Lehman collapse and their Madoff feeder fund exposure, Ernst and Young recently went through a terrible phase focused on their Bally’s sanctions, the Akai scandal and another fraud in Hong Kong.

The EY list includes the usual employment discrimination lawsuits that all of the firms face, in particular given the significant cuts they have all made to their ranks during the last two years. Ernst & Young also has several filings related to writedowns at Regions Financial Corporation. Regions is the largest audit client of Ernst & Young LLP’s Birmingham office. Back in 2003, that office’s largest client had been HealthSouth Corp., which turned out to be a massive fraud. Tough luck…

The Regions board and management team, as well as Ernst and Young, are accused of “continued reporting a grossly inflated value of the goodwill attributable to the AmSouth acquisition,” which later caused a large $6 billion write-down equal to more than 60 percent of the total acquisition, according to the lawsuit.

Bankruptcy cases are some of the biggest moneymakers for the firms now globally but can become contentious.

MP calls for probe into Nortel jobs

A MP has written to the insolvency regulator calling for an investigation into the actions of Nortel’s administrator Ernst & Young (E&Y).

“Ernst & Young’s handling of this insolvency case has been woeful and it would appear that they may have failed to pay appropriate regard to redundancy and employment legislation,” he said.

Next I’ll summarize which cases KPMG and PricewaterhouseCoopers are spending their legal dollars on.

Francine

Bob Jensen's threads on public accounting firm litigations are at
http://www.trinity.edu/rjensen/fraud001.htm

Question
Were the Ernst & Young's auditors negligent or cleverly deceived or complicit in the deception by the Lehman Brothers?

More from the examiner’s report:

Lehman never publicly disclosed its use of Repo 105 transactions, its accounting treatment for these transactions, the considerable escalation of its total Repo 105 usage in late 2007 and into 2008, or the material impact these transactions had on the firm’s publicly reported net leverage ratio. According to former Global Financial Controller Martin Kelly, a careful review of Lehman’s Forms 10‐K and 10‐Q would not reveal Lehman’s use of Repo 105 transactions. Lehman failed to disclose its Repo 105 practice even though Kelly believed “that the only purpose or motive for the transactions was reduction in balance sheet”; felt that “there was no substance to the transactions”; and expressed concerns with Lehman’s Repo 105 program to two consecutive Lehman Chief Financial Officers – Erin Callan and Ian Lowitt – advising them that the lack of economic substance to Repo 105 transactions meant “reputational risk” to Lehman if the firm’s use of the transactions became known to the public. In addition to its material omissions, Lehman affirmatively misrepresented in its financial statements that the firm treated all repo transactions as financing transactions – i.e., not sales – for financial reporting purposes.

"Report Details How Lehman Hid Its Woes as It Collapsed," by Michael de la Merced and Andrew Ross Sorkin, The New York Times, March 11, 2010 ---
 http://www.nytimes.com/2010/03/12/business/12lehman.html?src=me

It is the Wall Street equivalent of a coroner’s report — a 2,200-page document that lays out, in new and startling detail, how Lehman Brothers used accounting sleight of hand to conceal the bad investments that led to its undoing.

 

The report, compiled by an examiner for the bank, now bankrupt, hit Wall Street with a thud late Thursday. The 158-year-old company, it concluded, died from multiple causes. Among them were bad mortgage holdings and, less directly, demands by rivals like JPMorgan Chase and Citigroup, that the foundering bank post collateral against loans it desperately needed.

But the examiner, Anton R. Valukas, also for the first time, laid out what the report characterized as “materially misleading” accounting gimmicks that Lehman used to mask the perilous state of its finances. The bank’s bankruptcy, the largest in American history, shook the financial world. Fears that other banks might topple in a cascade of failures eventually led Washington to arrange a sweeping rescue for the nation’s financial system.

According to the report, Lehman used what amounted to financial engineering to temporarily shuffle $50 billion of troubled assets off its books in the months before its collapse in September 2008 to conceal its dependence on leverage, or borrowed money. Senior Lehman executives, as well as the bank’s accountants at Ernst & Young, were aware of the moves, according to Mr. Valukas, the chairman of the law firm Jenner & Block and a former federal prosecutor, who filed the report in connection with Lehman’s bankruptcy case.

Richard S. Fuld Jr., Lehman’s former chief executive, certified the misleading accounts, the report said.

“Unbeknownst to the investing public, rating agencies, government regulators, and Lehman’s board of directors, Lehman reverse engineered the firm’s net leverage ratio for public consumption,” Mr. Valukas wrote.

Mr. Fuld was “at least grossly negligent,” the report states, adding that Henry M. Paulson Jr., who was then the Treasury secretary, warned Mr. Fuld that Lehman might fail unless it stabilized its finances or found a buyer.

Lehman executives engaged in what the report characterized as “actionable balance sheet manipulation,” and “nonculpable errors of business judgment.”

The report draws no conclusions as to whether Lehman executives violated securities laws. But it does suggest that enough evidence exists for potential civil claims. Lehman executives are already defendants in civil suits, but have not been charged with any criminal wrongdoing.

A large portion of the nine-volume report centers on the accounting maneuvers, known inside Lehman as “Repo 105.”

First used in 2001, long before the crisis struck, Repo 105 involved transactions that secretly moved billions of dollars off Lehman’s books at a time when the bank was under heavy scrutiny.

According to Mr. Valukas, Mr. Fuld ordered Lehman executives to reduce the bank’s debt levels, and senior officials sought repeatedly to apply Repo 105 to dress up the firm’s results. Other executives named in the examiner’s report in connection with the use of the accounting tool include three former Lehman chief financial officers: Christopher O’Meara, Erin Callan and Ian Lowitt.

Patricia Hynes, a lawyer for Mr. Fuld, said in an e-mailed statement that Mr. Fuld “did not know what those transactions were — he didn’t structure or negotiate them, nor was he aware of their accounting treatment.”

Charles Perkins, a spokesman for Ernst & Young, said in an e-mailed statement: “Our last audit of the company was for the fiscal year ending Nov. 30, 2007. Our opinion indicated that Lehman’s financial statements for that year were fairly presented in accordance with Generally Accepted Accounting Principles (GAAP), and we remain of that view.”

Bryan Marsal, Lehman’s current chief executive, who is unwinding the firm, said in a statement that he was evaluating the report to assess how it might help in efforts to advance creditor interests.

Repos, short for repurchase agreements, are a standard practice on Wall Street, representing short-term loans that provide sometimes crucial financing. In them, firms essentially lend assets to other firms in exchange for money for short periods of time, sometimes overnight.

But Lehman used aggressive accounting in its Repo 105 transactions: it appears to have structured transactions such that they sold securities at the end of the quarter, but planned to buy them back again days later. These assets were mostly illiquid real estate holdings, meaning that they were hard to sell in normal transactions.

Continued in article

Jensen Comment
The links to Volumes 1-9 of the Examiner's Report ---
http://dealbook.blogs.nytimes.com/2010/03/11/lehman-directors-did-not-breach-duties-examiner-finds/#reports
(Scroll Down)

“A Lehman senior vice president raised questions about the propriety of these transactions as early as May 2008, but the report said that the accountants at Ernst & Young “took no steps to question or challenge the non-disclosure of its use of $50bn of temporary, off balance sheet transactions” ---
http://www.ft.com/cms/s/0/1be0aca2-2d79-11df-a262-00144feabdc0.html?nclick_check=1

Regarding FIN 41
Here’s a somewhat disturbing action by the FASB (caving in to Wall Street banks) --
http://edmontonobservers.net/fasb-eases-up-on-repo-funding-source/

March 14, 2010 reply from Bob Jensen

Hi Jim,

Your link word wrapped badly, so I snipped it to
http://snipurl.com/petersonlehman
You seem to ignore the many serious internal control weakness that Section 404 audits uncovered, e.g. at Kodak. But that's another matter.

No matter how we take the Examiner's report and the possible politics involved, it all boils down to a naïve investor (perhaps a first-year accounting student) looking up at the Lehman's new Repo 105 suit of clothes and exclaiming the "Emperor's not wearing a stitch of clothes."

A standard setter on the IASB sent me a private message this morning stated the following"

“As for Repo 105, I did read Volume 1 of the report.  Common sense tells me that if I “sell” something but have a binding obligation to buy it back, I really didn’t sell it – no matter what the technicalities of an accounting rule might say.”

This may be as simple as the Accounting 101 cheating that Worldcom kept from its Board and the public.

And Andersen's sorry audit of Worldcom was a simple violation of Auditing 101.

Let's not make these Repo 105 transactions too complicated as the Emperor rides by in his new suit of Repo 105 clothes --- http://en.wikipedia.org/wiki/Emperor%27s_New_Clothes

The Repo 105 uproar boils down to the simplicity of Accounting 101.
And the Ernst & Young audit is a violation of Auditing 101 no matter what rules are donned by the Emperor.

 Bob Jensen

"Calif County Accuses Lehman Executives, Auditor Of Fraud In Suit," CNN, November 13, 2008 --- Click Here 
http://money.cnn.com/news/newsfeeds/articles/djf500/200811131743DOWJONESDJONLINE000915_FORTUNE5.htm

March 11, 2010 reply from LynnETurne@aol.com

I’m forwarding this message from Lynn Turner without comment, because I’m in a bit over my head on this without having studied the nine-volume set of the Examiner’s report (2,200 pages). In fairness, I will probably still be in over my head after reading the 2,200 pages.

Lynn Turner is a former Coopers partner who became SEC Chief Accountant ---
http://www.s-ox.com/dsp_getSpotlightDetails.cfm?CID=2611

He’s one of my professional heroes, and I’ve enjoyed on occasion sharing a speaking platform with him.

Robert E. (Bob) Jensen
Trinity University Accounting Professor (Emeritus)
190 Sunset Hill Road
Sugar Hill, NH 03586
Tel. 603-823-8482
www.trinity.edu/rjensen

 

From: LynnETurne@aol.com [mailto:LynnETurne@aol.com]
Sent: Friday, March 12, 2010 2:07 PM
To: Jensen, Robert
Subject: Fwd: The Lehman Examiners Report on Auditorfs

 

---

From: eorenstein@financialexecutives.org
To: lynneturne@aol.com
Sent: 3/12/2010 11:56:58 A.M. Mountain Standard Time
Subj: RE: The Lehman Examiners Report on Auditorfs

 

Lynn, are you on Prof. Bob Jensen’s listserve (technically, it’s an accounting listserve out of Loyola University, but Bob Jensen is the most frequent poster/unofficial chairman of that listserve, so to speak). There have been numerous posts on their listserve today on that topic (the AECM listserve, and the CPAs-L listserve), they would probably be interested in the info you have provided here, including your attachment, you may want to forward this material to Bob at rjensen@trinity.edu if you’d like him to share it. Thank you. Regards, Edith

 

From: LynnETurne@aol.com [mailto:LynnETurne@aol.com]
Sent: Friday, March 12, 2010 1:44 PM
To: lynneturne@aol.com
Subject: The Lehman Examiners Report on Auditorfs

 

Below is the discussion regarding the independent auditors from the Examiner's report on Lehman.  It provides and excellent case study for students as it properly highlights how the courts and SEC have consistently said auditors cannot merely hide behind "GAAP."  This concept is also engrained in the language of Sarbanes Oxley which requires executives to sign off on the fair presentation of financial statements without mentioning GAAP.

 

The report also states the auditor did not inform the audit committee of the transactions in question.  There have been other enforcement cases in which it was found the auditor did not inform the audit committee of questionable accounting practices.  The PCAOB has done work in past years on the standard for communications between the auditor and audit committee but has never updated that standard.

 

From the Lehman Examiner Report - Volume 3, beginning page 945:

 

"(3) Lehman’s Board of Directors

Without exception, former Lehman directors were unaware of Lehman’s Repo
105 program and transactions.3642
As discussed in greater detail below, Lehman’s own Corporate Audit group led
by Beth Rudofker, together with Ernst & Young, investigated allegations about balance
sheet substantiation problems made in a May 16, 2008 “whistleblower” letter sent to
senior management by Matthew Lee.3643 On June 12, 2008, during the investigation, Lee
informed Ernst & Young about Lehman’s use of $50 billion of Repo 105 transactions in
the second quarter of 2008.3644 At a June 13, 2008 meeting, Ernst & Young failed to
disclose that allegation to the Board’s Audit Committee.3645

Former Lehman director Cruikshank recalled that he made very clear he wanted
a full and thorough investigation into each allegation made by Lee, whether the allegation was contained in Lee’s May 16, 2008 letter or raised by Lee in the course of
the investigation.3646 Another former Lehman director, Berlind, similarly stated that the
Audit Committee explicitly instructed Lehman’s Corporate Audit Group and Ernst &
Young to keep the Audit Committee informed of all of Lee’s allegations.3647 Berlind also
said that he would have wanted to know about Lehman’s Repo 105 program and that if
he had known about Lehman’s Repo 105 transactions, he would have asked Lehman’s
auditors to test the transactions to ensure they were appropriate.3648 Upon learning from
the Examiner the volume of Repo 105 transactions at quarter‐end in late 2007 and 2008,
Sir Christopher Gent said that he believed the volume mandated disclosure to the Audit
Committee and further investigation.3649

Dr. Kaufman, on the other hand, stated that he would have wanted to know
about Repo 105 transactions only if they were “huge” and fraudulent, by which he
meant in violation of specific accounting rules or in violation of the law.3650 Dr.
Kaufman did not believe that $50 billion in Repo 105 transactions was significant even if
that volume changed Lehman’s net leverage ratio by approximately two points.3651 Dr.Kaufman considered a four or five point change in the net leverage ratio to be
significant.3652

In late 2007 and 2008, management made numerous presentations to the Board
regarding balance sheet reduction and deleveraging; in no case was the use of Repo 105
transactions disclosed in those presentations.3653

i) Ernst & Young’s Knowledge of Lehman’s Repo 105 Program
During several Rule 30(b)(6)‐type3654 interview sessions, the Examiner
interviewed members of Ernst & Young’s Lehman audit team regarding Ernst &
Young’s knowledge of and involvement in Lehman’s Repo 105 program.
(1) Ernst & Young’s Comfort with Lehman’s Repo 105 Accounting
Policy

The Examiner interviewed Ernst & Young’s lead partner on the Lehman audit
team, William Schlich, regarding Lehman’s Repo 105 program. According to Schlich,
Ernst & Young had been aware of Lehman’s Repo 105 policy and transactions for many
years.3655 Consistent with the statements of Lehman’s John Feraca (Secured Funding
Desk), Schlich stated that Lehman introduced its Repo 105 Accounting Policy on the
heels of the FASB’s promulgation of SFAS 140.3656 During that time, Ernst & Young
“discussed” the Repo 105 Accounting Policy (including Lehman’s structure for Repo
105 transactions) and Ernst & Young’s team had a number of additional conversations
with Lehman about Repo 105 over the years.3657 However, according to Schlich, Ernst &Young had no role in the drafting or preparation of Lehman’s Repo 105 Accounting
Policy.3658

