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The 2008 global financial meltdown saw most of the top worldwide financial institutions

fall into bankruptcy and liquidation. The incident affected most of firms that either experienced a

drop in returns or liquidation. The failure of Lehman Brothers in the middle of the global

financial crisis was the most significant catastrophe to hit the financial industry in the U.S. On

September 15, 2008, the fourth largest investment bank in the U.S., Lehman Brothers (holding

over $600 billion in assets) filed for Chapter 11 bankruptcy protection, the largest bankruptcy

filing in the U.S history. This had raised concerns and questions by many famous players and

experts and players in international banking community. Lehman progressively turned to Repo

105 to reduce its reported net leverage and manage its balance sheet after a burden of huge

volume of illiquid assets that it could not readily sell. The acquisition of illiquid assets became

the subject for investigation relating to the valuation and liquidity issues. While Lehmans risk

decisions lay within the business judgment rule and did not give rise to debatable claims, those

decisions were labeled in review by many experts as poor judgment. Hence, there is the urgent

need for regulators of financial institutions to remove the gaps in their financial regulatory

framework that allow complex, large, unified firms like Lehman to operate without robust

consolidated supervision.


This paper investigates the case of Lehman Brothers Inc., the fourth largest investment

bank in the U.S. in which financial statement fraud played a key role in its collapse because

some senior officers ignored and certified deceptive financial statements resulting in its failure.

Lehman progressively used Repo 105 to manage its balance sheet and reduce its reported net

leverage intended to make the balance sheet appear healthier than they actually were after
burdening itself with a big volume of illiquid assets that it could not readily sell. The banks

acquisition of illiquid assets became the subject for financial fraud investigation relating to the

valuation and liquidity issues. This paper also examines the key issues of financial fraud, the

causes of Lehmans failure, the significant impact of the issue on company, the overall US

economy and the world, and the necessary recommendation to reduce and prevent any future

occurrence in the financial market. The thesis will also examine the importance of internal

control and the various possibilities of how companies are able to cook the books and ways in

which this kind of behavior can be prevented. The objective is to discover how managers and

accountants should be controlled to conduct ethical behavior in financial accounting, so that

companies would produce consistent and truthful financial records. The interest lies on how

financial fraud occurs and how can it be prevented possibly in the very initial stages.


Fraud and betrayal have existed fraud throughout history. For some reason, it appears that

greed for success and money are also part of human nature. During the earlier years many

amounts of corporate accounting scandals have been evident in the headlines; perhaps the most

renowned ones have been the Lehman Brothers in 2008 and the Enron case in 2001. In the Enron

case, the company as well as their accounting firm Arthur Anderson systematically produced

fraudulent financial reports and got involved in corrupt accounting by hiding liabilities and debts

as well as misrepresenting earnings (Roger 2010). When the depth of the deception materialized

to the public, creditors and investors retreated, forcing the company into bankruptcy in

December 2001. The company frequently used accounting gimmicks at the end of each quarter

to make its finances seem less shaky than they actually were. After the fall of Lehman Brothers,
other banks followed suit and this is believed to be the beginning of the 2008 global financial

crisis (Bloomberg BusinessWeek, 2009.)

One exciting fact is that most of these big companies caught in financial report fraud

cases have been audited by the Big Four auditing firms: KPMG, Deloitte Touche Tohmatsu

PricewaterhouseCoopers, and Ernst & Young (Wikipedia 2012). This raises eyebrows on how it

has been possible to cheat and scam the ones who should be there to assure the reliability of the

records. Or could there be something behind the scenes? Although big companies are the ones

ending up in the news, small firms experience unethical behavior and fraud evenly as much.

Implementing an internal control system is assumed to be one of the best ways to preventing

fraud. Many theory books write about the concept of the fraud triangle - motive, opportunity and

rationalization representing the three corners (Harrison,, 2011, 236). All the three corners

of the triangle exist in which there is a high possibility for a person to commit fraud which will

be discussed later.


The 2008 global financial crisis saw most of the leading financial institutions in the globe

crush into liquidation and bankruptcy (Mensah, 2012; Murphy, 2008). Those which were not

liquidated either experienced plummeting returns and their particular operations or filed for

voluntary bankruptcy (ISSER, 2008). The Lehman Brothers bankruptcy scandal in the midst of

the global financial crisis was the leading catastrophe to ever hit the U.S financial industry

(Morin & Muax, 2011). Lehman Brothers being the leader in the industry had assets worth over

$600 billion (DArcy, 2009). Apart from the well-known Enron failure in the early 2000, the

failure of Lehman Brothers was the largest unit financial institution to have collapsed with assets

so big (Jeffers, 2011). The leading US investment bank suffered massive losses within the month
of September. The stock price fell by 73% of its value in the first half of September and by the

mid of September 2008, lost about $3.9 billion in their effort to dispose of a majority of their

shares in one of their subsidiaries (Mauz and Morin, 2011).

Prior to their liquidation, the global crisis pressed the bank to close its leading subprime

lender (BNC Mortgages) in 23 locations (Wilchins and DaSilva, 2010). The losses were so

sequential such that Lehman Brothers filed for voluntary bankruptcy at the US Bankruptcy Court

by September 15th 2008 (Murphy, 2008). The voluntary bankruptcy was necessitated by the

failed attempt for a possible mergers and government bail-out coupled with some acquisition

attempt by companies such as Barclays bank and many others. To explain for the possible causes

of the Lehmans failure, many financial analysts have advanced series of practical and academic

arguments aimed at unearthing the exact causes of the melt-down. Others have also conducted

research purposely to account for Lehmans failure (Albrecht, 2004).

Lehman Brothers Case Background

Lehman Brothers (Lehman) was founded in 1850 by German immigrants Henry

Lehman and his brothers, Mayer and Emanuel. While Lehman flourished over the prevailing

decades, it had to undergo many challenges: the Russian debt default of 1998, the Great

Depressions of the 1930s, the two World Wars, amongst others. However, regardless of

Lehmans ability to endure these challenges, the subprime mortgage crisis brought the once

leading investment bank hurling to the ground. Lehmans troubles began with its decision to

enter the real estate business in 2003 during the U.S. housing bubble. Initially, this decision

under their CEO Richard Fuld appears credible. Record growth from Lehmans real estate

business allowed revenues in the capital markets unit to surge to 56% between 2004 and 2006. In

2006, the Company securitised $156 billion of mortgages, which represented a 10% increase
from 2005. For the full 2007 financial year, Lehman reported a record net income of $4.2 billion

on revenues of $19.3 billion (from $17.6 billion for the 2006 financial year).

In 2007, cracks started to surface in the U.S. housing markets with an increasing number

of defaults. Lehman began to experience the losses and resorted to illegal practices to mask its

loss. To hide its unhealthy financial situation, Lehman resorted to a window dressing method

known as Repo 105 (Repurchase Agreement) (Jeffers, 2011). Repo has historically been

implemented to enable companies to manage their short-term cash, however, in Lehmans case,

these transactions took on a strange spin that were intended to make Lehmans balance sheet

appear to look healthier than they really were (Jeffers, 2011, 46). Repo 105 allowed Lehman to

use arcane accounting practices to sell toxic assets to banks in Cayman Islands with the

understanding that they would ultimately be bought back. With the assistance of its auditors, this

accounting scheme was plotted to allow Lehman to create an impression that it had $50 billion

less in toxic assets on its books and $50 billion more in cash and artificially reduce its net debt

level (Valukas, 2010, 42). It was no surprise that Lehman consequently declared bankruptcy

with $615 billion in debt.

Financial statement fraud played a key role in the collapse of Lehman, because some

senior officers ignored and certified deceptive financial statements. This is not shocking because

the 1999 study of 200 financial statement frauds by the COSO (Committee of Sponsoring

Organizations) of the Treadway Commission from 1987 to 1997 revealed that senior

management is the most likely group to commit financial statement fraud (KuTenk 2000,

2009).The examination conducted on Lehmans bankruptcy identified claims against Lehmans

external auditor, Ernst & Young for their failure to challenge or question inadequate or improper

disclosures in Lehmans financial statements (Valukas, 2010). According to the Public Company
Accounting Oversight Board, an external auditor is accountable to plan and perform the audit to

acquire reasonable assurance on whether the financial statements are free of material

misstatement, whether caused by fraud or error (CAQ, 2010). Lartey (2012) observes that

auditors need to establish a high level of objectivity and independence when reviewing financial

statements. This objectivity and independence was completely lost in the case of Lehmans

external audit. According to Cooper (2005), in the six years before Enron's collapse, ASIC's

American counterpart, the SEC, projected that investors lost US$100 billion owing to

misleading, faulty, or fraudulent audits. It was confirmed that those linked with the Enron fiasco,

including its auditor, Arthur Andersen, had been shredding thousands of pages of incriminating

papers (Scott and Scott LLP, 2008).

