Acc 564 Assignment 3 Fraud in the Accounting Information System
In September 2008, one of the largest corporate scandals unfolded in the United States. Lehman Brothers, a global financial services firm was declared bankrupt. This was unanticipated considering the company’s financial statements indicated it was financially sound. What was not known, however, is that over $ 50 billion in loans had been carefully concealed as sales (Kimberly, 2011). In the ensuing scandal, Lehman allegedly conspired to disguise its true financial position by disposing off its toxic assets in the short term. The toxic assets costing the company $ 50 billion were sold off to Cayman Island banks on the condition that the company would buy them back. This created a false impression that Lehman had disposed off the toxic assets worth $ 50 billion, and hence the sales figure of the same amount reflected in its financial statements. The scandal was perpetrated by Lehman executives with the help Ernst & Young, the company’s auditors.
The firm’s accounting information system failed to prevent or even detect the fraud committed. This is because the fraud involved what may be termed as “creative accounting”, where the top executives as well as the company’s auditors conspired to conceal toxic assets as sales. A careful manipulation of the company’s financial statements through false reporting of repo transactions as disposals went largely unnoticed by both the public and the Securities and Exchange Commission (SEC). Repo transactions involve the sale of securities to a buyer where the seller agrees to buy back the security after a certain period of time and at a premium. Repo operations are commonly applied by financial institutions to raise short term capital or financing (Wiggins, 2015). Financial institutions use securities to act as collateral when borrowing short term finances through repo transactions. Repo transactions may involve assets where the assets are taken as collateral for credit.
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Following investigations, it was revealed that Lehman Brothers fraudulently used repos to give an inaccurate view to shareholders and other stakeholders of the true financial position of the company. This became known as “repo 105”. The company began engaging in repo transactions in 2007 following the start of the financial crisis. Lehman Brothers executives felt the company had too much leverage and the company could not be able to sell off assets and securities as the financial crisis had already set in. When the company engaged in repo transactions, the top executives disguised the transactions to look like actual disposal of assets. In order to make it look like an actual disposal of assets, the company transacted the assets at slightly less each asset’s fair value in the market. These transactions were thus recorded as actual sales of the assets in the accounting books. However, the company would still make repurchases of the items sold. The money obtained would be used to offset debts, and then the company would seek more loans to repurchase the assets.
The company continued to use repo transactions up to 2008 when the global financial crisis deepened. In 2008, the company used the same strategy to disguise debts totaling $ 50 billion. By making repo transactions, the amount was recorded as sale of assets instead of being recorded as debts in the firm’s accounting system. Interestingly, the company did not disclose the reasons behind using Repo 105 to the board and neither to the government. Such fraud could not have been easily prevented by the firm’s accounting information system. In addition, the company’s directors were accused of paying themselves hefty bonuses. According to CNBC (2008), the directors increased their bonuses to $ 480 million, making them among the highest paid directors in the world. Lehman Brothers scandal was therefore perpetrated by the company’s top executives. Owing to their unethical actions, it was difficult to detect the fraud occurring in the company as they carefully concealed their tracks.
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The effectiveness of the firm’s stakeholder is assured in circumstances where the accounting system suffers a breach. Majority of states in the U. S. have enacted laws requiring business organizations to notify the relevant stakeholders when security breach occurs and vital data is lost. For instance, customers are supposed to be notified immediately it is realized a security breach has occurred. Business organizations that suffer security breach should first engage the shareholders especially those who are directly affected by the data loss. Stakeholders such as customers have the right to receive compensation from any financial loss occurring resulting from data loss. In some states, more robust regulations are already in place detailing data security regulations (Erra, Filiol, & ECIWS, 2012).
The law does not provide clear standards on who to take responsibility during security breaches. The level of responsibility will often depend on the form the case takes. Various parties which share some degree of responsibility in security breaches include individual users, data storage providers, hardware manufacturers and the software providers (Erra, Filiol, & ECIWS, 2012). There is still no consensus on the level of responsibility to place on software providers during security breaches. Some factions suggest that a larger burden should be placed upon the software provider companies while others feel smaller burdens should be placed upon the software providers. Those who advocate for greater liability argue that software developers should carry the largest burden. However, the other factions argue against this since it is difficult to achieve balance of appropriate burden between the companies that write the codes and those that only store data.
Currently, companies that suffer huge data losses often try to assess whether software provides are available and if they can help share the cost. Lawsuits can therefore be brought against software developers, data storage companies, system outsourcing firms, system integrators and system consultants. Several lawsuits have already been filed against software developers for negligence in the software used by companies that suffer data loss. For instance in 2005, a lawsuit was filed against Savvis, a card systems security analysis company (Erra, Filiol, & ECIWS, 2012). In the lawsuit, the plaintiff had complained that Savvis had negligently given misleading information that resulted in data loss worth millions of dollars. Savvis had claimed that the card system was conformable with visa cards. In some areas, software providers sign agreements with their clients giving maintenance warranty of up to a certain extent.