Schlich stated definitively that Ernst & Young had no advisory role with respect
to Lehman’s use of Repo 105 transactions and that Ernst & Young did not “approve”
the Accounting Policy.3659 Rather, according to Schlich, Ernst & Young “bec[a]me
comfortable with the Policy for purposes of auditing financial statements.”3660
Following “consultation and dialogue” about the proper interpretation and
application of SFAS 140, Ernst & Young “clearly. . .concurred with Lehman’s approach”
to SFAS 140 and subsequent literature by FASB on the issue of “control” of assets
involved in a repo transactions.3661 Ernst & Young’s view, however, was not based upon
an analysis of whether actual Repo 105 transactions complied with SFAS 140.3662 Rather,
Ernst & Young’s review of Lehman’s Repo 105 Accounting Policy was purely
“theoretical.”3663 In other words, Ernst & Young solely assessed Lehman’s
understanding of the requirements of SFAS 140 in the abstract and as reflected in its
Accounting Policy; Ernst & Young did not opine on the propriety of the transactions as a balance sheet management tool.3664 Ernst & Young did not review the Linklaters letter,
referenced in the Accounting Policy Manual.3665

According to Martin Kelly, it was not unusual for him to discuss various issues,
including Repo 105, with Ernst & Young.3666 Indeed, Kelly recalled specifically speaking
with Schlich about Repo 105 transactions soon after becoming Financial Controller on
December 1, 2007, in an effort to learn more about the program and “to understand
[Ernst & Young’s] approach before talking to Callan.”3667

Kelly “wanted to ensure that Ernst & Young analyzed the program in the same
way that [Marie] Stewart [Global Head of Accounting Policy] had analyzed it.”3668
Kelly’s conversations with Ernst & Young focused on the accounting treatment of Repo
105 transactions.3669 According to Kelly, Ernst & Young “was comfortable with the
treatment under GAAP for the same reasons that Lehman was comfortable.”3670 Kelly also discussed with Ernst & Young Lehman’s inability to get a true sale opinion under United States law for Repo 105 transactions.3671 Kelly could not recall whether he
discussed with Ernst & Young his discomfort with Lehman’s Repo 105 program.3672
(2) The “Netting Grid”

Throughout 2007, Lehman maintained a document entitled “Accounting Policy
Review Balance Sheet Netting and Other Adjustments,” known colloquially among
Lehman’s Accounting Policy and Balance Sheet Groups, as well at Ernst & Young, as
the “Netting Grid.” The Netting Grid identified and described various balance sheet
netting mechanisms employed by Lehman: one such balance sheet mechanisms was
Lehman’s use of Repo 105 transactions.3673

Lehman provided the Netting Grid to Ernst & Young at least in August 2007 (the
close of Lehman’s third quarter 2007) and in November 2007 (the close of Lehman’s
fiscal year 2007).3674 Notably, the Netting Grid provided by Lehman to Ernst & Young in
August 2007 and November 2007 only contained Repo 105 volumes from November 30, 2006 and February 28, 2007.3675 Schlich was unaware whether Ernst & Young asked
Lehman to provide its second quarter 2007 and third quarter 2007 Repo 105 usage
figures or a forecast of Lehman’s fourth quarter 2007 Repo 105 numbers.3676
Ernst & Young reviewed the Netting Grid, analyzed the various balance sheet
netting mechanisms identified in the Netting Grid, and used the document in
connection with its 2007 year‐end audit of Lehman.3677 According to Schlich, Ernst &
Young, as part of its review of Lehman’s Netting Grid, approved of Lehman’s internal Repo 105 Accounting Policy only, and did not pass upon the actual practice.3678
The Netting Grid described the transactions and United States GAAP reference
as follows: “Under certain conditions that meet the criteria described in paragraphs 9
and 218 of SFAS 140, Lehman policy permits reverse repo and repo agreements to be
recharacterized as purchases and sales of inventory.”3679 With respect to Lehman’s use
of Repo 105 transactions to reduce its net balance sheet, the Netting Grid sets forth the conclusion that Lehman’s “current practice [for Repo 105] is correct.”3680 Schlich noted
that this conclusion about the Repo 105 practice was Lehman’s, not Ernst & Young’s.3681
To test Lehman’s conclusion, however, Ernst & Young “reviewed how Lehman applied
the control provisions of the accounting rules.”3682

Ernst & Young’s review, however, applied only to the accounting basis for these
transactions, not to their volume or purpose. Specifically, Ernst & Young’s review and
analysis of Lehman’s Repo 105 program did not account for the volumes of Repo 105
transactions Lehman undertook at quarter‐end.3683 Indeed, Schlich was unable to
confirm or deny the volumes of Repo 105 transactions Lehman undertook at Lehman’s
fiscal year‐end 2007, or in the first two quarter‐ends of 2008.3684 Nor was Schlich able to
confirm or deny that Lehman’s use of Repo 105 transactions was increasing in late 2007
and into mid 2008.3685

(a) Quarterly Review and Audit

Through Schlich, Ernst & Young maintained that its duties as Lehman’s auditor
required it to ensure that transactions were accounted for correctly (i.e., that they
complied with accounting rules) and that Lehman’s financial disclosures were not materially misstated.3686 According to Schlich, Ernst & Young’s audit did not require
Ernst & Young to consider or review the volume or timing of Repo 105 transactions.3687
Accordingly, as part of its year‐end 2007 audit, Ernst & Young did not ask Lehman
about any directional trends, such as whether its Repo 105 activity was increasing
during fiscal year 2007.3688 Notably, as part of its quarterly review process, Ernst &
Young did not audit any of Lehman’s Repo 105 transactions.3689

(3) Ernst & Young Would Not Opine on the Materiality of
Lehman’s Repo 105 Usage

Ernst & Young, through Schlich, was unwilling to comment to the Examiner on
the materiality of the volume of Lehman’s quarter‐end Repo 105 transactions.3690 Asked
whether, as part of its responsibility to ensure Lehman’s financial statements were not
materially misstated, Ernst & Young should have considered the possibility that strict technical adherence to SFAS 140 or any other specific accounting rule could nonetheless lead to a material misstatement in Lehman’s publicly‐reported financial statements,
Schlich refrained from comment.3691

When pressed further, Schlich stated that the volume of any particular
transaction impacts neither the question of whether accounting rules are applied correctly, nor the question of whether a financial statement is materially misleading.3692
However, Schlich eventually acknowledged that “when you look at a balance sheet
issue, volume is a factor.”3693

Notably, the definition of “materiality” contained in a “walk‐through” document
related to Ernst & Young’s 2007 fiscal year‐end audit of Lehman was: “any transaction
that would move Lehman’s firm‐wide net leverage by 0.1 or more.”3694 This definition
reflected “Lehman’s determination of a materiality threshold” in connection with
Lehman’s own criteria for when to consider reopening and adjusting its balance
sheet.3695

When Schlich was asked what level of impact to Lehman’s firm‐wide net assets
Ernst & Young would have considered “material,” Schlich replied that Ernst & Young
did not have a hard and fast rule defining materiality in the balance sheet context, and
that, with respect to balance sheet issues, “materiality” depends upon the facts and
circumstances.3696 Schlich agreed that Lehman made no specific disclosures about Repo 105 transactions in its Forms 10‐K and Form 10‐Q, including the MD&A section.3697
Schlich believed, however, that Lehman’s public filings would have included general
language regarding secured borrowings and compliance with SFAS 140.3698 Schlich was
not aware whether Ernst & Young ever discussed Lehman’s disclosures vel non of Repo
105 activity with senior Lehman management.3699

(4) Matthew Lee’s Statements Regarding Repo 105 to Ernst &
Young

On May 16, 2008, Matthew Lee, then‐Senior Vice President in the Finance
Division responsible for Lehman’s Global Balance Sheet and Legal Entity Accounting, sent a letter to certain members of Lehman’s senior management identifying possible violations of Lehman’s Ethics Code related to accounting/balance sheet issues.3700 Lehman involved Ernst & Young in its investigation of the concerns raised in Lee’s May
16, 2008 letter.3701

Subsequently, less than a month later, on June 12, 2008, Ernst & Young – Schlich
and Hillary Hansen – interviewed Lee.3702 Hansen’s notes of the interview reveal that
Lee made certain statements to Ernst & Young about Lehman’s Repo 105 practice,
including, most notably, the volume of Repo 105 activity that Lehman engaged in at
quarter‐end (May 31, 2008).3703 Hansen’s notes specifically recount Lee’s allegation that
Lehman moved $50 billion of inventory off its balance sheet at quarter‐end through
Repo 105 transactions and that these assets returned to the balance sheet approximately
a week later.3704 When interviewed by the Examiner, Schlich did not recall Lee saying anything
about Repo 105 transactions during that interview, although he did not dispute the
authenticity of Hansen’s notes from the Lee interview.3705 In spite of Hansen’s notes,
Schlich maintained that Ernst & Young did not know that Lehman engaged in the
following Repo 105 activity during the listed time periods: $49.1 billion at first quarter
2008 (Feb. 29, 2008); and $50.38 billion at second quarter 2008 (May 31, 2008).3706
During the Examiner’s interview of Hansen, Hansen recalled that while Ernst &
Young questioned Lee about his May 16, 2008 letter, Lee “rattled off” a list of additional
issues and concerns he held, one of which was Lehman’s use of Repo 105
transactions.3707 Ernst & Young had no further conversations with Lee about Repo 105
transactions.3708 Prior to her interview of Lee in June 2008, Hansen had heard the term
Repo 105 “thrown around” but she did not know its meaning; according to Hansen,
Schlich described Repo 105 transactions to her shortly after they met with Lee.3709
Following Ernst & Young’s June 12, 2008 interview of Lee, Schlich and Hansen
met with Lehman’s Gerard Reilly to discuss Lee’s assertions regarding improper valuations.3710 During that meeting, Hansen informed Reilly of the $50 billion Repo 105
figure Lee provided during Ernst & Young’s interview of Lee.3711 According to Schlich,
Reilly (now deceased) told the auditors that he had no knowledge that Lehman used
Repo 105 transactions to move $50 billion in assets off its balance sheet.3712 “Hillary
[Hansen] took away from the meeting with Reilly that he did not know and it was not
$50 billion.”3713

On June 13, 2008 – the day after Lee informed Ernst & Young of the $50 billion in
Repo 105 transactions that Lehman undertook at the end of the second quarter 2008 –
Ernst & Young spoke to Lehman’s Audit Committee but did not inform the committee of Lee’s allegation, even though the Chairman of the Audit Committee had clearly stated that he wanted every allegation made by Lee – whether in Lee’s May 16 letter or during the course of the investigation – to be investigated.3714 Ernst & Young met with
the Audit Committee on July 8, 2008, to review the second quarter financial statements and again did not mention Lee’s allegations regarding Repo 105.3715 On July 22, 2008,
Ernst & Young was also present when Beth Rudofker, Head of Corporate Audit, gave a
presentation to the Audit Committee on the results of the investigation into Lee’s
allegations.3716

Ernst & Young did not disclose to the Audit Committee – either during the
meetings or in private executive sessions after – that Lee made an allegation related to
Repo 105 transactions being used to move assets off Lehman’s balance sheet at quarterend.
3717 Cruikshank told the Examiner that he would have expected to be told about
Lee’s Repo 105 allegations.3718 Similarly, Sir Gent told the Examiner that the alleged volume of Lehman’s Repo 105 transactions mandated disclosure to the Audit
Committee as well as further investigation.3719
Ernst & Young did not follow‐up on either Lee’s allegations regarding Lehman’s
Repo 105 activity or Reilly’s claim that he had no knowledge of Lehman’s alleged $50
billion Repo 105 usage figure.3720 Ernst & Young signed a Report of Independent
Registered Public Accounting Firm for Lehman’s second quarter 2008 Form 10‐Q on
July 10, 2008, less than four weeks after Schlich and Hansen interviewed Lee.3721

 

(5) Accounting‐Motivated Transactions

Ernst & Young did not evaluate the possibility that Repo 105 transactions were accounting‐motivated transactions that lacked a business purpose.3722 Schlich
characterized the off‐balance sheet treatment of Lehman’s assets in Repo 105
transactions as a consequence of the accounting rules, rather than a motive for the
transactions.3723

j) The Examiner’s Conclusions

There is sufficient evidence to support a determination by a trier of fact that
Lehman’s failure to disclose that it relied upon Repo 105 transactions to temporarily
reduce the firm’s net balance sheet and net leverage ratio was materially misleading. In
addition, a trier of fact could find that Lehman affirmatively misrepresented its
accounting treatment for repos by stating that Lehman treated repo transactions as
financing transactions rather than sales for financial reporting purposes, despite the fact
that Lehman treated tens of billions of dollars in repo transactions – namely, Repo 105
transactions – as true sale transactions. The Examiner thus concludes that sufficient evidence exists from which a trier of fact could find the existence of a colorable claim that certain Lehman officers breached
their fiduciary duties to Lehman and its shareholders by causing the company to file deficient and materially misleading financial statements, thereby exposing the company
to potential liability. Certain officers of Lehman not only failed to inform the public of
its reliance on Repo 105 transactions to reduce its balance sheet, they also failed to
advise Lehman’s Board of Directors of the firm’s Repo 105 practice. Thus, the Examiner
concludes that a trier of fact could find that certain Lehman officers breached their
fiduciary duties to Lehman’s Board of Directors by failing to inform them of: (1) the
firm’s reliance upon Repo 105 to reduce the balance sheet at quarter‐end, (2) the rampup
in Repo 105 usage in mid‐to‐late 2007 and 2008, (3) the impact of these transactions
on Lehman’s publicly reported net leverage ratio, or (4) the fact that Lehman did not
disclose its Repo 105 practice in its publicly reported financials statements and MD&A.