Improper adjustment to financial statements as well as deceptive accounting is common

financial reporting frauds that auditors appear to usually cover up. For example, WorldCom,

whose accounts were audited by the so-called professional auditors, experienced a more

terrible loss of 17,000 jobs, having inflated profits by approximately US$4 billion through

improper adjustments and deceptive accounting to the financial statements (Cooper, 2005). It is

obvious from the collapse of Lehman Brothers that many auditors seem to be involved in

financial statement frauds. In the case of Dynegy in which $300 million bank loan was masked

to look like cash flow, through a sequence of complicated trades, the complex nature of the

trades would have required considerable detective work on the part of the auditor (Ziff Davis

Media Inc, 2004).

Discussion of the facts and issues

In the years leading to Lehmans bankruptcy in 2008, its exposure to the mortgage

market was risky since it borrowed considerable amounts to fund its investments. A major
portion of this leveraging was put in housing-related assets, making it susceptible to a downturn

in that market. Analyses conducted by many experts focused mainly on Lehmans valuation of

the following asset categories: residential whole loans, commercial real estate, collateralized debt

obligations, residential mortgagebacked securities, corporate equity and debt, and other

derivatives. This section discusses more of Lehmans business decisions that led to the collapse.

Lehmans business decisions and operations prior to the collapse

Prior to the fall of Lehman, many investment decisions were made, which analysts

described as risky and unnecessary. Investigation conducted with respect to Lehmans

commercial real estate confirmed insufficient proof to conclude that Lehmans valuations of its

commercial portfolio were unreasonable as of the second and third quarters of 2008; however,

the findings indicated that real estate assets were unreasonably valued during these quarters and

Lehmans valuations of its Archstone bridge equity investment were unreasonable as of the first,

second and third quarters of 2008 (Valukas, 2010). Moreover, RWLs (Residential Whole Loans)

also accounted greatly for Lehmans collapse.

RWLs are residential mortgages that can be traded and combined during the first phase in

the securitization process, the result of which is the creation of RMBS (Residential Mortgage

Backed Securities). According to Valukas (2010), Lehman stated that it owned RWLs with an

aggregate market value of about $8.3 billion, as consolidated across subsidiaries as of May 31,

2008. With this revelation, the investigation identified lack of robustness in Lehmans product

control process for residential whole loans; and established that there was some risk of

misstatement in this asset class. With the aim of taking advantage of speculative opportunities

and managing its exposure to market and credit risks resulting from trading activities, Lehman

entered into derivative transactions on its behalf and that of its clients (Valukas, 2010).
According to Valukas (2010), Lehman held over 900,000 derivatives positions globally as of

May and August, 2008 with a net value of around $21 billion as of May 31, 2008; making up a

rather small percentage of Lehmans total assets (approximately 3.3%).

Valukas (2010) also argues that the term derivative is a contract between two or more

parties often referred to as a financial contract. Lehman experienced a drop of $17.0 billion in

CDOs (Collateralized Debt Obligations) in financial year 2008, compared with the $16.2 billion

and $25.0 billion generated in financial years 2006 and 2007 correspondingly (Valukas, 2010).

Although the 2008 decline is not as severe as is generally consistent with the decline in the

global CDO market, many contend that it contributed considerably to the collapse of Lehman.

Notwithstanding the billions of dollars worth of CDOs that Lehman originated from 2006

to 2007, Lehman accounted for just 3% of the total value of new CDO issuances; and their CDO

portfolio was subjected to the disruptions in the credit markets and deteriorating value of

mortgages and mortgagelinked securities that occurred in 2007 and 2008 (Valukas, 2010). As

the market declined, Lehman was not able to sell subordinate pieces of securitizations, and many

of Lehmans CDO positions were such pieces. For instance, of the $431 billion of CDOs

originated in 20062007, more than half had experienced events of default by November 2008,

with increasing numbers of defaults over time (Valukas, 2010). Krugman (2010, cited in

Swedberg, 2010 ) established that "in the years before the crisis, regulators did not expand the

rules for banks to cover the growing 'shadow' banking system, comprising of institutions like

Lehman Brothers that performed bank-like functions although they did not offer conventional

bank deposits." The financial crisis that broke out after Lehman's fall on September 15 made

some of Lehmans executives realize very quickly that something else had to be done than just

attend to individual cases.

In June 2008, Lehman was able to raise approximately $6 billion in capital and took steps

to improve its liquidity position, but efforts in raising additional capital in the weeks leading up

to its failure proved insufficient (Bernanke, 2010). Lehman's high degree of leverage - the ratio

of total assets to shareholders equity - was 31 in 2007, and its huge portfolio of mortgage

securities made it progressively vulnerable to deteriorating market conditions. Lehman's

bankruptcy was many times more multifaceted than Enron's failure in 2001 as it was deeply

plumbed into the global financial system. According to Bernanke, "almost every large financial

institution in the globe in momentous danger of going bankrupt" (Bernanke, 2009, cited in

Swedberg, 2010).The following section analyzes some of the causes of Lehmans collapse, with

a particular emphasis on the implications of the bankruptcy on the international banking system.

Analysis of the facts and issues

The collapse of Lehman has made headline news in several newspapers and journals.

Several industry practitioners and authors have undertaken much research just to establish what

caused the failure of Lehman Brothers. This section examines the facts and issues relating to the

collapse of Lehman Brothers. What financial fraud factors that made Lehman Brothers go

bankrupt and how could its bankruptcy have such a huge impact on the financial system? How

could this event turn an economic crisis of some severity into a complete financial panic? These

and many other questions are the emphasis of this section.

Causes of action arising from Lehmans financial condition and failure

In recent years, there has been a sequence of publications on what caused the failure of

Lehman Brothers. While some blamed Lehmans CEO Dick Fuld for his overconfidence in

trying to save something for shareholders and failure to identify that Lehman faced a critical

crisis, others stressed that the foundation for the collapse was far beyond the control of the Chief
Executive. One reason why Lehman would later go bankrupt has to do with the fact that anyone

who was alleged as a threat by Fuld was immediately eliminated including some critics who

early on realized that Lehman was headed for serious trouble (Azadinamin, 2012). As in most

investment banks, the employees of Lehman were paid extremely high salaries and bonuses,

which ate up more than half of what the company earned in pretax profit (Dash, 2010). The Bank

of America was blamed or ending takeover talks with Lehman in favor of buying its main rival

Merrill Lynch for $50 billion; and Barclays was also blamed for rejecting to buy Lehman

without US governments support in the form of emergency funding (DArcy, 2009). However,

DArcy (2009) also noted that Lehman failed mainly because of three things: losses, liquidity,

and leverage.

According to DArcy (2009), the best way to improve your returns during the good times

is to 'gear up' by borrowing money to invest in assets that are rising in value. In 2004, Lehman's

leverage was running at 20 and rose past the twenties and thirties before peaking at an

astonishing 44 in 2007, i.e. Lehman was leveraged 44 to 1 when asset prices started heading

south (DArcy, 2009). Different authors have described the collapse of Lehman as a result of the

abolishment of the 1933 Glass-Steagall Act. The Glass-Steagall Act was endorsed to separate the

activities of investment and commercial banking (Tabarrok, 2010). The U.S. has historically

maintained a separation between investment banking and commercial banking until the late

1980s. However, following the repeal of the GlassStegall Act, Lehman began to compete with

large commercial banks that reserved large amounts of funds, pursuing a path of high risk.

Before the passage of the Banking Act of 1933, banking regulation was greatly tightened in the

U.S which led to more than 9,000 banks failing during the great depression years of 1930-1933

(Laroche, 2010).
Various experts have blamed these failures on the so-called unethical actions arising from

the amalgamation of investment and commercial banking. In their paper, Altnkl, et al. (2007)

observed that investment banks governance has responded to the deregulation of commercial

bank entry into investment banking by virtue of the repeal of the Glass-Steagall Act. Competing

with commercial banks was a huge undertaking for Lehman; therefore the easiest way to

compete was to use high amounts of leverage, thus taking on more risk. For an investment bank,

the processing and absorption of risk is a distinctive intermediation function comparable to a

commercial bank engaged in lending (Boot, 2008).

