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Application of Financial Accounting Theories in Real-Life Case

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Abstract

The collapse of the Lehman’s brothers led to Repo 105 find its way in the headlines of one of the newspapers. The report said that the accountants of Lehman had paid down fifty billion dollars in liabilities using accounting maneuver. The pay down was meant to lower leverage in the company’s balance sheet even before the announcement of the earnings. As a result, Lehman seemed to be less reliant when it comes to a debt which was not the case.

Introduction

Repo, which is also called repurchase agreement, is a transaction that the banks use when borrowing short term cash. This kind of transaction involves looking for cash which is used in funding operations. They do this by giving out or lending assets of high quality such as the treasury bills (Philips, 2010). Repo 105 is a trick used in accounting where a company will classify a loan such as the short term loan like a sale, and uses the proceeds of cash obtained from the said sales to help reduce the company’s liabilities. Companies can access the excess funds from different firms for a while as they exchange collaterals or bonds. A company which borrows the cash makes a promise to pay the STL with some interest. The collateral does not change hands. It is assumed that the collateral has been sold to be bought later.

Lehman Brothers came to an agreement with a bank in Cayman Island which involved repurchase. The deal was that Lehman could sell to the bank toxic assets and that they were to buy them later (Adam, 2013). This trick made the Lehman brothers look healthy in the paper now that they were desperate in the way they could fool the agencies concerned with credit rating as well as the investors. However if the truth spilled out, these people knew very well that they could rand in jail.

The banks also use such repo agreements but mark them as loans on the books. This is what they actually are. The brothers called them sales, which doesn’t sound like a big deal. However, Lehman brothers had fifty billion dollars in cash and fifty billion dollars toxic assets less. This complicated the whole thing because it was not a mistake (Adam, 2013). The whole idea was to trick the bank so that they could be given money. Even if Lehman did not manipulate their financial statements, they could still have received the same financing but now at low cost using the very counterparties and assets in Repo 105(Rodriguez, 2010).

In this paper I will look at the how Repo 105 helped Lehman Brothers financial statements look good basing on the accounting principles which are accepted. I will also discuss the major motives the firms have when manipulating the reported earnings. This will be supported by real life examples and literature on earning management. The paper will conclude by looking at whether imposing regulations on financial accounting would prevent accounting scandals in future.

What is a Repo?

Repo, also known as the repurchase agreement, can be defined as the transaction that the companies use when they want to borrow the short term loan. The type of transaction involves identifying the ways to obtain cash to be used in the funding operations. The companies or the banks do this by lending or giving out high quality assets such as the treasury bills (Philips, 2013). It is a trick that is used in accounting. The company will classify a loan as a sale; say for example a short term loan. The company then uses the money obtained from these “sales” to reduce the liabilities of the company. The company could also assess the funds in excess from various firms for some time as the bonds or collaterals are exchanged. The company which has borrowed the cash makes promises of paying the short term loan. The collaterals do not change hands as it is assumed that they have been sold and will be bought at a later date.

Now that the repurchase agreements were not sales but loans, they didn’t fit the intent of the rules. The rule had a provision where the assets that were involved could still be in the books of the company only if the firm accepts to buy them later at a price ranging from 98% to 102% of the amount it had obtained them for (Wharton, 2010).

How Repo 105 helped make Lehman Brothers’ financial statements look better.

Lehman used a device called off balance sheet called the ‘Repo 105’ scheme to remove inventory of securities from the balance sheet temporarily for a period of about 10 days. This is supposed to bring out a misleading picture of the financial conditions of the firm in the year 2007-2008(Wharton, 2010). The transaction of repo 105 was almost the same as the repo transaction which Lehman and the investment banks had used to get a short term loan. The only difference was that Lehman had marked the transactions as sales unlike the financing transactions. Lehman did away with the inventory from the balance sheet. The periodic reports of Lehman did not show cash borrowing in the Repo 105. That is, even if Lehman had borrowed a lot of cash, Lehman had not disclosed obligations of repaying the borrowed cash. Lehman actually used cash from Repo 105 to pay other liabilities and this reduced the assets and liabilities on the balance sheet hence reducing the leverage ratios. The Repo 105 therefore had a process of two steps to follow. One is undertaking the transactions of Repo 105 and two, use cash borrowing in Repo 105 to down pay the liabilities so as to reduce leverage (Tyrer, 2010). 

When the new quarter started, the Lehman brothers could get funds to enable them pay the cash and the interest, restore back the assets and purchase back the securities. Lehman did not disclose publicly the transactions of Repo 105, the accounting treatment of the transactions, the escalation of the usage of Repo 105 in 2007 and 2008, or even the impact the transactions could have on the company’s leverage ratio reported (Tyrer, 2010).  The Financial controller during that time commented that the unavailability of the economic substance in the transactions of Repo 105 could mean a reputation risk in Lehman Company if the public knew about the use of these transactions.

Is the ‘Repo 105’ an illegal accounting practice?

The report given by bankruptcy examiners about the Lehman brothers’ bankruptcy is an illustration of accounting fabrication and manipulation which stands as financial fraud. The Repo 105 is an artful term which denoted accounting device which was used by the Lehman brothers to manage and manipulate financial statements that was meant to temporarily remove some assets worth billion dollars from the balance sheet towards the end of the quarter (Rodriguez, 2010). Lehman used the Repo 105 financial report just to deceive the firm so as to get the money they wanted(Wharton, 2010).

There is a moral imperative on corporations to provide information to the other firms it has transactions with as well as those it affects seriously with its actions. Lehman did not tell the actual value of the assets it has on the balance sheet. This was put together with the hiding of the toxic assets not to be seen by the public. They used the Repo 105 and the actions mislead the investors as they showed a healthy position of the company’s finances. This affects the outcome materially and clearly crosses the line of unethical territory. The behavior of the Lehman’s auditors and executives could thus be regarded as illegal and unethical.