(1) Materiality

The materiality of information is evaluated from the perspective of a reasonable
investor.3724 Information is deemed material if there is “a substantial likelihood that the
disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.”3725
Materiality does not require, however, that the information be of a type that would
cause an investor to change his investment decision.3726

(a) Whether Lehman’s Repo 105 Transactions Technically
Complied with SFAS 140 Does Not Impact Whether a
Colorable Claim Exists

This Report does not reach the question of whether Lehman’s Repo 105
transactions technically complied with the relevant financial accounting standard, SFAS
140, because the answer to that question does not impact whether a colorable claim
exists regarding Lehman’s failure to disclose its Repo 105 practice and whether that
failure rendered the firm’s financial statements materially misleading.
Even if Lehman’s use of Repo 105 transactions technically complied with SFAS 140, financial statements may be materially misleading even when they do not violate GAAP.3727 The Second Circuit has explained that “GAAP itself recognizes that technical compliance with particular GAAP rules may lead to misleading financial statements, and imposes an overall requirement that the statements as a whole accurately reflect the financial status of the company.”3728

Similarly, as noted in In re Global Crossing Ltd. Securities Litigation, even if a
defendant established that its accounting practices “were in technical compliance with
certain individual GAAP provisions . . . this would not necessarily insulate it from liability. This is because, unlike other regulatory systems, GAAP’s ultimate goals of fairness and accuracy in reporting require more than mere technical compliance.”3729 The court
explained that “when viewed as a whole,” GAAP has no “loopholes” because its
purpose, shared by the securities laws, is “to increase investor confidence by ensuring
transparency and accuracy in financial reporting.”3730 Technical compliance with
specific accounting rules does not automatically lead to fairly presented financial statements. “Fair presentation is the touchstone for determining the adequacy of disclosure in financial statements. While adherence to generally accepted accounting principles is a tool to help achieve that end, it is not necessarily a guarantee of fairness.”3731 Moreover, registrants are “required to provide whatever additional information would be necessary to make the statements in their financial reports fair and accurate, and not
misleading.”3732

This view is echoed in an SEC enforcement order, concluding that GAAP
compliance does not excuse a misleading or less than full disclosure regarding a
transaction, especially if the transaction’s purpose is “the attainment of a particular
financial reporting result.”3733 “[E]ven if the transactions comply with GAAP, the issuer
is required to evaluate the material accuracy and completeness of the presentation
made by its financial statements.”3734 Issuers must “ensure that the way they publicly
portray themselves discloses, as required, the material elements of [their] economic and
business realities and risks.”3735

 

3732 Id. (citing 17 C.F.R. § 240.10b‐5(b) and 17 C.F.R. § 230.408 (requiring that “in addition to the information expressly required to be included in a registration statement, there shall be added such further material information, if any, as may be necessary to make the required statements, in the light of the circumstances under which they are made, not misleading”) (emphasis added); see also SEC v. Seghers, 298 Fed. App’x 319, 331 (5th Cir. 2008) (“The Commission’s proof of Segher’s misrepresentations and omissions does not depend on compliance with GAAP, but instead depends on evidence that Segher’s statements and omissions were false or misleading to investors.”); United States v. Olis, Civil Action No. H‐07‐3295, Criminal No. H‐03‐217‐01, 2008 WL 5046342, at *20 (S.D. Tex. Nov. 21, 2008) (“The scheme to defraud alleged and proved in this case did not turn on whether the treatment accorded to Project Alpha in Dynegy’s financial statements technically complied with GAAP or whether Olis and his coconspirators intended to violate GAAP but, instead, on whether the defendants’ disclosures about Project Alpha intentionally omitted material facts that caused Dynegy’s financial statements to be materially false and misleading.”) (citing United States v. Rigas, 490 F.3d 208, 221 (2d Cir. 2007), and United States v. Ebbers, 458 F.3d 110, 125‐26 (2d Cir. 2006)).

Repo105 --- http://en.wikipedia.org/wiki/Repo_105
Repo105.com --- http://www.repo105.com/

"Colorable claims exist that Ernst & Young did not meet professional standards, both in investigating Lee's allegations and in connection with its audit and review of Lehman's financial statements."

For those of you who don't have time to read the entire 2,200-page Examiners Report
that's so unkind to Ernst & Young and Lehman Executives

"Excerpts from the Lehman Report," The Wall Street Journal, March 13, 2010 ---
http://online.wsj.com/article/SB10001424052748704131404575117682843690948.html?mod=todays-us-money-and-investing

Thursday, a U.S. bankruptcy-court examiner investigating the collapse of Lehman Brothers Holdings Inc. released a scathing 2,200-page report. Here are some highlights.

* * *

Criminal Case? -- "Colorable Claims"

The allegations lodged by a bankruptcy-court examiner have raised questions about whether prosecutors could build a case against former Lehman executives.

"Colorable claims exist against the senior officers who were responsible for balance sheet management and financial disclosure, who signed and certified Lehman's financial statements and who failed to disclose Lehman's use and extent of Repo 105 transactions to manage its balance sheet."

--From the report, volume 1, executive summary, page 20

"Colorable claims exist that Ernst & Young did not meet professional standards, both in investigating Lee's allegations and in connection with its audit and review of Lehman's financial statements."

--From the report, executive summary, page 21

"The Examiner finds colorable claims against JPMorgan Chase ("Chase") and CitiBank in connection with modifications of guaranty agreements and demands for collateral in the final days of Lehman's existence. The demands for collateral by Lehman's Lenders had direct impact on Lehman's liquidity pool; Lehman's available liquidity is central to the question of why Lehman failed."

--From the report, executive summary, page 24

* * *

Whistleblower Letter -- "On Its Face Pretty Ugly"

Lehman employee Matthew Lee will gain fame as one of whistleblowers who tried to prevent the company's demise. The report says Lehman's auditors refer to Matthew Lee's letter to senior management as a "whistleblower letter" and an "ugly" one at that. No wonder Lehman's senior management and outside auditors, Ernst & Young, said they were "stressed."

"[W]e are also dealing with a whistleblower letter, that is on its face pretty ugly and will take us a significant amount of time to get through. I am confident from what I have seen it shouldn't result in any significant issues around financial reporting, but again there is a lot of work to do yet. This combined with some very difficult accounting issues around off balance sheet items is adding stress to everyone." (From a June 8, 2008, email from William Schlich, a former lead partner on Ernst & Young's Lehman team)

--From the report: Volume 3, page 961

Repo 105 -- "Another drug we r on"

The examiner criticized Lehman for the "materially misleading" approach it took to represent its financial condition. He focused on the so-called "repo" market, in which firms sell assets in exchange for cash to fund operations, often just overnight or for a few days.

The examiner said that Lehman -- anxious to maintain favorable credit ratings -- engaged in an accounting device known within the firm as "Repo 105" to essentially park about $50 billion of assets away from Lehman's balance sheet. The move helped Lehman look like it had less debt on its books.

"In this way, unbeknownst to the investing public, rating agencies, Government regulators, and Lehman's Board of Directors, Lehman reverse engineered the firm's net leverage ratio for public consumption."

--From the report, volume 3, page 739

* * *

The Repo 105 strategy sparked debate inside Lehman, according to the report. In an April 2008 email, Bart McDade called such accounting maneuvers "another drug we r on." Mr. McDade, then Lehman's equities chief, says he sought to limit such maneuvers, according to the report (page 763..

Numerous internal Lehman e-mails referred to Repo 105 transactions in pejorative terms, such as "balance sheet window-dressing."

An illustrative example is found in the following July 2008 e-mail exchange:

"Vallecillo: "So what's up with repo 105? Why are we doing less next quarter end?"

McGarvey: "It's basically window-dressing. We are calling repos true sales based on legal technicalities. The exec committee wanted the number cut in half."

Vallecillo: "I see . . . so it's legally do-able but doesn't look good when we actually do it? Does the rest of the street do it? Also is that why we have so much BS [balance sheet] to Rates Europe?

McGarvey: "Yes, No and yes. :)"

--From the report, volume 3, pages 860-866:

* * *

Senior management exerted pressure, particularly at or near quarter-end, to utilize the Repo 105 mechanism to meet the firm-imposed balance sheet targets:

Four days before the close of Lehman's fiscal year in November 2007, Mitch King wrote to Marc Silverberg: "Let me know if we have room for any more repo 105. I have some more I can put in over month end." Jerry Rizzieri, who reported directly to Kaushik Amin, replied to King: "Can you imagine what this would be like without 105?"

--From the report, volume 3, pages 860-866:

* * *

J.P. Morgan's Collateral Demands -- "Part Art, Part Science, and Part Catch Up"

Several factors helped to tip Lehman over the brink in its final days. Investment banks, including J.P. Morgan Chase & Co., made demands for collateral and modified agreements with Lehman that hurt Lehman's liquidity and pushed it into bankruptcy.

On September 11, J.P. Morgan executives met to discuss significant valuation problems with securities that Lehman had posted as collateral over the summer. J.P. Morgan concluded that the collateral was not worth nearly what Lehman had claimed it was worth, and decided to request an additional $5 billion in cash collateral from Lehman that day. Discussions between Lehman and J.P. Morgan executives were tense. According to J.P. Morgan witnesses, Steven Black, a senior J.P. Morgan executive, communicated the $5 billion collateral request to Richard Fuld by telephone on September 9. Black stated that he explained that the collateral was intended to cover J.P. Morgan's exposure to Lehman in its entirety. Lehman posted $5 billion in cash to JPMorgan by the afternoon of Friday, Sept. 12.

Mr. Black described J.P. Morgan's formulation of the $5 billion amount to the examiner as "part art, part science, and part catch up."

"Black stated that he relayed to Fuld that JPMorgan was not trying to solve JPMorgan's problem by creating new problems for Lehman. He asserted that he told Fuld that, if Lehman was "near the edge," Fuld should say so. According to Black, Fuld asked whether JPMorgan was interested in making a capital infusion, but JPMorgan was not. Black stated that he advised Fuld that if Lehman were skating close to the edge, Lehman should call the Federal Reserve so that the Federal Reserve could "herd the cats" needed to assist Lehman. According to Black, Fuld said Lehman was not anywhere close to the point of needing such assistance."

From the report, Volume 4, page 95

* * *

More on J.P. Morgan's Role -- Good Faith and Fair Dealing?

"Notwithstanding J.P. Morgan's concerns with the quantity and quality of collateral posted by Lehman, Lehman believed that J.P. Morgan was overcollateralized. There is no evidence, however, that Lehman requested in writing the return of the billions of dollars of collateral it had posted in September. Lehman did informally request the return of at least some of its collateral, and J.P. Morgan returned some securities to Lehman on September 12. J.P. Morgan did not, however, release any of the cash collateral that Lehman had posted in response to the September 9 and September 11 requests.

"Finally, the examiner concludes that the evidence may support the existence of a colorable claim – but not a strong claim – that J.P. Morgan breached the implied covenant of good faith and fair dealing by making excessive collateral requests to Lehman in September 2008. A trier of fact would have to consider evidence that the collateral requests were reasonable and that Lehman waived any claims by complying with the requests."

-- From the report, volume 4, page 1071

* * *

'Hail Mary' to Warren Buffett:

New details in the report contain insights on why Buffett passed on Lehman. They open a window on his methods for assessing management and some of the red flags that waved him off.

"Fuld and Buffett spoke on Friday, March 28, 2008. They discussed Buffett investing at least $2 billion in Lehman.2439 Two items immediately concerned Buffet during his conversation with Fuld.2440 First, Buffett wanted Lehman executives to buy under the same terms as Buffett.2441 Fuld explained to the Examiner that he was reluctant to require a significant buy‐in from Lehman executives, because they already received much of their compensation in stock.2442 However, Buffett took it as a negative that Fuld suggested that Lehman executives were not willing to participate in a significant way.2443 Second, Buffett did not like that Fuld complained about short sellers.2444 Buffett thought that blaming short sellers was indicative of a failure to admit one's own problems."

--From the report, Volume 2, page 480

* * *

How Liquid was Lehman's Liquidity Pool?

"[T]he importance of liquidity to investment bank holding companies cannot be overstated. Broker-dealers are dependent on short-term financing to fund their daily operations, and a robust liquidity pool is critical to a broker-dealer's access to such financing."

--From the report, volume 4, page 1066

"By the second week of September 2008, Lehman found itself in a liquidity crisis; it no longer had sufficient liquidity to fund its survival. Thus, an understanding of Lehman's collateral transfers, and Lehman's attendant loss of readily available liquidity, is essential to a complete understanding of why Lehman ultimately failed."

-- From the report, volume 4, page 1084

"Lehman represented in regulatory filings and in public disclosures that it maintained a liquidity pool that was intended to cover expected cash outflows for 12 months in a stressed liquidity environment and was available to mitigate the loss of secured funding capacity. After the Bear Stearns crisis in March 2008, it became acutely apparent to Lehman that any disruption in liquidity could be catastrophic; Lehman thus paid careful attention to its liquidity pool and how it was described to the market. Lehman reported the size of its liquidity pool as $34 billion at the end of first quarter 2008, $45 billion at the end of second quarter, and $42 billion at the end of the third quarter. Lehman represented that its liquidity pool was unencumbered – that it was composed of assets that could be "monetized at short notice in all market environments."

"The Examiner's investigation of Lehman's transfer of collateral to its lenders in the summer of 2008 revealed a critical connection between the billions of dollars in cash and assets provided as collateral and Lehman's reported liquidity. At first, Lehman carefully structured certain of its collateral pledges so that the assets would continue to appear to be readily available (i.e., the Overnight Account at JPMorgan, the $2 billion comfort deposit to Citi, and the three-day notice provision with BofA). Witness interviews and documents confirm that Lehman's clearing banks required this collateral and without it would have ceased providing clearing and settlement services to Lehman or, at the very least, would have required Lehman to prefund its trades. The market impact of either of those outcomes could have been catastrophic for Lehman. Lehman also included formally encumbered collateral in its liquidity pool. Lehman included the almost $1 billion posted to HSBC and secured by the U.K. Cash Deeds in its liquidity pool; Lehman included the $500 million in collateral formally pledged to BofA; Lehman included an additional $8 billion in collateral posted to JPMorgan and secured by the September Agreements; and Lehman continued to include the $2 billion at Citi, even after the Guaranty and DCSA amendments."

-- From the report, volume 4, page 1082-1083

* * *

"This Section of the Report examines the circumstances surrounding Lehman's provision of approximately $15 to $21 billion in collateral (both in cash and securities) to its clearing banks, and Lehman's simultaneous inclusion of those funds in its reported liquidity pool."

"Critically, the collateral posted by Lehman with its various clearing banks was initially structured in a manner that enabled Lehman to claim the collateral as nominally lien-free (at least overnight), and continue to count it in its reported liquidity pool. However, by September 2008, much of Lehman's reported liquidity was locked up with its clearing banks, and yet this fact remained undisclosed to the market prior to Lehman's bankruptcy."