A risky state for any bank is to lose liquidity. Like all banks, Lehman was a reversed

pyramid balanced on a splinter of cash. Even though it had a massive asset base, Lehman did not

have enough by way of liquidity. Believing that Lehman did not have sufficient liquidity at hand,

other banks declined to trade with it, so they moved to protect their own interests by pulling

Lehman's lines of credit (DArcy, 2009). Many blamed Lehmans failure on insufficient liquidity

to meet current obligations and inability to retain the confidence of counterparties and lenders

(Valukas, 2010). Lehmans available liquidity is fundamental to the question of why Lehman

failed. Liquidity offers firms the ability to convert assets into cash without complexity, thus

ensuring that investment decisions are maintained and shortterm obligations are satisfied. The

firm also stated that it had boosted its liquidity pool to an projected $45 billion, decreased gross

assets by $147 billion, reduced its exposure to commercial and residential mortgages by 20%,

and cut down leverage from a factor of 32 to approximately 25 (Valukas, 2010). Valukas (2010)

noted that there was a crisis of confidence since the confidence of lenders reduced on two

successive quarters with massive reported losses, $2.8 billion in second quarter 2008 and $3.9

billion in third quarter of 2008. Lehmans accounting system was a failure. The Repo 105

transactions used by the firm was described by its own accounting personnel as an accounting

gimmick, as it was a lazy way of managing the firms balance sheet (Valukas, 2010).This action

of accounting improprieties created a deceptive portrayal of Lehmans true financial health.

Amazingly, Lehmans external auditor, Ernst & Young took virtually no action to scrutinize the

Repo 105 allegations; and did not take any step to challenge or question the nondisclosure by

Lehman of its use of $50 billion of temporary, offbalance sheet transactions (Valukas,

2010).This unethical conduct by Lehmans auditor justifies Stern Stewarts (2002) conclusion

that accounting is no longer counting what counts and those in charge have not been wise or
strong enough to resist their ploys and to make the auditors definition of earnings into a reliable

measure of value. Many experts attribute that many companies fail and experience financial

crises because of disclosure fraud, accounting fraud, and accounting manipulation, that were

kept under cover; and auditors failed to warn the society and shareholders. Financial statement

fraud also played a key role in the collapse of Lehman because some senior officers overlooked

and certified misleading financial statements. For example, in the case of Crazy Eddie

Companys frauds, the auditors were rushed and did not have time to complete most of their

procedures (Kranacher, 2010).

Lehman was greatly exposed to the US real-estate market, having been the major

underwriter of property loans in 2007, by which Lehman had over $60 billion invested in CRE

(commercial real estate) and was very big in subprime loans, mortgages - to risky homebuyers

(DArcy, 2009). Lehman had vast exposure to innovative yet arcane investments such as CDOs

(collateralized debt obligations) and CDS (credit default swaps). These factors damaged the firm.

CDOs are derivative instruments through which a financial institution combines assets of

different types (prime and subprime mortgages). The packaged debt is later sold to a specific

vehicle, generally registered offshore in a low tax jurisdiction. The new entity then issues its own

bonds or equity to resell the debt to other investors, carving it up into diverse tranches with

different risk ratings using complex mathematical models (Wilks, 2008). Lartey (2012) argues

that overreliance on agency ratings of CDOs was a direct outcome of the strain in evaluating

such complex financial products. While many analysts have blamed Lehmans downfall on

complicit external auditors, others have expressed different views. It is argued that external

auditors are usually not effective in detecting fraud given frauds strategic nature (Carcello &

Hermanson, 2008). Also, Johnson (2010) argues that there is no assurance that all material

misstatements, whether caused by error or fraud, will be detected by auditors because auditors do

not examine every transaction and event (Ziff Davis Media Inc, 2004).

According to Lang & Jagtiani (2010), most of the initial losses in securities markets came

from CDOs and other structured securities that were linked to the residential mortgage market.

Thus, relative to their capital position, large financial institutions had highly concentrated

exposures to this organized but complex securities market. Fitch (2006, cited in Lang & Jagtiani,

2010) established that the number of subprime downgrades as of July-October 2006 was the

largest in its history. CDS are mainly credit derivatives in which the underlying asset is a
mortgage, loan, or any other form of credit. The risks in CDS and other types of OTC (over-

the-counter) derivatives played fundamental role in the financial crisis (European Commission,

2009). As property prices crashed and repossessions and debts increased, Lehman was caught in

a perfect storm and announced a $2.5 billion write-down due to its exposure to commercial real

estate (DArcy, 2009). While most authors blamed Lehmans bankruptcy on their 900,000

derivatives positions, the investigators did not find enough evidence to verify that Lehmans

valuation of its derivatives portfolio in 2008 was unreasonable (Valukas, 2010).

Literature review


Fraud is one of the key concerns for corporate executives. During the modern years many

organizations have encountered corporate scandals due to fraud, making the executives

experience the consequences of prison time and large fines (Ernst & Young 2009). Fraud,can

be defined as the misrepresentation of purpose, facts, of persuading another party to act in a

manner that causes damage to that party (Harrison et al. 2011, 233). The Fraud Triangle Model

created by criminologist Donald R. Cressey, represents the three factors that push a normal

person to commit fraud (figure 1).

Figure 1. The Fraud Triangle (UCMerced 2012)

If a person possesses three ingredients, motivation, opportunity and rationalization, a

there is a high possibility to commit fraud (Harrison et al. 2011, 234). From these three factors,

opportunity and motivation are something the organization can have an effect on. The two

factors are directly influenced by management and the corporate environment. The opportunity
can arise by the lack of security and control within the company. The motivation or pressure can

be created by demands of higher earnings in the company (Ernst & Young 2009, 1.)

Rationalization is like a psychological factor that arises within the person. By rationalizing the

fraudulent behavior, the individual committing the fraud assures him/herself that it is suitable to

be doing so (Harrison et al. 2011, 234). The common types of corporate fraud include corruption,

fraudulent financial reporting, and misappropriation of assets (Ernst & Young 2009, 1.)

The Literature on the Fraud Triangle

Pressure to Commit Occupational Fraud

Cressey (1953) theorized that individuals commit fraud due to non-sharable financial

pressure. Non-shareable financial pressure is a financial strain experienced by a person that does

not intend to share with others. The individuals failure to communicate the financial strain

serves as a motivation to disobey the law to solve the problem. The literature on the pressure to

commit occupational fraud can be generally classified into financial and non-financial pressures

(Albrecht et al., 2012). Non-financial pressures can be further classified as work-related pressure

(Holton, 2009; Bartlett et al., 2004; Peterson & Gibson, 2003); pressure linked with drug

addiction and gambling (Kelly & Hartley, 2010; Howe & Malgwi, 2006); and pressure

associated with people who want to make a statement by living lavish lifestyles (Dellaportas,

2013; Neu, 2013).

Monetary success, is understood as the impressive acquisition of millions through

personal achievement, is responsible for pursing success by any means necessary including

fraud (Choo & Tan, 2007: 209). A financial strain, such as a failed business or market

investment is the catalyst that drives many offenders to commit fraud (Dellaportas, 2013: 30). In

an organisational setting, financial pressures occur from the companys failure to meet Wall
Streets expectations (Power, 2013; Dorn, 2010). In other cases, financial pressure arises from

the companys failure to compete with other companies in similar industries (Albrecht,

2004). Within these purviews, monetary incentives in the form of compensation bonuses are

given to executives to improve the companys financial performance (Brennan & McGrath,

2007). Financial incentives, combined with the companys interest in investors relations (i.e.

keeping stock price high and preserving investors confidence), serve as extra incentives for

executives to manipulate financial statements (Mardjono, 2005).

Work-related non-financial pressures that stimulate fraud include workers displeasure

and alleged inequities in the workplace. Hollinger and Clark (1983) observed that work-related

pressures associated with fraud, mentioning that employees dissatisfaction is one of the main

indicators in predicting fraudulent behaviour in a company. In other studies conducted by

(Bartlett et al., 2004, 60-65), employees turn to fraud because of perceived inequities in the

work-place. These workers show little respect for the organisation they work for and generally

see fraud as an act of revenge against their employers (Baucus, 1994).

As earlier stated vices such as drugs and gambling represent another class of pressures

that motivate fraud (Dellaportas, 2013: 30). These increased opportunities motivate fraudsters to

steal assets and money to satisfy their chronic dependence on gambling (ACFE, 2012). Recent

studies have revealed that the vast majority of offenders, whose main motivation for fraud is

gambling, usually plough back their proceeds on gambling (Sakurai & Smith, 2003).

The offenders craving for material possessions creates pressure for them to live like their

more affluent colleagues (Everett & Rahaman, 2013). The type of pressure experienced by

offenders in this group differs by their individual circumstances (Morales et al., 2014). Many of

these offenders have selfish motivations and a desire to own more than one can afford,
(Dellaportas, 2013: 31). Egocentric motivations are an incentive to the fraudster and are said to

be any pressures to fraudulently increase personal prestige (Rezaee, 2005: 283). This type of

motive is commonly seen in those people with very hostile behaviour and desire to achieve

higher functional authority in the organisation (p. 283). Offenders in this category are extremely

ambitious and are obsessed with power and control; personality traits that make them more likely

to engage in risky behaviour that could lead to fraud (Dellaportas, 2013: 31).