However, it should be noted that repurchase agreement or the commonly known Repo is a widely recognized and used legitimate way of giving finances especially the short term cash. Banks often make use of the Repos when they want to borrow some cash from other companies which may have extra cash. The bank makes transfers of the assets as the security. Repos have been used in financial transactions with the assets that are temporarily transferred remaining in the balance sheet of the firm. The number which follows the term Repo i.e 105 shows the amount of collateral loan and shows the use of transaction as a tool in achieving the results of accounting (Chao and Schaefer, 2011).The Repo 105 is therefore legal when used in the right manner.

Why companies manipulate their reported earnings

The main aim of the companies to manipulate the reported earnings is;

  1. To be able to achieve targets which are related to the earnings normally. The contracts based on the earnings give the company an opportunity to manage the reported earnings upwards. The company focuses on debts and the contracts of executive compensation.
  2. The company aims at having influence on the information which is set and used by the information intermediaries or external investors to for future expectations of cash flows.
  3. To have a say in the third party’s information with the aim of the financial strength of the company, the potential competitors, suppliers, customers, politicians, pressure groups and workers

The motive of the third party is to manage the earnings downwards. For example, they fool the trade unions to accept wages that are lower than what the company can be able to pay (Financial reporting Faculty, 2013).  

Earnings management

Earnings management is one that managers make use of judgment when writing the final report and also structuring transactions so as to alter the financial reports with the aim of misleading the stakeholders on the company’s  economic performance. It involves the managerial decisions of not making a true report of the company. The managers can also make decisions on sub optimal operations so as to manage the earnings (Healy and Wahlen,1999).

The earnings management comes in when the management make use of the reporting discretion or even its influence in operating, investing, and even in financial decisions so as to make a financial statement that is biased and depicts the performance of the management in a way to serve its own interest. Some of the streams in the research of the earnings management are the differences in the quality of reporting between GAAP, US and the IFRS, use of the actual accounting earnings management and the effects of the rules of accounting. The main aim of earnings management is to fully utilize the manager’s compensation and private benefits, enjoy the regulations that are preferable like taxes, always respond to the stock market so as to be in a position to meet the earnings benchmarks and respond to equity issues. The managers have private benefits because they can mount evidence to show that the earnings management are related to the compensation which is performance linked. For example the stock options and the equity holdings (Cohen et al, 2008).

The managers try to manage the earnings in a manner that the firm performs only enough for them to be given a bonus and other earnings are hoarded to be used in future through the decreasing income of earnings management. They manage the earnings in a better way just to sustain their personal concerns such as job security (Ahmed et al, 2006).

Preventing Lehman like accounting scandals.

Many companies always tend to maneuver numbers so as to achieve budgets and also obtain bonuses. The companies take this very far. Factors like greed, immorality, bad judgment and desperation lead to many companies resulting to the corporate fraud (Forbes, 2013). WorldCom and Adelphia are some of the companies that have manipulated the books of records. World Com claimed assets valued billions of money but later on became bankrupt when the claims became exposed.

One way of controlling this manipulation is to learn the manipulation methods. To accelerate revenue, one has to know about payment on booking lump some to be the current sales after services are provided. For instance, when a service provider gets upfront payment of 4 years payment but writes the entire payments to e sales of the period received. The best method to use in making payments is amortizing the revenue.

Another method that can be used to accelerate revenue is channel staffing (Forbes, 2013). The manufacturer makes a big shipment to a certain distributor towards the end of quarter. The manufacturer records this shipment like sales. The distributor is however entitled to the unsold merchandise now that the goods are not guaranteed to be sales and can be taken back. Manufacturers should therefore keep the goods with the classification of inventory up to when the distributor sells the products.

Positive accounting theory deals with explaining the process of accounting. It predicts the firms or companies that make use of certain accounting methods and those that do not. The theory however, does not mention anything on the method that a company should use. However the theory of continuous contemporary accounting shows the way to undertake the financial accounting. The theory is said to be prescriptive. It shows the assets of an organization with the aim of making economic decision. It shows information about the current cash of a ompany. This can be used by the companies when they want to value the assets of a bank so as to lend them money.

However, the normative theories in accounting are not very much based on observation. They are not therefore good methods of evaluating the exact accounting practice.   

Conclusion

Repo 105 is a method that is used in accounting where a firm will classify a loan for example STL like a sale, and uses the cash obtained from the said sales to help reduce the company’s liabilities. Companies can access the excess funds from different firms for a while as they exchange securities such as collaterals or bonds. A firm which borrows the cash makes a promise to pay the loan with an agreed amount of interest. The collateral does not change hands as the parties assume that the collateral has been sold to be bought later.

This paper has discussed the way Repo 105 helped Lehman Brothers financial statements look good basing on the accounting principles. It continued to discuss the major motives the firms have when manipulating the reported earnings using the examples of Cendant firm and literature on earning management.

The earnings management has been also dealt with whereby the management makes use of the reporting discretion or its influence in operating, investing, and making financial decisions in order to make financial statements which are biased in that the performance of the management is made in a way to serve their interests. Some of the streams in the research of the earnings management are the differences in the quality of reporting between GAAP, US and the IFRS and actual accounting earnings management.

The paper has also looked at the way regulations on financial accounting would prevent accounting scandals in future and It has been noted that the Repo 105 is a legal transaction. The problem arose when the Lehman brothers wanted to deceive the company that was lending them the money. Other companies and banks use the method when they want to borrow some money from other institutions. The theory of positive accounting can however be used in preventing the repeat of Lehman’s brothers act. However it is not very much reliable as it does not show the exact image of the financial accounting.

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