-- From the report, volume 4, page 1067

Also see http://documents.nytimes.com/lehman-brothers-repo-105-valukas-report#p=1

From the Lehman Examiner Report - Volume 3, beginning page 945
as Forwarded (with highlights) to Bob Jensen by Lynn Turner

"(3) Lehman’s Board of Directors

Without exception, former Lehman directors were unaware of Lehman’s Repo
105 program and transactions.3642
As discussed in greater detail below, Lehman’s own Corporate Audit group led
by Beth Rudofker, together with Ernst & Young, investigated allegations about balance
sheet substantiation problems made in a May 16, 2008 “whistleblower” letter sent to
senior management by Matthew Lee.3643 On June 12, 2008, during the investigation, Lee
informed Ernst & Young about Lehman’s use of $50 billion of Repo 105 transactions in
the second quarter of 2008.3644 At a June 13, 2008 meeting, Ernst & Young failed to
disclose that allegation to the Board’s Audit Committee.3645

Former Lehman director Cruikshank recalled that he made very clear he wanted
a full and thorough investigation into each allegation made by Lee, whether the allegation was contained in Lee’s May 16, 2008 letter or raised by Lee in the course of
the investigation.3646 Another former Lehman director, Berlind, similarly stated that the
Audit Committee explicitly instructed Lehman’s Corporate Audit Group and Ernst &
Young to keep the Audit Committee informed of all of Lee’s allegations.3647 Berlind also
said that he would have wanted to know about Lehman’s Repo 105 program and that if
he had known about Lehman’s Repo 105 transactions, he would have asked Lehman’s
auditors to test the transactions to ensure they were appropriate.3648 Upon learning from
the Examiner the volume of Repo 105 transactions at quarter‐end in late 2007 and 2008,
Sir Christopher Gent said that he believed the volume mandated disclosure to the Audit
Committee and further investigation.3649

Dr. Kaufman, on the other hand, stated that he would have wanted to know
about Repo 105 transactions only if they were “huge” and fraudulent, by which he
meant in violation of specific accounting rules or in violation of the law.3650 Dr.
Kaufman did not believe that $50 billion in Repo 105 transactions was significant even if
that volume changed Lehman’s net leverage ratio by approximately two points.3651 Dr.Kaufman considered a four or five point change in the net leverage ratio to be
significant.3652

In late 2007 and 2008, management made numerous presentations to the Board
regarding balance sheet reduction and deleveraging; in no case was the use of Repo 105
transactions disclosed in those presentations.3653

i) Ernst & Young’s Knowledge of Lehman’s Repo 105 Program
During several Rule 30(b)(6)‐type3654 interview sessions, the Examiner
interviewed members of Ernst & Young’s Lehman audit team regarding Ernst &
Young’s knowledge of and involvement in Lehman’s Repo 105 program.
(1) Ernst & Young’s Comfort with Lehman’s Repo 105 Accounting
Policy

The Examiner interviewed Ernst & Young’s lead partner on the Lehman audit
team, William Schlich, regarding Lehman’s Repo 105 program. According to Schlich,
Ernst & Young had been aware of Lehman’s Repo 105 policy and transactions for many
years.3655 Consistent with the statements of Lehman’s John Feraca (Secured Funding
Desk), Schlich stated that Lehman introduced its Repo 105 Accounting Policy on the
heels of the FASB’s promulgation of SFAS 140.3656 During that time, Ernst & Young
“discussed” the Repo 105 Accounting Policy (including Lehman’s structure for Repo
105 transactions) and Ernst & Young’s team had a number of additional conversations
with Lehman about Repo 105 over the years.3657 However, according to Schlich, Ernst &Young had no role in the drafting or preparation of Lehman’s Repo 105 Accounting
Policy.3658

Schlich stated definitively that Ernst & Young had no advisory role with respect
to Lehman’s use of Repo 105 transactions and that Ernst & Young did not “approve”
the Accounting Policy.3659 Rather, according to Schlich, Ernst & Young “bec[a]me
comfortable with the Policy for purposes of auditing financial statements.”3660
Following “consultation and dialogue” about the proper interpretation and
application of SFAS 140, Ernst & Young “clearly. . .concurred with Lehman’s approach”
to SFAS 140 and subsequent literature by FASB on the issue of “control” of assets
involved in a repo transactions.3661 Ernst & Young’s view, however, was not based upon
an analysis of whether actual Repo 105 transactions complied with SFAS 140.3662 Rather,
Ernst & Young’s review of Lehman’s Repo 105 Accounting Policy was purely
“theoretical.”3663 In other words, Ernst & Young solely assessed Lehman’s
understanding of the requirements of SFAS 140 in the abstract and as reflected in its
Accounting Policy; Ernst & Young did not opine on the propriety of the transactions as a balance sheet management tool.3664 Ernst & Young did not review the Linklaters letter,
referenced in the Accounting Policy Manual.3665

According to Martin Kelly, it was not unusual for him to discuss various issues,
including Repo 105, with Ernst & Young.3666 Indeed, Kelly recalled specifically speaking
with Schlich about Repo 105 transactions soon after becoming Financial Controller on
December 1, 2007, in an effort to learn more about the program and “to understand
[Ernst & Young’s] approach before talking to Callan.”3667

Kelly “wanted to ensure that Ernst & Young analyzed the program in the same
way that [Marie] Stewart [Global Head of Accounting Policy] had analyzed it.”3668
Kelly’s conversations with Ernst & Young focused on the accounting treatment of Repo
105 transactions.3669 According to Kelly, Ernst & Young “was comfortable with the
treatment under GAAP for the same reasons that Lehman was comfortable.”3670 Kelly also discussed with Ernst & Young Lehman’s inability to get a true sale opinion under United States law for Repo 105 transactions.3671 Kelly could not recall whether he
discussed with Ernst & Young his discomfort with Lehman’s Repo 105 program.3672
(2) The “Netting Grid”

Throughout 2007, Lehman maintained a document entitled “Accounting Policy
Review Balance Sheet Netting and Other Adjustments,” known colloquially among
Lehman’s Accounting Policy and Balance Sheet Groups, as well at Ernst & Young, as
the “Netting Grid.” The Netting Grid identified and described various balance sheet
netting mechanisms employed by Lehman: one such balance sheet mechanisms was
Lehman’s use of Repo 105 transactions.3673

Lehman provided the Netting Grid to Ernst & Young at least in August 2007 (the
close of Lehman’s third quarter 2007) and in November 2007 (the close of Lehman’s
fiscal year 2007).3674 Notably, the Netting Grid provided by Lehman to Ernst & Young in
August 2007 and November 2007 only contained Repo 105 volumes from November 30, 2006 and February 28, 2007.3675 Schlich was unaware whether Ernst & Young asked
Lehman to provide its second quarter 2007 and third quarter 2007 Repo 105 usage
figures or a forecast of Lehman’s fourth quarter 2007 Repo 105 numbers.3676
Ernst & Young reviewed the Netting Grid, analyzed the various balance sheet
netting mechanisms identified in the Netting Grid, and used the document in
connection with its 2007 year‐end audit of Lehman.3677 According to Schlich, Ernst &
Young, as part of its review of Lehman’s Netting Grid, approved of Lehman’s internal Repo 105 Accounting Policy only, and did not pass upon the actual practice.3678
The Netting Grid described the transactions and United States GAAP reference
as follows: “Under certain conditions that meet the criteria described in paragraphs 9
and 218 of SFAS 140, Lehman policy permits reverse repo and repo agreements to be
recharacterized as purchases and sales of inventory.”3679 With respect to Lehman’s use
of Repo 105 transactions to reduce its net balance sheet, the Netting Grid sets forth the conclusion that Lehman’s “current practice [for Repo 105] is correct.”3680 Schlich noted
that this conclusion about the Repo 105 practice was Lehman’s, not Ernst & Young’s.3681
To test Lehman’s conclusion, however, Ernst & Young “reviewed how Lehman applied
the control provisions of the accounting rules.”3682

Ernst & Young’s review, however, applied only to the accounting basis for these
transactions, not to their volume or purpose. Specifically, Ernst & Young’s review and
analysis of Lehman’s Repo 105 program did not account for the volumes of Repo 105
transactions Lehman undertook at quarter‐end.3683 Indeed, Schlich was unable to
confirm or deny the volumes of Repo 105 transactions Lehman undertook at Lehman’s
fiscal year‐end 2007, or in the first two quarter‐ends of 2008.3684 Nor was Schlich able to
confirm or deny that Lehman’s use of Repo 105 transactions was increasing in late 2007
and into mid 2008.3685

(a) Quarterly Review and Audit

Through Schlich, Ernst & Young maintained that its duties as Lehman’s auditor
required it to ensure that transactions were accounted for correctly (i.e., that they
complied with accounting rules) and that Lehman’s financial disclosures were not materially misstated.3686 According to Schlich, Ernst & Young’s audit did not require
Ernst & Young to consider or review the volume or timing of Repo 105 transactions.3687
Accordingly, as part of its year‐end 2007 audit, Ernst & Young did not ask Lehman
about any directional trends, such as whether its Repo 105 activity was increasing
during fiscal year 2007.3688 Notably, as part of its quarterly review process, Ernst &
Young did not audit any of Lehman’s Repo 105 transactions.3689

(3) Ernst & Young Would Not Opine on the Materiality of
Lehman’s Repo 105 Usage

Ernst & Young, through Schlich, was unwilling to comment to the Examiner on
the materiality of the volume of Lehman’s quarter‐end Repo 105 transactions.3690 Asked
whether, as part of its responsibility to ensure Lehman’s financial statements were not
materially misstated, Ernst & Young should have considered the possibility that strict technical adherence to SFAS 140 or any other specific accounting rule could nonetheless lead to a material misstatement in Lehman’s publicly‐reported financial statements,
Schlich refrained from comment.3691

When pressed further, Schlich stated that the volume of any particular
transaction impacts neither the question of whether accounting rules are applied correctly, nor the question of whether a financial statement is materially misleading.3692
However, Schlich eventually acknowledged that “when you look at a balance sheet
issue, volume is a factor.”3693

Notably, the definition of “materiality” contained in a “walk‐through” document
related to Ernst & Young’s 2007 fiscal year‐end audit of Lehman was: “any transaction
that would move Lehman’s firm‐wide net leverage by 0.1 or more.”3694 This definition
reflected “Lehman’s determination of a materiality threshold” in connection with
Lehman’s own criteria for when to consider reopening and adjusting its balance
sheet.3695

When Schlich was asked what level of impact to Lehman’s firm‐wide net assets
Ernst & Young would have considered “material,” Schlich replied that Ernst & Young
did not have a hard and fast rule defining materiality in the balance sheet context, and
that, with respect to balance sheet issues, “materiality” depends upon the facts and
circumstances.3696 Schlich agreed that Lehman made no specific disclosures about Repo 105 transactions in its Forms 10‐K and Form 10‐Q, including the MD&A section.3697
Schlich believed, however, that Lehman’s public filings would have included general
language regarding secured borrowings and compliance with SFAS 140.3698 Schlich was
not aware whether Ernst & Young ever discussed Lehman’s disclosures vel non of Repo
105 activity with senior Lehman management.3699

(4) Matthew Lee’s Statements Regarding Repo 105 to Ernst &
Young

On May 16, 2008, Matthew Lee, then‐Senior Vice President in the Finance
Division responsible for Lehman’s Global Balance Sheet and Legal Entity Accounting, sent a letter to certain members of Lehman’s senior management identifying possible violations of Lehman’s Ethics Code related to accounting/balance sheet issues.3700 Lehman involved Ernst & Young in its investigation of the concerns raised in Lee’s May
16, 2008 letter.3701

Subsequently, less than a month later, on June 12, 2008, Ernst & Young – Schlich
and Hillary Hansen – interviewed Lee.3702 Hansen’s notes of the interview reveal that
Lee made certain statements to Ernst & Young about Lehman’s Repo 105 practice,
including, most notably, the volume of Repo 105 activity that Lehman engaged in at
quarter‐end (May 31, 2008).3703 Hansen’s notes specifically recount Lee’s allegation that
Lehman moved $50 billion of inventory off its balance sheet at quarter‐end through
Repo 105 transactions and that these assets returned to the balance sheet approximately
a week later.3704 When interviewed by the Examiner, Schlich did not recall Lee saying anything
about Repo 105 transactions during that interview, although he did not dispute the
authenticity of Hansen’s notes from the Lee interview.3705 In spite of Hansen’s notes,
Schlich maintained that Ernst & Young did not know that Lehman engaged in the
following Repo 105 activity during the listed time periods: $49.1 billion at first quarter
2008 (Feb. 29, 2008); and $50.38 billion at second quarter 2008 (May 31, 2008).3706
During the Examiner’s interview of Hansen, Hansen recalled that while Ernst &
Young questioned Lee about his May 16, 2008 letter, Lee “rattled off” a list of additional
issues and concerns he held, one of which was Lehman’s use of Repo 105
transactions.3707 Ernst & Young had no further conversations with Lee about Repo 105
transactions.3708 Prior to her interview of Lee in June 2008, Hansen had heard the term
Repo 105 “thrown around” but she did not know its meaning; according to Hansen,
Schlich described Repo 105 transactions to her shortly after they met with Lee.3709
Following Ernst & Young’s June 12, 2008 interview of Lee, Schlich and Hansen
met with Lehman’s Gerard Reilly to discuss Lee’s assertions regarding improper valuations.3710 During that meeting, Hansen informed Reilly of the $50 billion Repo 105
figure Lee provided during Ernst & Young’s interview of Lee.3711 According to Schlich,
Reilly (now deceased) told the auditors that he had no knowledge that Lehman used
Repo 105 transactions to move $50 billion in assets off its balance sheet.3712 “Hillary
[Hansen] took away from the meeting with Reilly that he did not know and it was not
$50 billion.”3713

On June 13, 2008 – the day after Lee informed Ernst & Young of the $50 billion in
Repo 105 transactions that Lehman undertook at the end of the second quarter 2008 –
Ernst & Young spoke to Lehman’s Audit Committee but did not inform the committee of Lee’s allegation, even though the Chairman of the Audit Committee had clearly stated that he wanted every allegation made by Lee – whether in Lee’s May 16 letter or during the course of the investigation – to be investigated.3714 Ernst & Young met with
the Audit Committee on July 8, 2008, to review the second quarter financial statements and again did not mention Lee’s allegations regarding Repo 105.3715 On July 22, 2008,
Ernst & Young was also present when Beth Rudofker, Head of Corporate Audit, gave a
presentation to the Audit Committee on the results of the investigation into Lee’s
allegations.3716

Ernst & Young did not disclose to the Audit Committee – either during the
meetings or in private executive sessions after – that Lee made an allegation related to
Repo 105 transactions being used to move assets off Lehman’s balance sheet at quarterend.
3717 Cruikshank told the Examiner that he would have expected to be told about
Lee’s Repo 105 allegations.3718 Similarly, Sir Gent told the Examiner that the alleged volume of Lehman’s Repo 105 transactions mandated disclosure to the Audit
Committee as well as further investigation.3719
Ernst & Young did not follow‐up on either Lee’s allegations regarding Lehman’s
Repo 105 activity or Reilly’s claim that he had no knowledge of Lehman’s alleged $50
billion Repo 105 usage figure.3720 Ernst & Young signed a Report of Independent
Registered Public Accounting Firm for Lehman’s second quarter 2008 Form 10‐Q on
July 10, 2008, less than four weeks after Schlich and Hansen interviewed Lee.3721

(5) Accounting‐Motivated Transactions

Ernst & Young did not evaluate the possibility that Repo 105 transactions were accounting‐motivated transactions that lacked a business purpose.3722 Schlich
characterized the off‐balance sheet treatment of Lehman’s assets in Repo 105
transactions as a consequence of the accounting rules, rather than a motive for the
transactions.3723

j) The Examiner’s Conclusions

There is sufficient evidence to support a determination by a trier of fact that
Lehman’s failure to disclose that it relied upon Repo 105 transactions to temporarily
reduce the firm’s net balance sheet and net leverage ratio was materially misleading. In
addition, a trier of fact could find that Lehman affirmatively misrepresented its
accounting treatment for repos by stating that Lehman treated repo transactions as
financing transactions rather than sales for financial reporting purposes, despite the fact
that Lehman treated tens of billions of dollars in repo transactions – namely, Repo 105
transactions – as true sale transactions. The Examiner thus concludes that sufficient evidence exists from which a trier of fact could find the existence of a colorable claim that certain Lehman officers breached
their fiduciary duties to Lehman and its shareholders by causing the company to file deficient and materially misleading financial statements, thereby exposing the company
to potential liability. Certain officers of Lehman not only failed to inform the public of
its reliance on Repo 105 transactions to reduce its balance sheet, they also failed to
advise Lehman’s Board of Directors of the firm’s Repo 105 practice. Thus, the Examiner
concludes that a trier of fact could find that certain Lehman officers breached their
fiduciary duties to Lehman’s Board of Directors by failing to inform them of: (1) the
firm’s reliance upon Repo 105 to reduce the balance sheet at quarter‐end, (2) the rampup
in Repo 105 usage in mid‐to‐late 2007 and 2008, (3) the impact of these transactions
on Lehman’s publicly reported net leverage ratio, or (4) the fact that Lehman did not
disclose its Repo 105 practice in its publicly reported financials statements and MD&A.