Opportunity to Commit Occupational Fraud

The opportunity to commit fraud is the next element of Cresseys (1953) fraud triangle. A

perceived opportunity to commit a fraudulent act arises when someone in a position of trust

infringes that trust to address a non-sharable financial pressure (Cressey, 1953: 30). In the

accounting literature, opportunity has been studied within the context of weak internal controls

which, according to KPMG (KPMG, 2010), is a key factor attributable to fraud (Albrecht &

Albrecht, 2004; Harrison, & Turner, 2010; Kelly & Hartley, 2010; Strand, 2010: 2013).

Such an opportunity arises when the individual has the knowledge and technical skills that

enables the fraudster to commit the fraud and conceal it (Coenen, 2008; 12). The opportunity to

engage in fraud increases as the organizations control structure to weaken, its corporate

governance becomes less operational, and the quality of its audit functions worsens (Power,


Others look to the criminology literature for explaining the opportunity to commit fraud

(Benson & Simpson, 2009). (Colvin et al. (2002) claimed that social support and coercion are

necessary conditions for criminal behaviour. Individuals, who are deprived of access to social

support from legitimate sources, may pursue social support from illegitimate sources (p. 25). In

the absence of social support, people that learn to manipulate others in order to gain social
support and in the process develop a calculative social bond, intermediately intense, will be more

likely to approach a criminal opportunity with a calculating spirit (p. 31). Donegan and Danon

(2008) examined opportunity from the perspective of sub-cultural deviance. They argued that the

opportunity to commit fraud comes from a sub-culture, which through its practices either sends a

message to inhibit or support fraudulent conduct.

The Rationalisation of Occupational Fraud

Rationalisation is the lack of feelings and indifference expressed by offenders to justify

any guilt arising from their misconduct (Dellaportas, 2013: 32). It is a mechanism by which an

employee determines that the fraudulent behaviour is okay in his/her mind. For those with

poor moral codes, the process of rationalization is easy. For those with higher moral standards, it

may be harder, they may have to convince themselves that a fraud is satisfactory by creating

excuses in their minds (Coenen, 2008: 12). The social criminology and psychology literature

both provide a great deal of help in understanding rationalisation. According to (Sykes & Matza,

1970: 669), criminals normally use the techniques of neutralisation to justify their acts.

Neutralisation techniques are often used to shield the individual from his/ her internal values

surrounding the existence of guilt.

The psychological process of sanitising one's principles was expanded upon more lately

by Murphy and Dacin (2011). Building on the work of Bandura (1999) (moral disengagement

theory), they found three psychological pathways to fraud nestled within rationalization/attitude:

(1) lack of awareness, (2) instinct attached to rationalisation, and (3) reasoning. The authors used

their framework to describe how fraud becomes standardised within an organisation and how

executives rationalise their criminal acts because they see it as an essential part of their job.
Rationalisation also involves the fraudster integrating his/her actions with commonly

accepted principles of trust and decency. According to (Dorminey et al., 2010: 19), self-serving

and morally acceptable rationalization is essential before the crime occurs. Maybe this is

because a fraudster who does not view him/herself as a criminal must justify his/her misdeeds

before committing them (p. 19).

The present discussion on the elements of the fraud triangle is structured around research

that assume fraud is committed by dishonest individuals lacking morals and it is the

responsibility of the organisation to establish reliable layers of controls to prevent their

employees from committing fraud or at least to detect fraud in a timely way (Morales et al.,

2013: 184). Other variants used diverse articulations to increase the descriptive potential of the

fraud triangle as a modern fraud diagnostic tool (Krancher, Riley & Wells, 2010). Albrecht et al.

(1984) introduced the Fraud Scale Model suggesting that the probability of fraud occurring can

be evaluated by examining the relative forces of opportunity, pressure, and personal integrity.

Rezaee (2002) provided another one referred to as the 3-C model that consists of three

components necessary to commit corporate fraud: Corporate structureConditions and

Choice. Wolfe and Hermanson (2004) proposed another dimension, capability, to the fraud

triangle and transformed it into a Fraud Diamond. Others prefer to combine the fraud triangle

with criminology, sociology, and psychology theories. Choo and Tan (2007) explain corporate

fraud by relating the fraud triangle to Messner and Rosenfelds (1994) work on the ADT

(American Dream Theory) of crime.

Financial fraud

The two most common types of fraud impacting financial statements include Harrison et

al. (2011, 235):

1. Misappropriation of assets: In this case employees steal money and cover it up by making

wrong entries to bookkeeping.

2. Fraudulent financial reporting: In this case, managers make misleading and false entries to the

financial statements, making the company seem better than it really is. Although fraudulent

financial reporting appears to be the least common form of fraud, it is by far the most expensive,

in terms of financial long-term damage (Ernst and Young, 2009, 2). The Association of Certified

Fraud Examiners has created a list of common accounting fraud schemes and related red flags,

on which managers should be conscious of. They mostly occur with understating expenses

overstating revenues, or improper asset valuation. The following paragraphs will describe them

in more detail.

Overstating or incorrectly recognizing revenues

These are one of the most common types of financial statements fraud. The schemes

include: recording gross revenue, instead of net; recording revenues of other companies when

acting as a broker; recording sales that have not occurred; recording future sales in the present

period and; recording sales of products that are out on consignment. The red flags in these kinds

of circumstances are: increased revenues, without a consistent increase in cash flow; unusual

transactions, especially ones closed near the end of a financial period; in receivables the unusual

expansion of days sales; or high revenue growth when competitors are experiencing poor sales

(Ernst & Young 2009, 2.)

Understating expenses

This is another common type of financial statement fraud that leads to overall net income

and higher operating income. The schemes in these kinds of cases include: reporting cost of

goods sold as a non-operating expense so it does not adversely affect gross margin; capitalizing
operating expenses, so recording them as assets rather than expenses; and some expenses are left

out recording, or they are recorded in the wrong period. Red flags associated with these can be:

unexpected increase in assets, unusual increase in income, or allowances for sales returns,

warranty claims, and others that are reducing in percentage terms or are otherwise out of line

with the companies from the same industry (Ernst & Young 2009, 4).

Improper asset valuation

This is another type of fraud. The schemes used are manipulating reserves, manipulating

the fair value of assets, and changing the useful lives of assets. The red flags associated with

these include: repeating negative cash flows, visible decrease in customer demand and increasing

business failure in the industry; or estimates on liabilities or assets, expenses and revenues are

based on high uncertainties. Some other schemes related to fraudulent financial reporting can

also relate to: smoothing of revenues, so overvaluing liabilities during good periods, and

storing away funds for future use; improper reporting of information, especially when it comes to

issues related to party transactions and loans to management; or implementing highly complex

transactions (Ernst & Young 2009, 4.)

Highlights in financial reports

This section will visualize the financial reports and identify the specific lines where the

most common types of fraud on financial statements have occurred. Example, the chapter will

examine reports presented by Lehman Brothers Holdings Inc. delivered to the US Securities and

Exchange Commission the same year the company filed for bankruptcy. First to note are some

examples from the Lehman Brothers quarterly income statement 2008, before the bankruptcy in

the figure below.

Lehman Brothers consolidated income statement (USSEC, 2008, 4)

As discussed earlier, overstating or incorrectly recognizing revenues is one of the most

common types of fraud affecting financial statements. This is obvious in the income statement

under various headings, as highlighted above. Realized and unrealized losses or gains from

Financial instruments and other inventory positions owned and Financial instruments and other

inventory positions sold but not yet purchased, and the losses or gains from certain short-term

and long-term borrowing obligations, principally particular hybrid financial instruments, and

certain deposit liabilities at banks that the Company measures at fair value are revealed in

Principal transactions in the Consolidated Statement of Income (USSEC, 2008, 11). According

to this, it can be understood that many complicated transactions and financial instruments have
been used by the company, and thus, in this case, it has been able to mask something that should

have been reported as borrowings, under revenues.

Also, the balance sheet can be presented in a fraudulent way. As earlier discussed,

improper asset valuation is also a common type of fraud companies have used. The possible

fraudulent procedures can include manipulating reserves, changing the useful lives of assets, not

reporting down when needed, and manipulating the fair value of assets. Figure 2 presents some

of these points highlighted. For example, Lehman Brothers Notes on how the long-lived assets

have been valued are as follows:

Equipment, property, and leasehold improvements are recorded at historical cost, net of

accumulated amortization and depreciation. Depreciation is identified using the straight-line

method over the estimated useful lives of the assets. Buildings are depreciated up to a maximum

of 40 years. Leasehold improvements are amortized over the lesser of their useful lives or the

terms of the underlying leases, approximately 30 years. Understating expenses can also be used

in making the overall net income and operating income seems higher. In the Notes to the

statements, Lehman Brothers describes their revenue recognition policies, under Principal

transactions, as follows:

Developed for Internal Use, is capitalized and then amortized over the projected useful

life of the software, usually three years, with a maximum of seven years. The Company reviews

long-lived assets for impairment periodically and whenever changes in circumstances show the

carrying amounts of the assets may be impaired. If the likely future undiscounted cash flows are

less than the carrying amount of the asset, an impairment loss is identified to the extent the

carrying value of the asset exceeds its fair value (USSEC, 2008, 16.)
Figure 2 Lehman Brothers consolidated Assets, balance sheet (USSEC, 2008, 5).