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A number of preventive measures in accounting and the information technology could have prevented fraud at Lehman Brothers from ever occurring. To start with, proactive risk management measures in Lehman Brothers could have saved the company from bankruptcy. Prior before the company filed for bankruptcy, a number of indicators had shown that the company’s financial status was bad. The risk managers had blatantly ignored the risk thresholds established by the bank. In 2007 for instance, the company engaged in over 30 real estate transactions whose risk level far exceeded the maximum level established by the bank. The Securities and Exchange Commission was also responsible of the perpetration of the fraud. Lack of proper oversight enabled the fraud to go on undetected. SEC was aware of Lehman Brothers’ management decisions to disregard set risk limits yet the regulator failed to carry out the necessary action (Kimberly, 2011). The bank also conducted stress testing examination in which the analysis of the most risky areas such as the real estate portfolio was omitted.
Lehman Brothers’ bankruptcy has also revealed an important area where current audits often overlook. In analyzing the financials status of firms, most audits consider certain areas such as liquidity of the firm, profitability, efficiency indictors and solvency. However, there is a tendency to overlook other critical areas such as the statement of the cash flows. A careful analysis of the cash flow statements of the company would have revealed the sources and uses of funds enabling external auditors to note inconsistencies. It is important to note that even profitable companies can still be affected by cash flow problem. For instance in March 2008, the company had declared a quarterly profit of $ 489 million. A short period thereafter, the company was facing bankruptcy. External stakeholders should ensure that they analyze the cash flow statements of a company in order to ascertain the true value of the revenue figures reported by a company. While profit figures can be exaggerated, it is difficult to for the management to alter statements of cash flow (Stanton & Burgess, 2010).
Accounting policies requiring for full disclosure of the use of repo transactions to relevant stakeholders such as investors, board and agencies could also have prevented the fraud from taking place. According to Stanton & Burgess (2010), Lehman Brothers did not disclose the use Repo 105 in managing its financial status to any of the relevant stakeholders. According to Norris (2011), the audit report issued by Ernst & Young was fairly stated as per the United States Generally Accepted Accounting Principles (GAAP). This has prompted the Financial Accounting Standards Board to develop new rules in relation to Repos. The new rules were affected in 2012 stating that any kind of Repo transactions would be treated as debt henceforth. On the same issue, the Judge presiding over the case against Ernst & Young asserted that the auditing standards spelled out by the accounting board were rather vague and too general, hence subject to wide variations in interpretation. Therefore, there is need for mandatory disclosures when companies use Repo transactions since they are a form of short term loans.
Entrenchment of proper ethics and accountability among the directors would have prevented the fraud. There was lack of integrity among the directors who took advantage of laxity in regulatory and oversight bodies. A robust financial system can only exist if there is transparency, fair dealings, and responsibility among the top leadership. Lack of proper ethics and a sense of responsibility exacerbated the financial situation at Lehman Brothers. For instance, the directors had tremendously increased their bonus payments in the period leading to the bankruptcy. Accounting standards that enforce proper ethics and accountability in organizations could have helped avoid the scandal. Directors at Lehman Brothers gave false reports which clearly contravene sound ethical behavior.
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Certain changes should be made to the Sarbanes-Oxley Act of 2002 and in other current laws in order to improve their strength in curbing fraud. The Sarbanes-Oxley Act of 2002 should include additional clauses that can help protect whistleblowers in fraud cases. The Sarbanes-Oxley Act is in a number of instances vague and vulnerable to exploitation. Section 806 of the act prohibits employers from “harassing” employees who may have engaged in any “lawful act.” However, the act does not define what constitutes harassment or what may be regarded to as a lawful act by the employee. During investigations, companies enlist outside help from various experts. These experts tend to analyze the facts brought out by the whistleblower for any elements of truth. In Lehman Brothers’ case, Mathew Lee, the whistleblower, was discharged by the company in June 2008 after he revealed the scandal (Stigliano, 2011).
In another area, the Sarbanes-Oxley Act has not much revolutionized the auditing field with respect to encouraging an increase in the number of audit firms. Currently, the auditing industry can be classified as an oligopoly market – characterized by four dominant players, Ernst & Young, Deloitte, KPMG and PricewaterhouseCoopers. Although the act aimed at ensuring total independence of auditors from clients, this has not been entirely achieved. The act placed limits on the various kinds of consulting that audit firms could engage in for their clients. However, the audit firms were left free to engage in tax work with their clients. Still, lead partners are required to rotate after a period of five years. However, an audit firm is allowed to serve the same client throughout. These are some of the flaws of the Sarbanes-Oxley Act. The flaws can be addressed by prohibiting audit firms from engaging in tax work for clients they have served in a certain period. The act should also make it mandatory for audit firms to rotate after serving the same client for five years. Lastly, the act should encourage creation of more audit firms.