(1) Materiality

The materiality of information is evaluated from the perspective of a reasonable
investor.3724 Information is deemed material if there is “a substantial likelihood that the
disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.”3725
Materiality does not require, however, that the information be of a type that would
cause an investor to change his investment decision.3726

(a) Whether Lehman’s Repo 105 Transactions Technically
Complied with SFAS 140 Does Not Impact Whether a
Colorable Claim Exists

This Report does not reach the question of whether Lehman’s Repo 105
transactions technically complied with the relevant financial accounting standard, SFAS
140, because the answer to that question does not impact whether a colorable claim
exists regarding Lehman’s failure to disclose its Repo 105 practice and whether that
failure rendered the firm’s financial statements materially misleading.
Even if Lehman’s use of Repo 105 transactions technically complied with SFAS 140, financial statements may be materially misleading even when they do not violate GAAP.3727 The Second Circuit has explained that “GAAP itself recognizes that technical compliance with particular GAAP rules may lead to misleading financial statements, and imposes an overall requirement that the statements as a whole accurately reflect the financial status of the company.”3728

Similarly, as noted in In re Global Crossing Ltd. Securities Litigation, even if a
defendant established that its accounting practices “were in technical compliance with
certain individual GAAP provisions . . . this would not necessarily insulate it from liability. This is because, unlike other regulatory systems, GAAP’s ultimate goals of fairness and accuracy in reporting require more than mere technical compliance.”3729 The court
explained that “when viewed as a whole,” GAAP has no “loopholes” because its
purpose, shared by the securities laws, is “to increase investor confidence by ensuring
transparency and accuracy in financial reporting.”3730 Technical compliance with
specific accounting rules does not automatically lead to fairly presented financial statements. “Fair presentation is the touchstone for determining the adequacy of disclosure in financial statements. While adherence to generally accepted accounting principles is a tool to help achieve that end, it is not necessarily a guarantee of fairness.”3731 Moreover, registrants are “required to provide whatever additional information would be necessary to make the statements in their financial reports fair and accurate, and not
misleading.”3732

This view is echoed in an SEC enforcement order, concluding that GAAP
compliance does not excuse a misleading or less than full disclosure regarding a
transaction, especially if the transaction’s purpose is “the attainment of a particular
financial reporting result.”3733 “[E]ven if the transactions comply with GAAP, the issuer
is required to evaluate the material accuracy and completeness of the presentation
made by its financial statements.”3734 Issuers must “ensure that the way they publicly
portray themselves discloses, as required, the material elements of [their] economic and
business realities and risks.”3735

3732 Id. (citing 17 C.F.R. § 240.10b‐5(b) and 17 C.F.R. § 230.408 (requiring that “in addition to the information expressly required to be included in a registration statement, there shall be added such further material information, if any, as may be necessary to make the required statements, in the light of the circumstances under which they are made, not misleading”) (emphasis added); see also SEC v. Seghers, 298 Fed. App’x 319, 331 (5th Cir. 2008) (“The Commission’s proof of Segher’s misrepresentations and omissions does not depend on compliance with GAAP, but instead depends on evidence that Segher’s statements and omissions were false or misleading to investors.”); United States v. Olis, Civil Action No. H‐07‐3295, Criminal No. H‐03‐217‐01, 2008 WL 5046342, at *20 (S.D. Tex. Nov. 21, 2008) (“The scheme to defraud alleged and proved in this case did not turn on whether the treatment accorded to Project Alpha in Dynegy’s financial statements technically complied with GAAP or whether Olis and his coconspirators intended to violate GAAP but, instead, on whether the defendants’ disclosures about Project Alpha intentionally omitted material facts that caused Dynegy’s financial statements to be materially false and misleading.”) (citing United States v. Rigas, 490 F.3d 208, 221 (2d Cir. 2007), and United States v. Ebbers, 458 F.3d 110, 125‐26 (2d Cir. 2006)).

This is just a reminder that the survival of auditing firms other than Ernst & Young are threatened by shareholder/creditor lawsuits resulting from audits of failed banks and the virtual failure of all auditors to issue going concern opinions of thousands of banks that failed in 2008 and 2009.
Where Were the Auditors --- http://www.trinity.edu/rjensen/2008Bailout.htm#AuditFirms
Even the crooked credit rating agencies are suing the auditors.

Bob Jensen's threads on all Big Four firms ---
http://www.trinity.edu/rjensen/fraud001.htm

"E&Y launches defence of Lehman audit:  Letter goes out to clients," by Gavin Hinks, Accountancy Age, March 23, 2010 ---
http://ow.ly/1qjQW

Ernst & Young has launched a defence of its work as auditor of collapsed investment bank Lehman writing letters directly to clients, according to Reuters.

Ernsy & Young were accused of negligence in their audit of Lehman in a 2,000 page report published two weeks ago by the US bankruptcy examiner Anton Valukas.

(Click here to see our Lehman special report).

The firm's response, according to Reuters, has seen some partners write to clients informing them that the lead audit partner "promptly" called the chairman of Lehman's audit committee when he learned of a key letter from a whistleblower about accounting at the bank.

The E&Y letter, seen by Reuters, reportedly says that the lead partner insisted that the Lehman management inform the watchdog, the Securities and Exchange Commission, and the Federal Reserve Bank of the letter.

E&Y say that the letter was discussed with the Lehman audit committee at least three times.

Criticism of Lehman in the examiner's report centered on the accounting treatment of so called Repo 105 transactions.

These involve the short-term sale of assets in order to raise cash. The deals come with an agreement to buy the assets back at a later date. As a result the assets remain on the seller's balance sheet because control of the assets has not been surrendered.

In Lehman's case the bankruptcy examiner claimed the bank used a technicality to get risky assets off its balance sheet. This was achieved by offering assets worth 105% of the cash received in consideration. Because this would not cover the cost of buying the assets back, control is said to have been lost, under US rules, and the assets could be taken off the balance sheet temporarily, even though Lehman would pay to take them back later. The difference between the price received for the assets and the sum paid to take them back is called the 'haircut'.

The E&Y letter to clients said the firm believes it "will prevail" if the examiner's claims turn into court action against the firm.

Reuters reports that the letter also reveals that the time leading up to the collapse of Lehman was, for E&Y, "among the most turbulent periods in our economic history."

The letter insists the failure of Lehman came about as a result of a collapse in liquidity caused by declining asset values and a loss of market confidence. The firm reportedly insists it was not as a result of accounting or disclosure issues.

The examiner's report said that there could be "colorable claims" against the auditor.

Bob Jensen's threads on Ernst & Young's troubles are at
http://www.trinity.edu/rjensen/fraud001.htm

Ernst & Young Explains Its Side of the Lehman Bankruptcy Examiner's Report Controversy

March 19, 2010 message from Dennis Beresford [dberesfo@TERRY.UGA.EDU]

In light of the extensive discussion of the Lehman Bros. and E&Y matter on this listserv over the past couple of weeks, I thought readers might be interested in the message I've copied below. This was sent to me in my capacity as an audit committee chairman.

I hope this might balance the discussion somewhat. I would observe that to date the postings have been based mainly on newspaper accounts of the bankruptcy examiner's lengthy report that was completed for the purpose of determining whether the bankruptcy estate might have claims against various parties. In effect, basing one's conclusions about a situation on this source material is roughly equivalent to a judge or jury reaching a decision after hearing only the prosecution's side of the case. While the message below is necessarily very brief, I think it illustrates that there are other facts and arguments that should be fairly evaluated before anyone is found guilty in the court of public opinion or otherwise.

Denny Beresford

I hope this note finds you well and enjoying the early days of Spring.

In light of your role in our Audit Committee Leadership Network, I am sending you this note to brief you on a matter given there have been extensive media reports about the release of the Bankruptcy Examiner’s Report relating to the September 2008 bankruptcy of Lehman Brothers. As you may have read, Ernst & Young was Lehman Brothers’ independent auditors.

The concept of an examiner’s report is a feature of US bankruptcy law.

It does not represent the views of a court or a regulatory body, nor is the Report the result of a legal process. Instead, an examiner’s report is intended to identify potential claims that, if pursued, may result in a recovery for the bankrupt company or its creditors. EY is confident we will prevail should any of the potential claims identified against us be pursued.

We wanted to provide you with EY’s perspective on some of the potential claims in the Examiner’s Report. We also wanted to address certain media coverage and commentary on the Examiner’s Report that has at times been inaccurate, if not misleading.

A few key points are set out below.

*_General Comments_*

· EY’s last audit was for the year ended November 30, 2007. Our opinion stated that Lehman’s financial statements for 2007 were fairly presented in accordance with US GAAP, and we remain of that view. We reviewed but did not audit the interim periods for Lehman’s first and second quarters of fiscal 2008.

· Lehman’s bankruptcy was the result of a series of unprecedented adverse events in the financial markets. The months leading up to Lehman’s bankruptcy were among the most turbulent periods in our economic history. Lehman's bankruptcy was caused by a collapse in its liquidity, which was in turn caused by declining asset values and loss of market confidence in Lehman. It was not caused by accounting issues or disclosure issues.

· The Examiner identified _no_ potential claims that the assets and liabilities reported on Lehman’s financial statements (approximately

$691 billion and $669 billion respectively, at November 30, 2007) were improperly valued or accounted for incorrectly.

*_Accounting and Disclosure Issues Relating to Repo 105 Transactions_* · There has been significant media attention about potential claims identified by the Examiner related to what Lehman referred to as “Repo 105” transactions. What has not been reported in the media is that the Examiner _did not_ challenge Lehman’s accounting for its Repo 105 transactions.

·As recognized by the Examiner, all investment banks used repo transactions extensively to fund their operations on a daily basis; these banks all operated in a high-risk, high-leverage business model.

Most repo transactions are accounted for as financings; some (the Repo

105 transactions) are accounted for as sales if they meet the requirements of SFAS 140.

· The Repo 105 transactions involved the sale by Lehman of high quality liquid assets (generally government-backed securities), in return for which Lehman received cash. The media reports that these were “sham transactions” designed to off-load Lehman’s “bad assets” are inaccurate.

· Because effective control of the securities was surrendered to the counterparty in the Repo 105 arrangements, the accounting literature (SFAS 140) /required /Lehman to account for Repo 105 transactions as sales rather than financings.

· The potential claims against EY arise solely from the Examiner’s conclusion that these transactions ($38.6 billion at November 30, 2007) should have been specifically disclosed in the footnotes to Lehman’s financial statements, and that Lehman should have disclosed in its MD&A the impact these transactions would have had on its leverage ratios if they had been recorded as financing transactions.

· While no specific disclosures around Repo 105 transactions were reflected in Lehman’s financial statement footnotes, the 2007 audited financial statements were presented in accordance with US GAAP, and clearly portrayed Lehman as a leveraged entity operating in a risky and volatile industry. Lehman’s 2007 audited financial statements included footnote disclosure of off balance sheet commitments of almost $1 trillion.

· Lehman’s leverage ratios are not a GAAP financial measure; they were included in Lehman’s MD&A, not its audited financial statements. Lehman concluded no further MD&A disclosures were required; EY did not take exception to that judgment.

· If the Repo 105 transactions were treated as if they were on the balance sheet for leverage ratio purposes, as the Examiner suggests, Lehman’s reported gross leverage would have been 32.4 instead of 30.7 at November 30, 2007. Also, contrary to media reports, the decline in Lehman’s reported leverage from its first to second quarters of 2008 was not a result of an increased use of Repo 105 transactions*. *Lehman’s Repo 105 transaction volumes were comparable at the end of its first and second quarters.

*_Handling of the Whistleblower’s Issues_*

· The media has inaccurately reported that EY concealed a May 2008 whistleblower letter from Lehman’s Audit Committee. The whistleblower letter, which raised various significant potential concerns about Lehman’s financial controls and reporting /but did not mention Repo 105/, was directed to Lehman’s management. When we learned of the letter, our lead partner promptly called the Audit Committee Chair; we also insisted that Lehman’s management inform the Securities & Exchange Commission and the Federal Reserve Bank of the letter. EY’s lead partner discussed the whistleblower letter with the Lehman Audit Committee on at least three occasions during June and July 2008.

· In the investigations that ensued, the writer of the letter did briefly reference Repo 105 transactions in an interview with EY partners. He also confirmed to EY that he was unaware of any material financial reporting errors. Lehman’s senior executives did not advise us of any reservations they had about the company’s Repo 105 transactions.

· Lehman’s September 2008 bankruptcy prevented EY from completing its assessment of the whistleblower’s allegations. The allegations would have been the subject of significant attention had EY completed its third quarter review and 2008 year-end audit.

Should any of the potential claims be pursued, we are confident we will prevail.

March 20, 2010 reply from Bob Jensen

Hi Denny,

Thank you for this. I was worried that Ernst & Young would refrain from commenting on this hot topic that will probably end up in pending litigation.

The E&Y response is terribly discouraging to me because the audit firm tries to hide behind the letter of the rules of GAAP rather than the spirit of GAAP. Yesterday I pointed out that USC's Jerry Arnold (who is truly an expert on the rules of GAAP) tried to earn his million dollars defending Enron's founder, Ken Lay, by arguing in court that Enron abided by the letter of GAAP (except where Andy Fastow was lying about SPEs and really embezzling money from Enron itself). In Ken Lay's case Arnold's testimony did not prevent his client's being found guilty on ten counts of fraud and conspiracy to mislead investors in Enron's audited financial statements. In court, the verdicts often focus on the spirit of the law instead of the letter of the law.