Although in Lehmans case, there had not been any improper asset valuation, the balance

sheet and the Notes provide an example of where fraudulent reporting could occur. As the Notes

explain, the equipment, property, and leasehold improvements are valued at historical cost,

which for instance could mean that the inflation or other economic factors affecting the values
have not been taken into consideration. As a more detailed example, it mentions that buildings

are depreciated up to a maximum of 40 years. However, the company provided financial

statements that were produced fraudulently but was not caught, even by the auditors.

Implications of Lehmans Collapse to the international banking industry

Many analysts have associated Lehmans collapse to risky real estate lending. The U.S.

subprime crisis was one of the main crises that had serious repercussion on the global banking

system, and still poses many threats to many banks, particularly those with investment banking

activities. Through securitization, the risks of sub-prime lending were transferred from mortgage

lenders to third-party investors (IFSL Research, 2008). Lehman's bankruptcy had caused some

price depreciation of commercial real estate. For instance, the liquidation of Lehmans $4.3

billion in mortgage securities generated a selloff in the commercial mortgage-backed securities

(CMBS) market.

Lehmans downfall gave rise to the drop in the Primary Reserve Fund. Lehman's

bankruptcy led to over $46 billion of its market value being wiped out. The collapse also served

as the catalyst for the acquisition of Merrill Lynch by Bank of America in an emergency deal

that was also publicized on September 15. The collapse of Lehman resulted in the loss of 70% of

$48 billion of receivables from derivatives that could have been relaxed (Valukas, 2010) and as

much as $75 billion in value was ruined (McCracken, 2008). Many countries, companies and

types of actors were also directly associated with Lehman and its bankruptcy. For instance, in

England, around 5,600 retail investors had bought Lehman-backed structured products for $160

million (Ross, 2009); while in Hong Kong, 43,000 individuals, many of them senior citizens, had

bought mini-bonds to a value of $ 1.8 billion. Famous cities and counties in the U.S lost more

than $ 2 billion (Caplan, 2010). One public bank in Germany, Sachsen Bank, lost about half
a billion Euros (Kimberly, S. (2011). Pension funds, such as the New York State Teachers'

retirement plan had also suffered losses due to the collapse of Lehman (Bryan-Low, 2009). A

large number of hedge funds in London also had some $12 billion in assets frozen when Lehman

declared bankruptcy (Wilchins & DaSilva, 2010).

Internal control

Internal control is a system of procedures used by company management designed to

follow objectives as: safeguard assets, promote operational efficiency, encourage employees to

follow company policy, ensure reliable, accurate, accounting records and comply with legal

requirements (Harrison et al. 2011, 237). COSO is one of the main sources providing guidance

and frameworks on enterprise risk management, internal control and fraud deterrence (COSO

2011). According to COSOs framework, internal control is an essential part of enterprise risk

management. The role of internal control is to manage risk, rather than to eradicate it (KPMG

1999, 14). Therefore, before discussing the concept of internal control, it is important to examine

some facts and discussion related to risk management.

Fraudulent financial reporting in U.S. public companies

The Committee of Sponsoring Organizations of the Treadway Commission (COSO),

conducted a study to provide better understanding of financial statement fraud cases. According

to the study, from 1998 to 2007 there were 347 cases of fraudulent financial reporting in US

public companies. The misappropriations accounted for nearly $120 billion in total of 300 fraud

cases. The most common type of fraud identified was improper revenue recognition, which

accounted for over 60% of the cases, following by the exaggeration of existing assets or

capitalization of expenses (Beasley, 2010). The study revealed that fraud affects companies

no matter the size. The organizations involved had median revenue and total assets under $100
million in the period before committing fraud. The company sizes differed from startups to

companies with over $100 billion in revenues, so it can be supposed that fraud is not limited to

particular sized companies. 73% of the fraud companies common stock traded in over-the-

counter markets and were not listed in the American Stock Exchanges (Beasley et al. 2010, 2.)

One of the significant insights made by the study was that characteristics between audit

committees of fraud and no-fraud companies do not generally differ. For instance, nearly all of

the companies investigated in the study had audit committees. These committees were in both

company cases (fraud and no-fraud) groups of about three people and on average these groups

met around four times a year. So, it can be said, there is little proof that the characteristics of the

audit committees can be associated with fraudulent financial reporting. For what it comes to

external auditors, it appears as though fraud goes undetected by all types and sizes. 79% of the

companies that had committed fraudulent reporting were audited by the Big Four auditing firms

(Beasley, 2010, 5). After the Lehman and Enron cases, in 2002 as a way to prevent

fraudulent financial reporting a new US legislation, called the SOX (Sarbanes-Oxley Act), was

set forth. As the timing of this study includes only five years of the Sarbanes-Oxley Act period, it

is hard to give any valid conclusions on how it has affected the possible fraud behavior of

companies. In specific interest is the Sarbanes-Oxley Act Section 404, which states internal

control systems mandatory for all US companies (Sarbanese-Oxley Act 2002).

Internal control framework by COSO

In 1992, COSO issued Internal Control Integrated Framework to assist businesses and

other entities with their internal control systems. In the recent years, the concern over fraud and

the focus on risk management have highly increased. COSO noticed an urgent need for a robust

framework to efficiently manage risk. Therefore, in 2001 it initiated a project, together with gent

PricewaterhouseCoopers, to develop a restructured framework that would be readily usable by

management. In 2004 the framework was published, and COSO believes this updated framework

Enterprise Risk Management Integrated Framework fills the need. It expands on internal

control and offers a more broad focus on the whole subject of enterprise risk management. As

earlier mentioned, internal control and risk management are closely related, and according to

COSO internal control is integrated within the framework of risk management (COSO 2004).

This section examines Enterprise Risk Management Integrated Framework (2004).

The final assumption of enterprise risk management is that companies exist to offer value

for their stakeholders. All companies face uncertainty that presents both risks and opportunities.

One of the main challenges is to establish how much risk a company is ready to accept while

reaching for creating more value. Enterprise risk management should allow management to

efficiently deal with these uncertainties to create more value (COSO 2004, 1.)

The aim of the enterprise risk management (ERM) framework is to allow companies to

realize their objectives. According to the framework the objectives can be seen in the context of

four categories: strategic, operations, reporting and compliance. The final assumption of

enterprise risk management is that companies exist to offer value for their stakeholders. All

companies face uncertainty, which presents both opportunities and risks. One of the main

challenges is to define how much risk a company is willing to accept while reaching for creating

more value (COSO 2004, 1.)

1. Strategic

This refers to high-level goals, which should be aligned with and supporting the companys


2. Operations

Efficient and effective use of resources

3. Reporting

Reliability of reporting

4. Compliance

Compliance with appropriate law and regulations. This category makes it possible to have

focus on separate aspects and it addresses various company needs (COSO 2004, 3).

The ERM framework considers activities from all different levels of the company: enterprise

level, division or subsidiary and business unit processes (IIA 2004, 8.)
In front of the cube (figure 5) the eight pillars signify eight connected components of the

framework. These components derive from the way management runs a company and are

incorporated in the managements processes. The eight components are:

1. Internal Environment

This sets the tone of an organization, and is the foundation for how risk is viewed and

addressed by the employees. This includes the philosophy of risk management ethical values and

integrity, and the environment in which they operate.

2. Objective Setting

Objectives are vital for an organization because management is able to identify possible events

affecting the companys accomplishments. The chosen objectives should align and support the

entitys mission and be consistent with its risk appetite.

3. Event Identification

External and internal events affecting attainment of objectives need to be identified, and

determined as opportunities and risks. Opportunities should be channeled back to the

managements objective or strategy-setting processes.

4. Risk Assessment

The possibility and impact of risks are analyzed to determine how they should be managed.

5. Risk Response

Management needs to choose how to respond to the risks. This means developing a set of

actions to align risks based on the companys risk tolerances and risk appetite.

6. Control Activities
To ensure that risk responses are efficiently carried out, policies and procedures need to be

set out.

7. Information and Communication

Relevant information needs to be identified and communicated in a way that employees can

carry out their responsibilities. Effective communication is as well flowing down, across, and up

the organization.

8. Monitoring

The companys whole enterprise risk management needs to be monitored, and if essential

modifications should be made when needed. The monitoring happens through management

activities and evaluations. All of the components mentioned above are correlated, where almost

every component influences another. The cube (figure 5) describes the correlation between the

eight components, the entitys units and the four objectives in a three dimensional matrix. The

objectives are symbolized in the vertical columns, the components in the horizontal columns and

the business units in the third dimension (COSO 2004, 3-5.)

