Is E&Y in trouble?

So basically, I read this article about the bankruptcy exam for Lehman Brothers, and some interesting items pop up so I thought it would be nice to put something up here.

I was going to put more thoughts on the report that the examiner produced, but I realized that I didn't quite understand A LOT OF the stuff in it.....-_-

This BusinessWeek article says:

“The demands for collateral by Lehman’s lenders had direct impact on Lehman’s liquidity pool,” said Anton Valukas, the U.S. Trustee-appointed examiner, in a 2,200-page report filed in Manhattan federal court. “Lehman’s available liquidity is central to the question of why Lehman failed.”

But this is really not what interests me most. I mean, it's business. From a technical CFE perspective (which btw I'm not going to pursue....just too much hassal - -), there might be more stuff to dig into I guess, like what could've been done or undone by Citi and JP (aka "Lehman's lenders") that might've made life easier, but that's really not for outsiders like us to say. What really brought some light to me is that, the examiner revealed that there might be potential fraud and malpractice against E&Y in connection with its audit engagement with Lehman and failure to disclose the questionable "Repo 105" transaction, cited by the examiner as "accounting gimmick".

OK, so what is this whole Repo 105 all about and what Lehman and E&Y did around it? Or didn't...

Here's the part in the 2200 page long report that explains:

Lehman employed off‐balance sheet devices, known within Lehman as “Repo 105” and “Repo 108” transactions, 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.


Repo 105 transactions were nearly identical to standard repurchase and resale (“repo”) transactions that Lehman (and other investment banks) used to secure short‐term financing, with a critical difference: Lehman accounted for Repo 105 transactions as “sales” as opposed to financing transactions based upon the overcollateralization or higher than normal haircut in a Repo 105 transaction. By recharacterizing the Repo 105 transaction as a “sale,” Lehman removed the inventory from its balance sheet.


Lehman regularly increased its use of Repo 105 transactions in the days prior to reporting periods to reduce its publicly reported net leverage and balance sheet. Lehman’s periodic reports did not disclose the cash borrowing from the Repo 105 transaction – i.e., although Lehman had in effect borrowed tens of billions of dollars in these transactions, Lehman did not disclose the known obligation to repay the debt.2851 Lehman used the cash from the Repo 105 transaction to pay down other liabilities, thereby reducing both the total liabilities and the total assets reported on its balance sheet and lowering its leverage ratios. Thus, Lehman’s Repo 105 practice consisted of a two‐step process: (1) undertaking Repo 105 transactions followed by (2) the use of Repo 105 cash borrowings to pay down liabilities, thereby reducing leverage. A few days after the new quarter began, Lehman would borrow the necessary funds to repay the cash borrowing plus interest, repurchase the securities, and restore the assets to its balance sheet.


Lehman never publicly disclosed its use of Repo 105 transactions, its accounting treatment for these transactions . . .

So this is something that was not revealed by E&Y in their audit report, and E&Y obviously has stood up and claimed that this is totally within the GAAP umbrella.

But other professionals might think otherwise. A comment from the former chief accountant of the SEC really cracked me up. When asked if that was an acceptable way of booking things on the financial statement, she said: "Unless it's in 'Alice in Wonderland,' I've never seen this."

It's interesting that, well not really "interesting", but it's been a long time since we last scrutinize auditors over big events in the financial business world. When Enron and Worldcom collapsed, Arthur Anderson came down as well for providing fraudulent audit reports. Then Sarbanes-Oxley Act came into effect, which has since made every auditor's life hectic and miserable. When Lehman claimed chapter 11 everyone was blaming the bankers for introducing all the troubles and I was glad that this is not another public accounting scam. But hey, you never know, if it's related to money, you probably want to check on the auditors, just to be safe. :)