I am particularly distressed by the following claim (in the message below) by Ernst & Young:

Begin Quotation
Because effective control of the securities was surrendered to the

counterparty in the Repo 105 arrangements, the accounting literature

(SFAS 140) /required /Lehman to account for Repo 105 transactions as

sales rather than financings.
End Quotation

If Lehman is obligated in a matter of days to buy back the poisoned Repo 105 securities at prices greater than the “selling prices” I have a hard time with the auditor’s assertion that these were legitimate sales where the seller gave up control. The buyer is not like to keep those securities or sell them to anybody other than Lehman since the selling prices were phony inflated prices way above fair market value.

This is a Jerry Arnold déjà vu where auditors are trying to hide behind the letter of accounting rules but not the spirit of accounting rules. It makes a mockery out of the “present fairly” concept. If this was anything but a ploy from having to show impaired-value assets on the balance sheet I will eat my hat.

I will never, ever accept the E&Y argument that the 2007 audited report of Lehman fairly presented the poison CDO investments of Lehman. The poison in those CDOs existed before the end of 2007, and surely the auditors must've known the bad debt reserves were underestimated by hundreds of billions of dollars. Where were the asset impairment tests required for auditors?

Where were the auditors?
http://www.trinity.edu/rjensen/2008Bailout.htm#AuditFirms

 

It seems to me that there’s a whole lot more professionalism issues involved in the Lehman audits and reviews just like there should’ve been a whole lot more involved in the Enron audits and reviews.

In any event, Andersen does not appear to have applied the GAAP requirement to recognize asset impairment (FAS 121). From our reading of the Powers Report, the put-options written by the SPEs that, presumably, offset Enron's losses on its merchant investment, were not collectible, because the SPEs did not have sufficient net assets.
"ENRON: what happened and what we can learn from it," by George J. Benston and Al L. Hartgraves, Journal of Accounting and Public Policy, 2002, pp. 125-137:

3.3 Independent public accountants (CPAs)

The highly respected firm of Arthur Andersen audited and unqualifiedly signed Enron's financial statements since 1985.  According to the Powers Report, Andersen was consulted on and participated with Fastow in setting up the SPEs described above.  Together, they crafted the SPEs to conform to the letter of the GAAP requirement that the ownership of outside, presumably independent, investors must be at least 3% of the SPE assets.  At this time, it is very difficult to understand why they determined that Fastow was an independent investor.  Kopper's independence also is questionable, because he worked for Fastow.  In any event, Andersen appears, at best, to have accepted as sufficient Enron's conformance with the minimum specified requirements of codified GAAP.  They do not appear to have realized or been concerned that the substance of GAAP was violated, particularly with respect to the independence of the SPEs that permitted their activities to be excluded from Enron's financial statements and the recording of mark-to-market-based gains on assets and sales that could not be supported with trustworthy numbers (because these did not exist).  They either did not examine or were not concerned that the put obligations from the SPEs that presumably offset declines in Enron's investments (e.g., Rhythms) were of no or little economic value.  Nor did they require Enron to record as a liability or reveal as a contingent liability its guarantees made by or though SPEs. Andersen also violated the letter of GAAP and GAAS by allowing Enron to record issuance of its stock for other than cash as an increase in equity.  Andersen also did not have Enron adequately report, as required, related-party dealings with Fastow, an executive officer of Enron, and the consequences to stockholders of his conflict of interest.

4.1 GAAP

We believe that two important shortcomings have been revealed.  First, the US model of specifying rules that must be followed appears to have allowed or required Andersen to accept procedures that accord with the letter of the rules, even though they violate the basic objectives of GAAP accounting.  Whereas most of the SPEs in question appeared to have the minimum-required 3% of assets of independent ownership, the evidence outlined above indicates that Enron in fact bore most of the risk.  In several important situations, Enron very quickly transferred funds in the form of fees that permitted the 3% independent owners to retrieve their investments, and Enron guaranteed the SPEs liabilities.  Second, the fair-value requirement for financial instruments adopted by the FASB permitted Enron to increase its reported assets and net income and thereby, to hide losses.  Andersen appears to have accepted these valuations (which, rather quickly, proved to be substantially incorrect), because Enron was following the specific GAAP rules.

Andersen, though, appears to have violated some important GAAP and GAAS requirements.  There is no doubt that Andersen knew that the SPEs were managed by a senior officer of Enron, Fastow, and that he profited from his management and partial ownership of the SPEs he structured.  On that basis alone, it seems that Andersen should have required Enron to consolidate the Fastow SPEs with its financial statements and eliminate the financial transactions between those entities and Enron.  Furthermore, it seems that the SPEs established by Fastow were unlikely to be able to fulfill the role of closing put options written to offset losses in Enron's merchant investments.  If this were the purpose, the options should and would have been purchased from an existing institution that could meet its obligations.

Andersen also seems to have allowed Enron to violate the requirement specified in FASB Statement 5 that guarantees of indebtedness and other loss contingencies that in substance have the same characteristics, should be disclosed even if the possibility of loss is remote.  The disclosure shall include the nature and the amount of the guarantee.  Even if Andersen were correct in following the letter, if not the spirit of GAAP in allowing Enron to not consolidate those SPEs in which independent parties held equity equal to at least 3% of assets, Enron's contingent liabilities resulting from its loan guarantees should have been disclosed and described.

In any event, Andersen does not appear to have applied the GAAP requirement to recognize asset impairment (FAS 121).  From our reading of the Powers Report, the put-options written by the SPEs that, presumably, offset Enron's losses on its merchant investment, were not collectible, because the SPEs did not have sufficient net assets.  (Details on the SPEs' financial situations should have been available to Andersen.)  GAAP (FAS 5) also requires a liability to be recorded when it is probable that an obligation has been incurred and the amount of the related loss can reasonable be estimated.  The information presently available indicates that Enron's guarantees on the SPEs and Kopper's debt had become liabilities to Enron.  It does not appear that they were reported as such.

GAAP (FAS 57) specifies that relationships with related parties "cannot be presumed to be carried out on an arm's-length basis, as the requisite conditions be competitive, free-market dealings may not exist".  As Executive Vice President and CFO, Fastow clearly was a "related party".  SEC Regulation S-K (Reg. §229.404. Item 404) requires disclosure of details of transactions with management, including the amount and remuneration of the managers from the transactions.  Andersen does not appear to have required Enron to meet this obligation.  Perhaps more importantly, Andersen did not reveal the extent to which Fastow profited at the expense of Enron's shareholders, who could only have obtained this information if Andersen had insisted on its inclusion in Enron's financial statements.

4.2 GAAS

SAS 85 warns auditors not to rely on management representations about onset values, liabilities, and related-party transactions, among other important items.  Appendix B to SAS 85 illustrates the information that should be obtained by the auditor to review how management determined the fair values of significant assets that do not have readily determined market values.  We do not have access to Andersen's working papers to examine whether or not they followed this GAAS requirement.  In the light of the Wall Street Journal report presented above of Enron's recording a fair value for the Braveheart project with Blockbuster Inc., though, we find it difficult to believe that Andersen followed the spirit and possibly not even the letter of this GAAS requirement.

SAS 45 and AICPA, Professional Standards, vol. 1, AU sec. 334 specify audit requirements and disclosures for transactions with related parties.  As indicated above, this requirement does not appear to have been followed.

An additional lesson that should be derived from the Enron debacle is that auditors should be aware of the ability of opportunistic managers to use financial engineering methods, to get around the requirements of GAAP.  For example, derivatives used as hedges can be structured to have gains on one side recorded at market or fair values while offsetting losses are not recorded, because they do not qualify for restatement to fair-value.  Another example is a loan disguised as a sale of a corporation's stock with guaranteed repurchase from the buyer at a higher price.  If this subterfuge were not discovered, liabilities and interest expense would be understated.  Thus, as auditors have learned to become familiar with computer systems, they must become aware of the means by which modern finance techniques can be used to subvert GAAP.

The above findings from the Powers Report appear to be inconsistent with the testimony of four years later.

"Accountants: Enron Financials Correct ," by Michael Graczyk (Associated Press Writer), SmartPros, May 4, 2006 --- http://accounting.smartpros.com/x52873.xml 

May 4, 2006 (Associated Press) — Last-minute changes to quarterly earnings reports prosecutors contend were ordered by Enron Corp. Chief Executive Jeffrey Skilling to improve the company's reputation on Wall Street were accurate, and not the result of improper tapping of company reserves, a defense expert testified Wednesday.

"The whole process of financial reporting, in a company as large as Enron, to get financial statements out ... is an enormous undertaking," said Walter Rush, an accounting expert hired by Skilling. "And people are scrambling, trying to get these estimates put together.

"There are changes going on up to the very last second. It is universal. Every company goes through this."

Rush was the second consecutive accounting expert to take the stand, following University of Southern California professor Jerry Arnold, who testified for Enron founder and former CEO Kenneth Lay.

They are among the last defense witnesses, as lawyers for the two top chiefs at Enron expect to conclude their case early next week, the 15th week of their federal fraud trial.

Mark Koenig, former head of investor relations at Enron, testified early in the trial that he believed top Enron executives were so bent on meeting or beating earnings expectations to keep analysts bullish on the company's stock that they made or knew of overnight changes to estimates. Paula Rieker, Koenig's former top lieutenant, said Koenig told her Skilling ordered abrupt last-minute changes to two quarterly earnings reports to please analysts and investors.

"They could have just had a bad number," Rush said, referring to Koenig's and Rieker's testimony about a late-night change in a fourth-quarter 1999 report that boosted earnings per share from 30 cents to 31 cents.

Arthur Andersen, Enron's outside accounting firm, already had the 31-cent number days earlier, Rush said.

"They could have been a couple steps behind the way the process was evolving," he said of Koenig and Rieker.

In addition, Rush said the intention to "beat the street," a phrase attributed to Skilling, was typical in business.

"Companies set goals and forecasts for themselves all the time," Rush said.

Prosecutors also contend Enron achieved its rosy earnings by drawing improperly from reserves. But Rush, responding specifically to second-quarter earnings in 2000, said a transfer from one reserve was not material since Enron had another, underreported reserve.

"That number had the effect of understating Enron's profits," he said.

He also disputed government contentions Enron executives improperly moved parts of the company's retail operation into its highly profitable wholesale business unit to hide financial problems under the guise of an accounting process called "resegmentation."

"I do believe it was properly disclosed and properly accounted for," Rush said, adding that he believed Enron went beyond the rules in disclosing particulars about the resegmentation.

"The rules only require we tell we have made a resegmentation. You just merely need to alert the reader there has been a change."

Earlier Wednesday, Arnold repeated his sentiment that Lay did not mislead investors about the company's financial health in the weeks before it filed for bankruptcy protection in December 2001.

Arnold said third-quarter 2001 financial statements cited by Lay in discussions with investors complied with Securities and Exchange Commission rules.

"That is my view," he said, answering repeated questions about the quarter when Enron reported $638 million in losses and a $1.2 billion reduction in shareholder equity.

The government contends Lay knew many Enron assets were overvalued and that losses were coming and misrepresented this to the public.

Several former high-ranking Enron executives have testified Lay misled investors when he said the losses were one-time events.

"I disagree with their interpretation," Arnold said, who noted his company had been paid $1 million for his work on the Enron defense.

Only 10 minutes into his testimony Wednesday, U.S. District Judge Sim Lake grew impatient when Arnold and prosecutor Andrew Stolter repeatedly went round and round on the same question.

"I'm not going to have sparring over minor, uncontroverted issues," a clearly irritated Lake barked.

Skilling, who testified earlier, and Lay, who wrapped up six days on the witness stand Tuesday, are accused of repeatedly lying to investors and employees about Enron when prosecutors say they knew the company's success stemmed from accounting tricks.

Skilling faces 28 counts of fraud, conspiracy, insider trading and lying to auditors, while Lay faces six counts of fraud and conspiracy.

The two men counter no fraud occurred at Enron other than that committed by a few executives, like Fastow, who stole money through secret side deals. They attribute Enron's descent into bankruptcy proceedings to a combination of bad publicity and lost market confidence.

Bob Jensen

March 20, 2010 reply from Dennis Beresford [dberesfo@TERRY.UGA.EDU]

Bob,

This will be my one and only response to your comment.

As "the guy who wrote GAAP" for 10 plus years, it's pretty hard for me to criticize anyone who followed the letter of the rules. However, much more important is to understand the context of SFAS 140. While I was gone from the Board when it was developed, I was there for its predecessor, SFAS 125. That standard involved a very long, laborious process of determining extremely precise rules for when liabilities should and shouldn't be "derecognized" from the balance sheet. I can't tell you how many meetings we had with lawyers involved with securitization transactions and the like. In the end the document attempted to walk a fine line like Goldilocks of getting it "just right"- trying to derecognizing those liabilities where responsibility for obligations had truly been passed to third parties while leaving those on the balance sheet the ones for which the substance of an obligation was retained. In the typical fashion of standards setting, that necessitated very precise rules including legal opinions in some cases.

Not too long after SFAS 125 was issued, it became clear that it wasn't working very well and it wasn't accomplishing the "just right" objective. So the Board began another project that took several more years and resulted in SFAS 140. Still more (or, rather, different) rules were developed in an effort to accomplish the same objective of keeping true obligations on the balance sheet and derecognizing those for which risks and rewards of ownership had passed to third parties.

SFAS 140 has been seen as not fully satisfactory by many parties, most notably because of the "QSPE" exception that allowed Fannie Mae and many other large financial institutions to keep huge amounts of securitization trusts and similar amounts off the balance sheet when the trusts were considered set up on "auto pilot." The FASB changed this last year through SFAS 166 and 167 and Fannie Mae will consolidate $2.5 trillion of trust assets and liabilities that it doesn't own or owe in its first quarter 2010 financial statements.

The bottom line is that this has been a highly contentious aspect of accounting for many years. GAAP has been evolving and it may evolve further. Would we have been better off with a "principle based" approach? I personally doubt it although a New York Times article on Friday suggested exactly that. The rules based approach to this general area is far from perfect but I think it at least has resulted in more consistency from company to company. I shudder to think how individual companies would have applied a judgmental approach in an area like this.

Denny Beresford

 

March 20, 2010 reply from Bob Jensen

Hi Denny,

I will not prolong the agony, but I surely would like to have someone explain to me how the Repo 105 accounting in the particular context used by Lehman served any economic purpose other than to deceive investors and creditors in the financial statements.

How in the world can the auditors conclude that Lehman severed "all controls" over poisoned investments that they were 100% certain would come back to Lehman in a few days. There was zero chance that the market values of these poisoned CDOs would bounce back.

What could Lehman possibly gain other than balance sheet trickery?

Would Lehman have even entered into these Repo 105 transactions if Lehman had to book the buy-back obligations as debt having higher values than the sales prices at inflated and phony values.

I'm not sure auditors should follow any rules-based standards for transactions only intended to deceive. Egads! Will Patricia Walters love to hear me say that. Darn! She'll hang this one over my head for as long as I live.