For a company to have effective ERM the eight components need to be there and

operative. No material weaknesses can exist and all the risks need to be considered in the risk

appetite for the components to function correctly. However, one must keep in mind that the eight

components do not function identically in all organizations. For example, in smaller firms they

may be more informal and less structured, but still effective. Regardless of the benefits of ERM

certain limitations exist. As the operators of the system are just human, errors and mistakes are

naturally a part of so called human failures (COSO, 2004, 5).

Internal control guidelines by KPMG

Most companies have created their own internal control systems; nevertheless they tend

to follow the principles set by COSO. For example, this part will examine one of the leading

auditing companies systems. The KPMG guide links the theoretical concepts a bit more into

practice, and hence beneficial to take a look at. As the business world is always changing, and

the companies live in a turbulent environment, a successful internal control system also needs to

be open for changes. Internal control and effective risk management therefore need regular

evaluation of the extent and nature of risks. The ultimate responsibility of the internal control

should be with the board. This also implies that the board should be the one sending a clear

message to the whole organization that the responsibility of internal control should be taken

seriously (KPMG 1999, 18.)

In order to have an effective system of internal control, the board should consider the following

aspects (KPMG 1999, 19):

The extent and nature of the risks facing the company

The categories and extent of risks that can be acceptable for the company to bear

The possibility of the risks which concerned materializing

The companys capacity to reduce the occurrence and impact on the risks that do


The costs of operating specific controls relative to the benefit, thus managing the related


Following COSOs framework of internal control published in 1992, KPMG also

includes the same common elements to its system: control environment, identification and

evaluation of risks and control objectives, control activities, information and communication

processes, and processes for monitoring the effectiveness of the system of internal control.
Figure 6 below represents the five diverse components mentioned, with the board as the center

(KPMG 1999, 19-21.)

However, it is not sufficient only to have all the components present, it is also vital to

understand the context and nature of the control. First of all, as control should be able to respond

quickly to changing risks, it is important to get the control as close to the risk as possible. The

organization needs to have the capacity to adapt and respond to unexpected situations and risks,

and to make decisions despite having all the information. This is why the control needs to be

close to the related risks - the shorter the chain, the quicker the reaction (KPMG 1999, 22.)

Secondly, the costs of the control need to balance against the benefit of controlling the risk. As it

may occur that the cost of additional control becomes greater than the actual benefit arising from

the controlling of the risk. Thirdly, the control system needs to consist reporting procedures,

which communicate directly to the right management levels of any major control failings or

weaknesses that are identified. The reporting should also include details of the actions being

undertaken. This also implies that the philosophy of control should come from the top of the

company, with an emphasis on continual learning, instead of a blaming culture.

Although control can minimize risks and errors, it cannot guarantee absolute assurance

that they will not happen. However, it would be important to include the control system in the

companys operations and have it as an element of the companys corporate culture. As a

company is run by people, the control system is affected by people throughout the company, so

all the people in the company are accountable, the possibility of an effective control system is

increased (KPMG 1999, 22-24.) KPMG has developed a Risk Management Diagnostic, to

assists organizations follow whether all of the necessary components for an efficiently working

internal control system exist.

Policy and Philosophy

Is your organizations risk management policy and philosophy clearly defined,

communicated and certified by the board?


Are those responsible for risk provided with suitable formal training?

Does the organization learn from the risk events when things go wrong rather than seek


Roles and responsibilities

Is the responsibility for reporting clearly defined?

Are responsibilities written into all pertinent employee job descriptions?

Demonstration of performance and risk effectiveness

Is the board provided with a clear picture of performance?

Are KPIs clearly measured and defined?

Translating strategy to business objectives

Do business objectives reflect strategy?

Are business objectives clearly communicated?

Performance appetite

Is your organizations risk appetite clearly defined?

Are action plans developed to move the organization to a more desired risk profile?

Risk to delivering performance

Does the risk information assist management in identifying accumulations and

dependencies? Are management controls and actions identified and monitored for the risks?
KPMG believes that for any control model to work effectively and be pertinent to the

performance of the business, it must comprise these key components:

Starting from the tip of the triangle;

Philosophy and policy represents how the board should make the risk management

expectations clear. Employees must know what is expected from them and what is not.

Roles and responsibilities represent the significance of making all the responsibilities

and roles of the key performers explicit.

Converting strategy to business objectives includes the idea of making strategic and

business objectives clear. This way the probability of overlooking significant risks will be

reduced, as the connection between business planning and strategy is a critical risk management


Risk to delivering performance refers to how the significant business risks should be

officially identified by the board and this way show that they are aware of the likely risks.

In the left bottom of the pyramid KPMG has Performance appetite meaning that the

likelihood of the risk of occurring and of the impact of that risk should be analyzed. The cost and

benefit relations need also to be analyzed.

Demonstration of performance and risk effectiveness refers to how performance

should be monitored against targets; an evaluation of the effectiveness of the control should

periodically be provided to the board. This process has some indirectness, as monitoring may

lead to re-evaluating the companys control and objectives. Finally, the triangle has Behavior,

which represents shared moral values. These include responsibility, authority, values, integrity,

and accountability, should be established, communicated and implemented around the whole
organization (KPMG, 1999, 67-68). Some of the most common weaknesses in organizations

happen with (KPMG 1999, 26):

Philosophy it is understood, so it is open for misinterpretation

Roles and responsibilities the responsibilities are not clear throughout the organization

Converting strategy to business objectives strategic objectives are not directly

business objectives.

Risk to delivering performance a form of risk profiling, but usually differs from the

reality of doing business. In their paper, Lartey (2012) argues that the 2007-2008

financial crisis could have been evaded if the financial institutions adopted effective risk

management practices in their derivative trading. Before the collapse, Lehman had

invested so much in risky derivatives. The initial idea of derivatives was to help actors in

the real economy insure against risk but many derivatives trades have crossed the line of

price stabilization and risk management into speculations (Wilks, 2008).

Performance appetite missing the understanding of the organizations risk appetite

Performance and risk effectiveness boards do not receive the right information, so

either too little or too much.

Could the crisis have been prevented?

Although the international banking industry had witnessed numerous bankruptcies over

the past two decades, many experts believe that Lehman's collapse had huge consequences on the

economy in general, as it was that anaphylactic shock to the financial system that led to the

global economic downturn (The Independent, 2009). Lehmans collapse could have been

prevented if proactive measures were taken by senior management to guarantee effective risk

management in their operations. Just before its collapse, executives at Neuberger Berman sent e-
mail memos to Lehmans senior management proposing that Lehman Brothers' management

forgo multi-million dollar bonuses to send a strong message to both investors and employees that

management was not avoiding accountability for recent performance. Rather than waiting to

bailout banks in times of financial pain, many governments have adopted new strategies such as

directly investing into the capital of their banks. For instance, on October 8, 2010, the British

government declared that they would invest 400 billion pounds directly into the capital of their

banks; a quicker way of strengthening the banks rather than by buying up their toxic assets

(Swedberg, 2010).

There were many controversies surrounding the executives pay during the collapse. On

October 17, 2008, CNBC reported that some Lehman executives have been summoned in a case

relating to securities fraud. Lehman Brothers executive pay was reported to have increased

considerably before filing for bankruptcy. Most analysts were highly serious of Lehman's

executives, specifying that they should have done better. Valukas (2010) blamed Lehman

executives for worsening the firm's problems, resulting in financial fallout to shareholders and

creditors. According to Valukas (2010), the conduct of Lehmans executives "ranged from

serious but non-culpable errors of business judgment to actionable balance sheet manipulation."

The auditor's report criticizes Lehman's failure to disclose its use of the "Repo 105 accounting

tool. According to the report, accounting rules allowed Lehman to treat this transaction as sales

instead of financings, so as to exclude assets from the balance sheet (Wong & Smith, 2010).

Lehman Brothers failed to be rescued by the government or a buyer bailout. It has been

recommended by many experts that public sources be used to capitalize banks and other key

financial institutions.

Preventive measures
The severity of Lehmans failure in international business has been labeled by financial

analysts as second to none of an individual firm bankruptcy impacting on a broad spectrum of

businesses globally (Aversa, 2008). Some believe Lehmans failure partly caused the 2007

economic meltdown (Murphy, 2008). A bulk of preventive measures has been attributed by

various analysts who if adhered to, would have prevented the collapse of Lehman Brothers.

According to Kimberly (2011), the collapse would have being prevented assuming management

had taken more proactive risk management actions than their reactive measures at a time the

company was almost collapsing. The indicators were written all over but management could not

find the correct solution to inhibit the crisis (Valukas, 2010). Significantly, credit agencies and

regulators cannot be exonerated from these failures. Company regulators were the right agencies

to have warned and guided Lehman to participate and operate within the confines of business

jurisdiction however; the regulators were reported on many occasions to have kept a blank eye

on the unethical and illegal activities of Lehmans executives.