Lehman Brothers’ scandal ignited the debate on the effectiveness of the International Accounting Standards Board (IASB) in deterring crime compared with other bodies such as the Financial Accounting Standards Board (FASB). The IASB has been found ineffective in curbing fraud and other incidences owing to its reliance on principles rather than establishing rules to guide operation of companies. Standards which are based on rules are seen as rigid and more effective in deterring companies from engaging in crime. On the other hand, principles are subject to manipulation and wide interpretation and hence they do not serve their purpose. In the case against Ernst & Young, the judge found the company not to have committed any crime under the IASB following the wide interpretations of principles. This came despite the auditing company failing to identify the $ 50 billion in terms of borrowings. The IASB standards should be toughened to ensure there are no loopholes such as the one exploited by Ernst & Young. For instance, they should require companies to make disclosures once a certain value of an asset is transferred through Repos (Bradbury & Schroder, 2012).
The Securities and Exchange Commission (SEC) should also toughen its laws to ensure that cases of fraud reduce. SEC should create new laws to require companies to make disclosures with respect to the short term loan facilities they obtain. Companies should provide both qualitative and quantitative information concerning all short-term borrowings. Other relevant details which can help SEC establish the authenticity of Repo transactions include but not limited to: operation results, financial condition of the company, management agreements, and other crucial details.
In order to prevent future business information failures, the company should enact stringent internal compliance checks that every employee is supposed to uphold. The main reason contributing to the company’s financial woes was lack of compliance by the management to established risk thresholds. The company undertook massive real estate investments at a time when the real estate market was about to collapse. The senior management clearly disregarded risk threshold levels established in the company. As a result, huge investments were made in the real estate sector. To make the situation worse, the financial crisis drove the real estate sector down, leading to the collapse of Lehman Brothers. The management was clearly aware that the real estate investments had overstepped the outlined checks. However, there were no appropriate compliance measures to ensure the management did not overstep its mandate.
The top management should also comply with the necessary legislations and regulations. Financial institutions should ensure that there are checks which can be used to gage compliance of each and every individual in the organization to established rules and regulations. Studies indicate that employees are more likely to comply with established rules and regulations when there are checks on their behavior in the organization. In creating the necessary checks and balances, it is important to ensure that critical decisions especially involving finance are not handled by a single person. There should be separation of duties to reduce cases of theft. Surprise audits can be a great way of ensuring compliance in the organization. These can be best conducted by a third party to ensure the independence of the auditors.
To implement the strategy, the company should first re-articulate all regulations and policies guiding the employees’ conduct in relation business transactions. The role of each individual including their mandate should be well articulated. The second step involves identifying the necessary programs to be put in place in order to ensure compliance to business policies and procedures. The directors as well as employees should be aware of all the necessary compliance issues. This can be achieved through training in order to cultivate a culture of compliance towards the organization’s policies and procedures.
In conclusion, a firm’s accounting information system is critical in deterring or preventing fraud. However in some circumstances such as the Lehman Brothers’ case, the accounting information system may fail to prevent fraud due to certain unforeseen loopholes in the system. In the case of Lehman Brothers, the directors were able to conceal borrowings as sales through engaging in Repo transactions. There is need to enact certain changes in the firm’s accounting information system as well as in other current laws such as the Sarbanes-Oxley Act in order to seal the loopholes identified. More importantly, there is need to reevaluate the role of bodies such as IASB which have been found to be ineffective in curbing fraud.
Bradbury, M. E., & Schroder, B. L. (2012). The Content of Accounting Standards: Principles Versus Rules. The British Accounting Review, 44 (3): 1-10.
Erra, R., Filiol, E., & European Conference on Information Warfare and Security. (2012).Proceedings of the 11th European Conference on Information Warfare and Security: The Institute Ecole Superieure en Informatique Electronique et Automatique, Laval, France, 5-6 July 2012.
Kimberly, S. (2011). Misconceptions about Lehman Brothers’ Bankruptcy and the role of derivatives played. Retrieved from: http://www.stanfordlawreview.org/online/misconce ptions-about-lehman-brothers-bankruptcy
Norris, F. (2011, July 28). Lehman Case Hints at Need to Stiffen Audit Rules. The New York Times.
Stanton, S., & Burgess, M. (2010, Feb. 14). Profits are nice but cash flow is what lenders want. The National.
Stigliano, A. L. (2011). Sarbanes-Oxley and Corporate Greed. University of Connecticut. Retrieved from http://digitalcommons.uconn.edu/cgi/viewcontent.cgi?article=1175&context=srhonors
Wiggins, R. Z. (2015). The Lehman Brothers Bankruptcy: Managing the Balance Sheet through the Use of Repo 105. Yale Program on Financial Stability Case Study.