I think I'm interpreting principles-based a little differently than you.
You are taking a micro view from the specific rules in FAS 140. I'm taking a macro view that auditors have both a right and a duty to look at any transactions that have only one purpose --- to deceive investors and/or possibly members of the board. Accordingly auditors have a right and a duty to disclose more to the persons being deceived, whether they are members of the board of directors or individual investors.

Also the seeking out an opinion from an England-based law firm has shades of Enron painted all over it in the eyes of many of us in the academy. This is especially the case for those of us that remember how Ken Lay hired a shyster law firm to whitewash the whistle blowing of Sherron Watkins ---
http://www.trinity.edu/rjensen/FraudEnron.htm

You know the story. If it walks like a duck, quacks like a duck, and looks like a duck then it probably is a duck.

I really think that all Big Four auditors have for years been helping Wall Street banks write fiction in their financial statements.

Frank Partnoy and Lynn Turner contend that Wall Street bank accounting is an exercise in writing fiction:
 Watch the video! (a bit slow loading)
 Lynn Turner is Partnoy's co-author of the white paper "Make Markets Be Markets"
 "Bring Transparency to Off-Balance Sheet Accounting," by Frank Partnoy, Roosevelt Institute, March 2010 ---
 http://www.rooseveltinstitute.org/policy-and-ideas/ideas-database/bring-transparency-balance-sheet-accounting
 Watch the video!

Thanks Denny.

Bob Jensen

Bob Jensen's threads on the Lehman Examiner's Report ---
http://www.trinity.edu/rjensen/fraud001.htm#Ernst

Question
It appears that Lehman is was trying to whitewash it's creative accounting with a ruling from a shady law firm.

Because no U.S. law firm would bless the transaction, Lehman got an opinion letter from London-based law firm Linklaters. That letter essentially blessed using the maneuver for Lehman's European broker-dealer under English law. If one of Lehman's U.S. entities needed to engage in a Repo 105 transaction, the firm moved the securities to its European arm to conduct the deal on the U.S. entity's behalf, the report found. That is likely why the counterparties on the repo transactions were largely a group of seven non-U.S. banks. These included Germany's Deutsche Bank AG, Barclays PLC of the U.K. and Japan's Mitsubishi UFJ Financial Group.

What other loser corporation and its auditing firm sought to hide behind a shady law firm's blessing on deceptive accounting?
Hint:  The law firm was contacted after a whistle blower notified both the client's CEO and the its auditing firm.

Answer
If you don't recall the answer, scroll down past the following tidbit.

"Repos Played a Key Role in Lehman's Demise:  Report Exposes Lack of Information And Confusing Pacts With Lenders," by Suzanne Craig and Mike Spector, The Wall Street Journal, March 13, 2010 ---
http://online.wsj.com/article/SB20001424052748703447104575118150651790066.html#mod=todays_us_money_and_investing

The rare look into the repo market embedded in the report comes 18 months after Lehman Brothers collapsed in the U.S.'s largest bankruptcy filing. While top Lehman executives were quick to blame the real-estate market for their woes, the exhaustive report singles out senior executives and auditor Ernst & Young for serious lapses.

The report exposed for the first time what appears to be an accounting slight of hand known as a Repo 105 transaction, where Lehman was able to book what looked like an ordinary asset for cash as an out-and-out sale, drastically reducing its leverage and making its financial picture look better than it really was. The transactions often were done in flurries in a financial quarter's waning days, before Lehman reported earnings.

Four days prior to the close of the 2007 fiscal year, Jerry Rizzieri, a member of Lehman's fixed-income division, was searching for a way to meet his balance-sheet target, according to the report. He wrote in an email: "Can you imagine what this would be like without 105?"

A day before the close of Lehman's first quarter in 2008, other employees scrambled to make balance-sheet reductions, the report said. Kaushik Amin, then-head of Liquid Markets, wrote to a colleague: "We have a desperate situation, and I need another 2 billion from you, either through Repo 105 or outright sales. Cost is irrelevant, we need to do it."

Marie Stewart, the former global head of Lehman's accounting policy group, told the examiner the transactions were "a lazy way of managing the balance sheet as opposed to legitimately meeting balance-sheet targets at quarter end."

Lehman's use of this accounting technique goes back to the start of the decade when Lehman business units from New York and London met to discuss how the firm could manage its balance sheet using accounting rules that had taken effect in September 2000. Lehman soon created the "Repo 105" maneuver: Because assets the firm moved amounted to 105% or more of the cash it received in return, Lehman could treat the transactions as sales and remove securities inventory that otherwise would have to be kept on its balance sheet.

Because no U.S. law firm would bless the transaction, Lehman got an opinion letter from London-based law firm Linklaters. That letter essentially blessed using the maneuver for Lehman's European broker-dealer under English law. If one of Lehman's U.S. entities needed to engage in a Repo 105 transaction, the firm moved the securities to its European arm to conduct the deal on the U.S. entity's behalf, the report found. That is likely why the counterparties on the repo transactions were largely a group of seven non-U.S. banks. These included Germany's Deutsche Bank AG, Barclays PLC of the U.K. and Japan's Mitsubishi UFJ Financial Group.

In a statement, a Linklaters spokeswoman said the report "does not criticize" the legal opinions it gave Lehman "or suggest or say they were wrong or improper." The law firm said it was never contacted during the investigation.

Jensen Comment
Although Lehman could not find a shady U.S. law firm to "bless the transaction," Ken Lay at Enron managed to find a shady law firm to bless the Raptors' transactions after Sherron Watkins (an Enron executive) sent her infamous whistle blowing memo to both Ken Lay and to Andersen executives in Chicago.

"Warning on Enron Recounted," by Alexei Barrionuevo, The New York Times, March 16, 2006 --- http://www.nytimes.com/2006/03/16/business/businessspecial3/16enron.html?_r=1&oref=slogin

Ms. Watkins, 46, attracted national attention after testifying before Congress in February 2002 about Enron's collapse two months earlier. She was named one of Time magazine's people of the year in 2002 for raising red flags about the company's accounting while still working there. She has since written a book with a Houston journalist about Enron's fall, and formed a consulting practice that advises companies on governance issues.

Defense lawyers, during combative cross-examination, tried to paint Ms. Watkins as an opinionated fame-seeker who had profited from the Enron scandal on the lecture circuit. The defense lawyers also suggested that Ms. Watkins was never charged with insider trading for selling Enron shares because she was wrong in believing that the Raptors were fraudulent.

Prosecutors contend that the partnerships and hedges Ms. Watkins testified about were part of a broad effort by Mr. Skilling and Mr. Lay to manipulate earnings and hide debt. The former chief executives are accused of overseeing a conspiracy to deceive investors about Enron's finances so they could profit by selling Enron shares at inflated prices.

Defense lawyers contend that prosecutors are seeking to criminalize normal business practices and that the Enron executives were the victims of thieving subordinates like Andrew S. Fastow, the former chief financial officer.

Ms. Watkins's appearance on the stand came as the government neared the end of its case. Judge Simeon T. Lake III said Wednesday that he estimated that the case could be wrapped up by the end of April.

Ben F. Glisan Jr., a former Enron treasurer, is scheduled to take the stand next week. Mr. Glisan pleaded guilty to conspiracy and is currently serving a five-year prison term.

In often-colorful testimony, Ms. Watkins recounted how she became concerned around June 2001 that about a dozen Enron assets were being hedged, or guaranteed against loss, by the Raptors vehicles, which she soon learned contained only Enron stock. The Raptors were intertwined with partnerships run by Mr. Fastow, who became Ms. Watkins's boss that summer. The value of the assets, she said, "had tanked," dragged down by Enron's plummeting share price.

After doing some investigation, she wrote an anonymous letter about her concerns, then on Aug. 22, 2001, she met with Mr. Lay to discuss them. The meeting came about a week after Mr. Lay had stepped back into the role of chief executive after the resignation of Mr. Skilling.

At the meeting, they discussed a letter of hers in which she had said that she was "incredibly nervous that Enron would implode in a wave of accounting scandals." She also noted to Mr. Lay that employees were talking about a "handshake deal" that Mr. Fastow had with Mr. Skilling that ensured that Mr. Fastow would not lose money on transactions done with the LJM partnership, which Mr. Fastow was running.

Mr. Lay seemed to take her seriously, Ms. Watkins testified.

Days after the meeting, she learned that Vinson & Elkins, the law firm that had originally approved the Raptors, was doing the internal investigation into the partnerships. The firm, after consulting with Arthur Andersen, Enron's auditor, issued a report saying that while the "optics" or appearances were bad, the accounting was appropriate.

Ms. Watkins said she remained adamant that Andersen, which had received several high-profile setbacks, should not be trusted.

"I thought this was bogus," she said of the investigation.

Concerned that Enron was manipulating its financial statements, Ms. Watkins stepped up efforts to leave the company, which she had begun shortly after she concluded the Raptors could be fraudulent. She did not leave until after the bankruptcy.

Ultimately, Mr. Lay decided to unwind the Raptors and take a write-off in a single quarter rather than restate the accounting of Enron's financial statements. Ms. Watkins, under questioning from Chip B. Lewis, a lawyer for Mr. Lay, conceded that while that was not her preference, "continuing the fraud would have been worse."

Defense lawyers sparred with Ms. Watkins from the outset. Mr. Lewis placed a copy of Ms. Watkins's book, "Power Failure," in front of her, calling it a "housewarming present."

Ms. Watkins acknowledged that she could not explain why prosecutors did not charge her with insider trading for selling Enron shares.

Continued in article

"Enron Employee Told Lay Last Summer Of Concerns About Accounting Practices," by Michael Schroeder and John Emshwiller, The Wall Street Journal, January 15, 2002 --- http://interactive.wsj.com/articles/SB1011043581125393520.htm 

A House committee asked Enron Corp. for information related to a newly discovered letter written by an Enron employee last summer warning the company's chairman about its accounting practices, which prompted an internal investigation.

That inquiry, conducted by Enron's outside law firm, Vinson & Elkins, "has the appearance of a whitewash," said House Energy and Commerce Committee spokesman Ken Johnson.

A committee investigator combing through 40 boxes of documents supplied by Enron found the letter over the weekend. The author, Sherron Watkins, an Enron Global Finance executive who wasn't identified further, questioned the propriety of accounting methods, writing: "I am incredibly nervous that we will implode in a wave of accounting scandals."

Enron, suffering from a crisis of confidence by investors, filed for Chapter 11 bankruptcy-court protection on Dec. 2, shielding it from creditors as it seeks to reorganize.

In concluding its review of the matters raised in the letter, Vinson & Elkins told Enron that "further widespread investigation by independent counsel and auditors" was unwarranted. But the firm warned that "bad cosmetics" involving the transactions and the decline of Enron's stock posed the "serious risk of adverse publicity and litigation."

The internal review was dated Oct. 15, 2001 -- one day before Enron announced its big third-quarter loss and a $1.2 billion reduction in shareholder equity because of losses later associated with various partnerships involving Enron officials.

Ms. Watkins's letter and the lawyers' conclusion were quoted Monday in a request for additional documents from the House committee to Enron Chairman Kenneth Lay; the firm's outside auditor, Arthur Andersen LLP; and Vinson & Elkins. The panel is seeking additional information about the letter and Enron's response to it.

Joe Householder, a spokesman for Vinson & Elkins, said the firm had received the committee's request for information, but that "we're not prepared to respond yet to the specific questions in the letter."

An Enron spokesman didn't return a call seeking comment. Ms. Watkins, who no longer works for Enron Global, couldn't be reached for comment.

Her letter to Mr. Lay questioned special-purpose entities that Enron used to help keep its debt off its books, the adequacy of public disclosure and the financial impact of the decline of Enron's stock.

The committee said the existence of the internal investigation suggests that "senior officials at Enron and Andersen were aware of the controversial financial transactions and accounting practices that would ultimately contribute significantly to Enron's demise."

Mr. Johnson said Vinson & Elkins "had one hand tied behind its back" by Enron officials as it began its review of Ms. Watkins's warnings. "As part of Vinson & Elkins's mandate for investigating the letter, they were told [by Enron officials] not to second guess Arthur Andersen and not to analyze specific transactions," he said.

Ms. Watkins wasn't the first Enron insider to raise concerns about partnerships related to Chief Financial Officer Andrew Fastow. Sometime before the end of 2000, then-Enron Treasurer Jeffrey McMahon went to company President Jeffrey Skilling and complained about potential conflicts of interest posed by partnerships operated by Mr. Fastow, which began in 1999 and early 2000. Mr. Fastow quit the partnerships last July.

Mr. Skilling didn't share Mr. McMahon's concerns, say people familiar with the matter. Mr. McMahon requested and received reassignment to another post. In October, Mr. McMahon was named as successor to Mr. Fastow as Enron's chief financial officer in the face of rising controversy over the partnerships.

Ms. Watkins's August 2001 letter came when what now appears to be the first major crack in Enron's facade appeared. Mr. Skilling, who had been given the chief-executive post earlier in the year, unexpectedly resigned on Aug. 14. He initially cited unspecified personal reasons.

But in an interview the next day, he said that his frustration over Enron's falling stock price played a major role in his decision to quit after only six months as chief executive. That remark has since raised questions about whether Mr. Skilling saw problems ahead for Enron because some of its partnership arrangements relied heavily on the use of Enron stock and their stability could be threatened by a falling price.

Separately, Andersen issued a statement providing more details about an e-mail sent by an in-house attorney that resulted in the destruction by Andersen employees of numerous Enron-related audit documents.

Mr. Odom forwarded the e-mail to David Duncan, the partner in charge of the Enron audit as a reminder of the firm's existing policy, Andersen said. The firm added that the e-mails "are not a representation that there were no inappropriate actions" and said it is continuing to investigate the matter.

Andersen's records-retention policy goes into great detail about what documents should be kept for what periods of time and when they should be disposed of. But the policy does note, "In cases of threatened litigation, no related information will be destroyed." At the time the e-mail was sent, no subpoenas had been issued, but Enron's problems were mounting and drawing the attention of attorneys representing shareholders.

"Liberté, Egalité, Fraternité: Big Lehman Brothers Troubles For Ernst & Young," by Francine McKenna, re: The Auditors, March 15, 2010 ---
http://retheauditors.com/2010/03/15/liberte-egalite-fraternite-lehman-brothers-troubles-for-ernst-young-threaten-the-big-4-fraternity/

Ernst & Young, the audit firm, had a long and lucrative relationship with Lehman Brothers. Lehman Brothers has paid EY more than $160 million in audit and other fees since fiscal year 2001.  Although this isn’t nearly as much as Goldman Sachs and AIG pay PwC – almost $230 million a year combined in 2008 – it was still a huge amount and represented a significant client relationship for Ernst & Young.

It all started with Shearson Lehman American Express back in 1975.  Lehman Brothers inherited an audit relationship with Ernst & Young when Lehman was spun off from American Express in 1994. Current Ernst & Young Global Chairman Jim Turley cut his teeth on American Express.