In an attempt to predict the failure of firms, Lehmans failure has exposed the weaknesses

in different models employed for this purpose. For example, in analyzing the financial health of

companies, areas of performance such as liquidity, profitability, solvency and efficiency

indicators are considered (Mensah, 2012) however; much weight is not placed on the cash flows

of those companies. A careful consideration of cash flow indicators could have prevented the

liquidity problems of the company. In view of the above measures, the inadequacies inherent the

auditing processes partially accounted for this failure. The assurance of a full disclosure by

external auditors in relation to the alleged financial statement fraud perpetuated by Lehmans

management could have helped in avoiding this huge catastrophe (Kimberly, 2011).

Nevertheless the numerous preventive measure ascribed by analyst, a take-over or bail-out

coupled with good corporate governance practices, Lehmans failure could have being predicted

and prevented (DArcy, 2009).


The international banking industry has undergone tremendous transformation across all

economies and markets over the past few years. Recent regulations and competition in the

banking industry have compelled many investment banks to pursue growth in sectors that

traditionally fell within the domain of other financial institutions such as commercial banks. This

exposes the banks to take on more risks, often leading to crisis. With regards to Lehmans

reaction to the subprime lending crisis and other economic events, some earlier decisions taken

by Lehmans management were questionable, although they fell within business judgment rule.

Most of the valuation procedures employed by Lehman were unreasonable for purposes of a

bankruptcy solvency analysis. The failure by Lehman to disclose the use of its Repo 105

accounting practice provided ample evidence of the loop-holes in their accounting system.

Again, there was a serious indictment for the inability of its external auditor, Ernst & Young to

meet professional standard in connection with the lack of disclosure of accounting and financial

statement frauds. The demands for collateral by Lehmans Lenders (J.P.Morgan and CitiBank)

had direct impact on Lehmans liquidity pool. While majority of Lehmans failures were from

within the companys own operations, many questions arose as to whether the interaction

between Lehman and the Government agencies that regulated and monitored Lehman

contributed to the collapse. Many analysts believed that Lehman's bankruptcy had set off a panic

that would end up by threatening not only the U.S. financial system but also the entire global

financial system. Subsequent to the demise of Lehman, many concerns have been raised as to
what led to the failure of the one-time leading investment bank in the U.S. The fact is that, these

questions are currently hard to answer, among other reasons because there is very little exact

knowledge about what happened once Lehman went bankrupt.

Misrepresentation of Financial Statements

Misrepresentation of financial statements, often referred to as cooking the books, takes

place when the financial statements are deliberately misstated to make the financial position of

the company look better than it actually is. This often encompasses increasing reported revenues

and/or decreasing reported expenses. It could also comprise misrepresenting balance sheet

accounts to make ratios, such as the current or debt to equity ratios, look more favorable.

Reporting amounts different from what would have been reported under GAAP is also regarded

a misrepresentation of financial statements (Messier 111). Of the two fraud practices,

misrepresentation of financial statements is usually much more harmful to the company in the

long run. With misuse of assets it is hard to fraudulently misappropriate large amounts, while it

is much easier to just add large sums of money that never really existed to several accounts.

Once fraudulent financial reporting is revealed, share prices usually drop and companys true

value is usually revealed to be much less than was being reported.

Causes of Lehmans failure

Following the fall of Lehman Brothers, various reasons have been accredited to the

failure after full investigations were conducted by financial and non-financial analysts

(Kimberly, 2011). None of these analysts gave a single cause to this failure (Azadinmin, 2012);

but, a number of factors were revealed for their failure. The factors that accounted for this failure

were poor management choices together with unethical actions; liquidity crisis; repeal of the

Glass- Steagall Act of 1933; financial leverage; unsuccessful bail-out and take-overs, subprime
mortgage crisis, excessive losses; Repos 105, massive credit default swaps, and complex capital

structure (DArcy, 2009; Kimberly, 2011; Morin & Maux, 2011).

Repeal of the Glass-Steagall Act

The supporters of the Glass-Steagall Act of 1933 blamed the whole US financial crisis on

the enactment of the Gramm-Leach-Biley Act of 1999 to replace the Glass-Steagall Act

(LaRoche, n.d). To eradicate or reduce possible conflict of interest, the Glass-Steagall Act of

1933 was ratified to separate commercial banking from investment banking after the great

depression (Tabarrok, n.d). During the great depression, 9,000 banks were described to have

failed (Lartey, 2012). This Act was revised and replaced in 1999 to permit commercial banks

carry investment banking activities. The replacement of the 1933 Glass-Steagal Act of 1933 saw

many commercial banks merging with investment banks. Financial analysts attributed this

change on the failure of Lehman. In their pursuit to compete with commercial banks which has

high leverage positions, Lehman merged and acquired many investment and commercial banks

(Valukas, 2008). The unethical merging activities exposed them to many risks leading to their

bankruptcy (Boot, 2008).

Unethical Management practices

In their quest to achieve their expansion strategy and other objectives, managers of

Lehman chose to use various suspicious mechanisms, obnoxious accounting practice coupled

with their obvious disregard for prudent corporate governance practices (Caplan et al, 2012).

According to Gasaparino (2008), Lehman used window dressing presentation facilitating the

manipulation of their financial statement intended at attracting investments and showing an

altered picture of the company. This was verified by the application of charges against their

auditors Ernst &Young by the Attorney General for helping Lehman Brothers in perpetrating
financial statement fraud (Valukas, 2010). Lehman further used Repos 105 transactions to

improve the companys financial health at the end of the financial year.

Lehmans managers deliberately violated the Sarbenes-Oxely Act as a result, many

accounting scandals were dubious transactions, and Lehman employed (Repos 105 to alter the

financial statement of the company (Morin & Maux, 2011). According to Kimberly (2011), the

Lehman balance sheet in June 2008 was fabricated with window-dressing method popularly

referred to as Repos 105. This action led to the removal of $50 billion in pledge from their

financial statement (Morin & Maux, 2011). Nevertheless the unethical employment of Repos 105

by Lehman, it is lawful for banks to engage in Repos 105 transactions (Wilchins & DaSilva,

2010). Basically, repurchase agreement has been traditionally used by banks to manage their

short-term cash liquidity (Mensah, 2012). This involves the pledging of short- term low risk

instruments or government bonds in return for short-term funds (Casu et al, 2006). Traditional

Repos involves the agreement between two or more financial institutions in which one of these

institutions decides to dispose of its short-term security for cash with the condition that after a

some agreed time, the seller will buy it back at a prearranged rates and date (Mensah, 2012;

Agyemang, 2012).

The apparent security disposed by the seller serves as security (Jeffers, 2011). These

short-term securities will then return back to the seller after paying the cash received in addition

to the interest thereon. In case the seller fails to pay on the due date, the buyer may dispose of the

pledged securities for reimbursement (Casu et al, 2006). In a nutshell, Repos 105 is just a

measure employed by firms to raise short-term funds by pledging their long-term financial assets

to improve their liquidity position. To account for Repos 105, the bank pledging its securities for

cash reports it as a loan with security (Jeffers, 2011). To support their unethical practices,
Lehman instead failed to use the right accounting method to report Repos 105 thus failing to

disclose it to credit agencies investors, the government, and its own board of directors (Morin &

Maux, 2011). According to Wilchins and DaSilva (2010), Lehman extended this practice by

obtaining government bond from another bank using one of its special units in the U.S. Just

before the end of the quarter, Lehman transfers these bonds to their London affiliates (Lehman

Brothers International). Their London affiliate then transfers the bonds to another bank for cash

with a pledge to buy it back at a higher rate (105 percent of the price). The cash received is then

transferred to the Lehman Brothers US to pay off a large amount of liabilities therefore reducing

the firms liabilities to show healthier quarterly reports and improve investors confidence,

equivalent ratios, regulators and the general public.

Prior to the successive quarter, Lehman Brothers will then borrow more at other lending

institutions to purchase back the securities from their London affiliates at 105% of the initial

price. The financial statement will then return back to its initial unhealthy position after such

practices making Lehman worse-off because they want their financial position to look healthy in

the eyes of the government, investors, and regulators. This practices amount to financial

statement fraud (COSO, 2005) and one of the factors that led to its collapse (Valukas, 2010). By

extension, the external auditors of Lehman cannot be acquitted from this terrible crime (Carcello

and Hermanson, 2008).

Liquidity crisis

Central to the failure of Lehman was their failure to meet short term obligation (Valukas,

2011). Despite its high asset base, Lehman was experiencing erratic liquidity problems. As a

result, Lehman was losing its market confidence; evidently, most banks withdrew their credit

lines and services to Lehman Brothers (DArcy, 2009). At this point, the confidence level of
customers and lenders halted; rendering Lehman unpleasant in the eyes of investors and

prospective investors (Mensah, 2012). To address this challenge, Lehman reduced their gross

asset base $147 billion to improve their liquidity position$45 billion (Valukas, 2011).

Their liquidity redemption strategy further saw the reduction in their commercial mortgage

exposure by 20% and leverage from a factor of 32 to about 25 (Lartey, 2012). Unlike their rivals

Bear Beach Stearn which suffered the same fate in March 2008, Lehmans liquidity crisis was

not liberated by their proposed strategy and bailout. Bear Beach Stearns was rescued by

JPMorgan Chase to erode their liquidity crisis (DArcy, 2009).

Collateralized Debt obligation and Derivative crisis

In their effort to take advantage of opportunities in the real estate market, Lehman

Brothers before the collapse were reported to have engaged into some unnecessary and risky

investments (Murphy, 2008). According to Kimberly (2011), RLWs (Residential Whole Loans)

was also reported to have accounted to the failure of Lehman Brothers. RWLs are residential

mortgages that is usually traded and pooled during the process of securitization and subsequently

change into RMBS (Residential-Mortgaged Backed Securities) (Lartey, 2012). As at May 2008,

Lehmans consolidated market value of RWLs amongst its subsidiaries amounted to about $8.3

billion (Valukas, 2010). According to Murphy (2008), Lehman lacked a healthy product control

process to account for residential whole loans combined with misstatement in assets further

worsening their position. To capitalize on speculative opportunities and reducing its exposure to

credit risk in the financial market, Lehman entered the derivative market. This is intended to

manage the volatility of their exposure and assets. As at the time of filling their bankruptcy,

Lehman had in its books an approximated estimated derivative to the tune of $35 trillion in their
portfolio (Kimberly, 2011) and held over 900,000 derivative positions worldwide (Valukas,


These derivative instruments enable firms to derive the value of investment from the

changes in the price and value of other underlying assets such as stocks or commodities

(Buchanan, 2000). Most of these derivatives were credit default swaps; evidently, the property

prices crashed in the financial market during the global economic crisis leading to repossession

of assets, Lehman was reported to have written its credit default swaps (CDS) by $2.5 billion

(DArcy, 2009). Credit derivatives such as mortgages, loans, and other forms of loans are the

main underlying assets CDS. CDOs (Collateralized Debt Obligations) also accounted for the

losses in the securities market during the global financial crisis of 2007 (Lang & Jagtiani, 2010).

CDOs are derivative instruments which involves the accumulation of both prime and subprime

securities planned to be sold to a special purpose vehicle in a low-tax jurisdiction (Wilks, 2008).

The buyer then repackages the loans and issues them as bonds or equity to other interested

investor. Between the period 2006 and 2007, half of Lehmans CDOs projected at $431 billion

had experienced defaults by November 2008 (Valukas, 2010). The decline in the values of CDOs

significantly contributed to the collapse of Lehman Brothers.


The high borrowing approach of Lehman to finance their assets terminated into high

leverage position (Lartey, 2012). A companys financial leverage is its ability to finance a

portion of its assets with securities bearing fixed rate of interest with the confidence of increasing

the final returns to the equity shareholders (Keown et al, 2005). As at 2007, Lehmans high

leverage ratio has augmented from 20 in 2004 to 44 to 1 shareholders equity (DArcy, 2008). By

effect, for every $1 of cash and other available financial resources, Lehman would lend $44
which was too high a leverage ratio to maintain (Valukas, 2010). The impact of the global

financial crisis that saw prices decreasing coupled with increased interest rates, Lehmans

financial position were harmfully impacted leading to their bankruptcy (DArcy, 2009).

Complex Capital Structure

As a result of having to cope with doing business in over 3,000 different legal entities,

Lehman Brothers was confronted with issues about capital structure (Steinberg & Snowdon,

2009). As difficulties arose due to their expansion strategy culminating into a significant growth,

the growth was alleged to have contributed to the high degree of capital structure complexity.

Many financial analysts identified this phenomenon as a key factor that contributed to the failure

of Lehman.

Unsuccessful bail-out and takeover attempts

Describing the events prior to their liquidation, Lehman Brothers tried different measures

to redeem their operations. This was compelled by the massive losses recorded in 2008 and their

failed attempt to dispose of some of their subsidiaries. In their second financial quarter alone, the

company reported losses of $2.8 billion which hastened the disposal of $6 billion worth of their

assets due to the low rated mortgage in their subprime position (Anderson, 2008). By September

10, 2008, the firm announced a loss of $3.9 billion in their attempt to sell-off their majority

shares in most of their subsidiaries including Neuberger Bremen. As a result, investors

confidence continued to erode when their stock prices lost nearly half of its value, thus, S&P 500

dipped by 3.4%. This incidence further saw the Dow Jones losing about 300 points the same time

on investors perception about the security of the bank (Yandel, 2009). Their situation was

worsened by the US governments announcement plan not to assist any financial crisis that

emerged at Lehman (Anderson, 2009). In their enactment to turn-around the fortunes of Lehman
after the governments announcement; Lehman Brothers reported a possible take-over deal with

Barclays bank and the Bank of America (Caplan et al, 2012).

Impact of Lehmans failure

The collapse of Lehman Brothers revealed difficulty in the operation of numerous

organizations in the US and the world. In the US alone, Lehmans failure led to depreciation in

price of commercial real estates, an extinguishing 70% of $48 billion of receivables from

derivatives, and $46 billion of its market value (McCracken, 2008). The hedge market was not

spurred since over 1000 hedge funds used Lehman as the leading broker and mostly depended on

the firm for funding. Freddie Macs exposure to Lehman in relation to single-family home loans

was valued at $400 million (Murphy, 2008). Lehmans collapse also led to the writing-off of $48

million debts owed to the Federal Agricultural Corporation in September (Bryce, 2008).

Constellation Energy was also reported to have its stock falling to 56 percent on the New York

Stock Exchange halting trading of Constellation Energy culminating into it buy-out by Mid-

American Energy (Maurna, 2008). The international community was not completely exonerated

from the significant impact of Lehmans failure. Insurers and Japanese banks reported a possible

loss of 249 billion yen ($2.4 billion) while a counsel from the Royal Bank of Scotland Group is

reported to be facing dues between $1.5 billion and $1.8 billion with respect to an unsecured

guarantee from Lehman Brothers (Emily, 2008). In England, about 5,600 investors had invested

in Lehmans backed-structured product totaling $160 million (Ross, 2009). In Germany, a state-

owned bank lost approximately 500,000 euros (Kirchfeld & Simmons, 2008) whereas hedge

funds amounting to over $12 million were frozen in England as a result of Lehmans bankruptcy

(Spector, 2009). The validation of these losses in the US and the international business

community portrays the seriousness of Lehmans failure on businesses.


The collapse of Lehman clearly demonstrates the connection between regulations and

action management systems. The failures exposed the deficiency in the regulatory system thus

requiring urgent need for strict supervision of specific performance indicators such as a solvency,

liquidity position, and profitability. Policy makers such as the International Financial Reporting

Standards, SEC, etc. must initiate strict policies to address Lehman failure to prevent any future

occurrence. Firms must also be required to abide to good corporate governance practice to

restore investors confidence. Sound ethical standards and practices must adhere to and

replicated in every organization.

Lehmans failure provides very vital lessons. First, regulators of financial institutions

should remove the gaps in their financial regulatory framework that allows complex, large,

interconnected companies like Lehman to operate without robust consolidated supervision.

In September 2008, no government agency had adequate authority to compel Lehman to operate

in a sound and safe manner and in a way that did not pose dangers to the whole financial system.

There is also the need for a new resolution regime, similar to that already established for failing

banks, to avoid having to choose in the future between bailing out a failing, systemically critical

firm or permitting its disorderly bankruptcy. Such a regime, according to many experts in the

global banking industry, would both protect the economy and improve market discipline by

guaranteeing that the failing firm's creditors and shareholders take losses and its management is



The current competition in the banking industry has led to most banks engaging in

fraudulent and risky exposures. The collapse of Lehman is a clear sign of this phenomenon. The
failure could be attributed to a multiplicity of factors ranging from dubious accounting practices,

unethical management practices, over investment in risky unsecured investments, laxity on the

part of regulators (Morin & Maus, 2011). External auditors also played a major part in this

failure by not discovering these financial statement malpractices by the Lehman managers.

According to Greenfield (2010), the main indicators of fraud could be detected in the financial

statement apparently; the external auditors could not discover this activity. It must however be

noted that the collapse of Lehman had not impacted on the US economy only but the world as a

whole thus; firms ought to avoid unnecessary business strategies, strict supervision of existing

regulations, amended of the reporting standards to prevent dubious accounting practices,

formulation of practical and alternative financial failure prediction regulations and models of the

derivative market. The international business community must ensure that businesses hold high

standards and ethical culture which to a large extent necessary in avoiding collapse of firms in

the global business world.