“The decision to make Lehman Brothers an independent company again, owned by American Express shareholders and Lehman employees, completes American Express’s effort to rid itself of the draining weight of its extraordinary, and ultimately unsuccessful, expansion in the 1980s…the two companies will share no directors and that Richard S. Fuld Jr. will continue as president and chief executive of Lehman. Fuld, in a brief telephone press conference, said Lehman was vigorously pursuing its plan to cut costs by $200 million but could not say if that would result in further loss of jobs. “It is much more important for us to talk in terms of dollars and not in terms of people,” he said.”

Ernst and Young (EY) was fired by American Express at the end of 2004.  After a string of issues with independence that threatened their credibility and ability to accept new audit work, American Express unceremoniously dumped them and hired PricewaterhouseCoopers.

“In 2003, Amex shelled out $23 million to E&Y in audit fees, and $3.5 million for other services. The audit fee was the largest paid by any U.S.-based E&Y client…an E&Y spokesman declined to comment on the reasons the firm was dropped…E&Y has been in the Securities and Exchange Commission’s (SEC) cross-hairs for about a year, including one probe into whether the audit firm violated federal auditor independence rules by entering a so-called profit-sharing agreement in the 1990s with Amex’s travel-service unit…”

But EY’s relationship with Lehman continued until the bitter end.  So it comes as no surprise to me that EY had a hard time acting independently with their “sticky” client.  Lehman Bankruptcy Examiner Anton Valukas, of local Chicago Jenner & Block, sums it up nicely:

The Examiner concludes that sufficient evidence exists to support colorable claims against Ernst & Young LLP for professional malpractice arising from Ernst & Young’s failure to follow professional standards of care with respect to communications with Lehman’s Audit Committee, investigation of a whistleblower claim, and audits and reviews of Lehman’s public filings. (V3, Pg 1027)

For my first installment in this series, let’s take each “colorable claim” individually and give them a Red (toast) ,Yellow (may be vulnerable), or Green (not likely to be too damaging) rating. I’m not going to repeat the details from Anton Valukas’ superb Bankruptcy Examiner Report in detail. I’ll offer my opinion and analysis on the “colorable claims,” EY’s potential defenses, and any details or issues I believe may not have been covered or any questions left unanswered.

(There’s a great summary of E&Y’s myriad sins and probably soon-to-be ill-fated Financial Services Office over at Zerohedge.  I will be writing more about this story, including looking more deeply into the valuation issues, the impact on the other large audit firms, the role of Lehman’s internal audit function, the specific  accounting for the Repo 105 transactions, the relationship of this bankruptcy to the Lehman bankruptcy case in the UK, and my prior theory about the fraud and additional theories for litigation. )

Ernst & Young failed to follow professional standards of care with respect to communications with Lehman’s Audit Committee.

Ernst & Young failed to follow professional standards of care with respect to an investigation of a whistleblower claim

Lehman’s own Corporate Audit group led by Beth Rudofker, together with Ernst & Young, investigated allegations about balance sheet substantiation problems made in a May 16, 2008 “whistleblower” letter sent to senior management by Matthew Lee. On June 12, 2008, during the investigation, Lee informed Ernst & Young about Lehman’s use of $50 billion of Repo 105 transactions in the second quarter of 2008. At a June 13, 2008 meeting, Ernst & Young failed to disclose that allegation to the Board’s Audit Committee. (V3 page 945)

As the lawyers would say, the optics are bad here.  The Audit Committee asks EY to support Lehman’s internal auditor in investigating a “whistleblower’s” allegations of balance sheet improprieties.  The auditors interview the “whistleblower” and then don’t say anything at any of the Audit Committee meetings. Turns out what Mr. Lee the “whistleblower” was alleging is what the examiner believes is the fundamental problem and grounds for “colorable claims” against top officers and EY.

The word “whistleblower” is colored with tons of emotion post-Enron.  We now look at those called “whistleblowers” and see heroes.  But let’s look at what I think may have actually happened.  Internal Audit, not EY, was in charge of the investigation.  They “naturally” asked their trusted, all-things-to-all-people advisor, EY, to help.

That was their first mistake.  If I’ve said it once, I’ve said it a thousand times:  The external auditor should not be conducting or assisting with internal investigations of potential fraud or illegal acts by top executives.  I wrote about it at Siemens, subject of the largest ever FCPA settlement in history.  KPMG, their auditor, got sued.

The external auditor should stay the hell away from internal investigations because they may get caught up in something they would rather not know.  They may want to claim plausible deniability.  And a company should not engage the external auditor to support internal investigations especially regarding fraud or illegal acts by top management.  Do they do it to be cheap or to keep dirty laundry inside? The external auditor is too often part of the problem, an enabler, instead of part of the solution.

If Lehman had hired another firm, a law firm or anyone except their external auditor, to do the investigation, the investigation would have been covered end to end in privilege, the external auditor may or may not (in this case EY would have been better not) have been included in the “circle of privilege,”  and the investigation would have been completed professionally.

However, by supporting this investigation, EY was essentially doing internal audit work, a prohibited service under Sarbanes-Oxley for independence reasons.  It’s shocking to me that the EY audit partners did not at least turn over the investigation to EY’s Forensic Accounting and Investigations Practice in order to provide some semblance of independence and professionalism.

Even though EY may have been an unwilling party to knowledge of an ugly situation right before an audit committee meeting, they got stuck.  They had an obligation under AU 380, as the external auditor  - not as an investigator – to inform the Audit Committee.  They could have been on the other side being informed – or not – instead of being the one supposed to be doing the informing.

AU 380, the  rules for auditor communication with the Audit Committee, are very clear.  But they relate to the auditors role as an auditor not the role  of an auditor who is lent as muscle to an internal investigation.  By playing the “trusted advisor” they screwed themselves.

Stoplight?  Yellow. Looks bad, but EY may be able to talk their way out of this one once it gets to court. They need to explain how they were still looking into the issue, doing their “auditor” work and make sure their full but limited role and responsibilities for the process are explained. If they lose on this chalk it up to another case of audit partners wanting to be supermen to their clients, the corporation’s executives, rather than looking out for their own best interests. Unfortunately in this situation, the shareholders were probably going to lose either way.

Ernst & Young failed to follow professional standards of care with respect to audits and reviews of Lehman’s public filings.

The Examiner finds that sufficient evidence exists to support the finding of colorable  claims  against Richard Fuld, Christopher O’Meara, Erin Callan, and  Ian Lowitt in connection with their actions in causing or allowing Lehman to file periodic reports that did not disclose Lehman’s use of Repo 105 transactions and against Ernst & Young for its failure to meet professional standards in connection with that lack of disclosure…While there were credible facts and arguments presented by each that may form the basis for a successful defense, the Examiner concluded that these possible defenses do not change the now final conclusion that there is sufficient evidence to support a finding that claims of breach of fiduciary duty exist against Fuld, O’Meara [CFO 2004-2007], Callan [CFO 12/07 to 6/2008], and Lowitt [CFO 6/2008 to Chapter 11 9/08]  and a colorable claim of professional malpractice exists against Ernst & Young.” (V3, pages 990-991)

This one is about mandated disclosure and unfortunately for EY – and these Lehman executives – it looks like a prima facie case of securities laws violation for the executives and malpractice for EY.

Color this stoplight RED for “EY is burnt toast.”

EY’s only hope is perhaps an “in pari delicto” defense.  The Lehman executives will surely be subject to civil and criminal fraud charges.  In that case, given the challenges for a Bankruptcy Trustee who, strictly speaking, stands in the shoes of felons whose actions may be imputed to Lehman the corporation, EY may be able to try what PwC and Grant Thornton/PwC/EY have tried in the AIG and Refco cases coming before the New York Court of Appeals.  But if those questions are resolved in favor of the plaintiffs, EY will not be able to count on Fuld, O’Meara, Callan and Lowitt to shield them from accountability.

Why did this happen?  Well, any obfuscation, if intentional, was meant to fool investors, ratings agencies, short sellers, counterparties and anyone else whose confidence the Lehman executives required. They wanted to appear to be in better financial shape than they really were – for as long as possible.

They may have been prolonging the inevitable, but at some point they knew the inevitable would occur.  Liquidity crises are rarely sudden. But they are often suddenly acknowledged.  In Lehman’s case, the Bear Stearns failure was probably the bell that tolled hollow, loud and clear.

So why did EY “fail to meet professional standards” in connection with that lack of disclosure? Brad Hintz, Lehman’s CFO in the late 1990’s told Bloomberg on March 12, “over ten years, a lot of venial sins add up…” I’m assuming he means the mortal sin of accounting manipulation.  I think that over almost ten years EY may have ignored a lot of venial sins until “the drug we’re on,” as Lehman’s McDade calls the now notorious Repo 105 transactions, added up to the mortal sin of accounting manipulation that was hidden form investors by lack of disclosure.

Brad Hintz told me that the average CFO tenure post-Lehman IPO 1994 was 540 days.  The Examiners’s Report refers to three CFOs during the period under examination alone.  I’ve already told you what was wrong with the last two, Callan and Lowitt.  You can sense their boredom and disdain for accounting details when you read their testimony.

Continued in article

Bob Jensen's threads on Ernst & Young's troubles are at
http://www.trinity.edu/rjensen/fraud001.htm#Ernst

Bob Jensen's threads on the Enron/Andersen scandals are at
http://www.trinity.edu/rjensen/FraudEnron.htm

Bob Jensen's threads on all large international auditing firms ---
http://www.trinity.edu/rjensen/fraud001.htm

My Hero Lawyer, Professor, and Wall Street Financial Expert Weighs In

Question
In the bankruptcy court examiner's report on Lehman's downfall, is Volume 3 more or less important than Volume 2?

Answer
For Ernst & Young it is probably Volume 3, but my true hero exposing Wall Street scandals opts for Volume 2.

My favorite Wall Street books exposing the inside greed and fraud on Wall Street are those written by Frank Partnoy. My timeline of his exposes can be found at http://www.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds .

Professor Partnoy's Senate Testimony was among the first solid explanations of how derivative financial instruments frauds took place at Enron. His entire testimony can be found at http://www.trinity.edu/rjensen/FraudEnron.htm#FrankPartnoyTestimony
See his explanation of the infamous Footnote 16 of the Year 2000 Enron Annual report ---
http://www.trinity.edu/rjensen/FraudEnron.htm#Senator

His books are among the funniest and best books I've ever read in my life, even better than the books of Michael Lewis.
http://www.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds
They are the most dog-eared and scruffed up books in my entire library.

"Lehman Examiner Punted on Valuation,"
by Frank Partnoy, Professor of Law and Finance University of San Diego School of Law and author of Fiasco, Infectious Greed, and The Match King
Naked Capitalism, March 14, 2010 --- http://www.nakedcapitalism.com/2010/03/frank-partnoy-lehman-examiner-punted-on-valuation.html

The buzz on the Lehman bankruptcy examiner’s report has focused on Repo 105, for good reason. That scheme is one powerful example of how the balance sheets of major Wall Street banks are fiction. It also shows why Congress must include real accounting reform in its financial legislation, or risk another collapse. (If you have 8 minutes to kill, here is my recent talk on the off-balance sheet problem, from the Roosevelt Institute financial conference.)

But an even more troubling section of the Lehman report is not Volume 3 on Repo 105. It is Volume 2, on Valuation. The Valuation section is 500 pages of utterly terrifying reading. It shows that, even eighteen months after Lehman’s collapse, no one – not the bankruptcy examiner, not Lehman’s internal valuation experts, not Ernst and Young, and certainly not the regulators – could figure out what many of Lehman’s assets and liabilities were worth. It shows Lehman was too complex to do anything but fail.

The report cites extensive evidence of valuation problems. Check out page 577, where the report concludes that Lehman’s high credit default swap valuations were reasonable because Citigroup’s marks were ONLY 8% lower than Lehman’s. 8%? And since when are Citigroup’s valuations the objective benchmark?

Or page 547, where the report describes how Lehman’s so-called “Product Control Group” acted like Keystone Kops: the group used third-party prices for only 10% of Lehman’s CDO positions, and deferred to the traders’ models, saying “We’re not quants.” Here are two money quotes:

While the function of the Product Control Group was to serve as a check on the
desk marks set by Lehman’s traders, the CDO product controllers were hampered in
two respects. First, the Product Control Group did not appear to have sufficient
resources to price test Lehman’s CDO positions comprehensively. Second, while the
CDO product controllers were able to effectively verify the prices of many positions
using trade data and third‐party prices, they did not have the same level of quantitative sophistication as many of the desk personnel who developed models to price CDOs. (page 547)

Or this one:

However, approximately a quarter of Lehman’s CDO positions were not affirmatively priced by the Product Control Group, but simply noted as ‘OK’ because the desk had already written down the position significantly. (page 548)

My favorite section describes the valuation of Ceago, Lehman’s largest CDO position. My corporate finance students at the University of San Diego School of Law understand that you should use higher discount rates for riskier projects. But the Valuation section of the report found that with respect to Ceago, Lehman used LOWER discount rates for the riskier tranches than for the safer ones:

The discount rates used by Lehman’s Product Controllers were significantly understated. As stated, swap rates were used for the discount rate on the Ceago subordinate tranches. However, the resulting rates (approximately 3% to 4%) were significantly lower than the approximately 9% discount rate used to value the more senior S tranche. It is inappropriate to use a discount rate on a subordinate tranche that is lower than the rate used on a senior tranche. (page 556)

It’s one thing to have product controllers who aren’t “quants”; it’s quite another to have people in crucial risk management roles who don’t understand present value.

When the examiner compared Lehman’s marks on these lower tranches to more reliable valuation estimates, it found that “the prices estimated for the C and D tranches of Ceago securities are approximately one‐thirtieth of the price reported by Lehman. (pages 560-61) One thirtieth? These valuations weren’t even close.

Ultimately, the examiner concluded that these problems related to only a small portion of Lehman’s overall portfolio. But that conclusion was due in part to the fact that the examiner did not have the time or resources to examine many of Lehman’s positions in detail (Lehman had 900,000 derivative positions in 2008, and the examiner did not even try to value Lehman’s numerous corporate debt and equity holdings).

The bankruptcy examiner didn’t see enough to bring lawsuits. But the valuation section of the report raises some hot-button issues for private parties and prosecutors. As the report put it, there are issues that “may warrant further review by parties in interest.”

For example, parties in interest might want to look at the report’s section on Archstone, a publicly traded REIT Lehman acquired in October 2007. Much ink has been spilled criticizing the valuation of Archstone. Here is the Report’s finding (at page 361):

… there is sufficient evidence to support a finding that Lehman’s valuations for its Archstone equity positions were unreasonable beginning as of the end of the first quarter of 2008, and continuing through the end of the third quarter of 2008.

And Archstone is just one of many examples.

The Repo 105 section of the Lehman report shows that Lehman’s balance sheet was fiction. That was bad. The Valuation section shows that Lehman’s approach to valuing assets and liabilities was seriously flawed. That is worse. For a levered trading firm, to not understand your economic position is to sign your own death warrant.