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IFRS and GAAP and how it affected Lehman Brothers

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IFRS and GAAP and how it affected Lehman Brothers

Introduction

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            There are several accounting principles and practices that are practiced throughout the world.  Most approaches are standardized in order to prepare and present the accounting information in ways that are easily understandable by consumers of the information.  However, there are two major approaches that are internationally recognized; the GAAP and IFRS approaches.   Both of them have benefits and shortcomings, some of which will be analyzed in the paper.  The paper aims at analyzing the effect of these approaches in relation to Lehman Brother’s operations.

IFRS approach.

            International Financial Reporting Standards are interpretations and standards used in presenting accounting information.  They are used by the International Accounting Standards Board and are also called the International Accounting Standards.  These standards are generally used to govern the preparation and presentation of accounting information, through the use of regulations and rules.  The IFRS operates using four principles that define the purpose of financial statements.

  These principles state that financial statements are prepared for providing information on financial performance, financial position, and any change in the two aspects, in relation to an entity.  This information is very important to variety of users who consume financial information and use it to make decisions.   Such people include the public at large, company shareholders, investors, and other people who use this information.

             The IFRS however assumes that the business transactions follow the going concern and accrual basis.  Going concern assumes that companies or entities will not cease to operate in the near future.  Accrual concept on the other hand recognizes transactions in business immediately after occurrence, and not after money is paid or received.  Financial statements, according to IFRS should be relevant, reliable, understandable, and comparable with those from other entities.

GAAP approach.

            Generally Accepted Accounting Principles are also guidelines that govern the preparation, presentation and reporting of accounting information.  The accounting information is used by privately held and publicly traded companies, governments and non profit organizations.  It encompasses accounting law, framework, standards and rules.  In the US, these standards are not set by the government due to the confidence of the private sector’s effectiveness in setting the standards.  The US announced recently that it would switch to IFRS standards, from the current GAAP standards.  This decision was announced by the Chairman of the SEC.  This commission aimed at switching to IFRS by 2016, for all companies that operate in the US.

            The major aims of the GAAP is providing potential creditors and investors with information that will help them make informed credit and investment decisions.  GAAP is also aimed at presenting potential creditors and investors with information that would enable them to analyze uncertainty, timing, and amounts of cash expected.  Thirdly, GAAP also aims at informing stakeholders about changes and claims to economic resources.

            The assumptions that operate under GAAP include the business entity factor[1].  This factor assumes that businesses are separate from other businesses or their owners.  Another assumption is that the business is a going concern, which assumes that companies or entities will not cease to operate in the near future.  The third assumption is monetary unit factor, and this assumes that the currency used for business transactions is stable.  Finally, the factor relating to time period assumes that business activities that are carried out can be split into periods of time.

            There are several principles that are used in GAAP.  The first principle is the cost principle and under it, companies are obligated to value assets according to the cost of acquiring them rather than their market values.  The second principle is the revenue principle and it requires companies to factor in revenue after it is earned or realized and not after receipt of cash.  The third principle is the matching principle and it requires the matching of expenses with revenue.  This principle directs recognition of expenses after products have made contributions to revenue, and not after doing work or producing products. The advantage of this approach is that it evaluates actual performance and profitability on a broader scale than most of the other approaches.  This is due to the reason that it reflects the expenses that were incurred to earn revenues.   However, the principle states that such matching only takes place under reasonable circumstances.  The fourth principle is the principle of disclosure and it states that the kinds and amounts of information that are disclosed should meet reasonable costs.  This is because of the reason that preparation and sue of information is costly.  Disclosure can be made as supplementary information or notes alongside the financial statement.

Weaknesses.

            This approach of financial reporting neglects a major accounting principle; the principle of prudence, which states that when faced with two situations and one has to make a decision between the two, the person should choose the situation that overstates income and assets the least.  This approach ignores this principle principally because of the revenue concept that recognizes cash before it is received, and the method that is used to value assets.  As previously stated, GAAP approach values assets at cost, which does not reflect the current prices of the assets in the market[2].  This means that there is a likelihood of misrepresentation of value of those assets without the knowledge of the management.  As it  will be later shown, reliance of this approach was hazardous to many companies in the US due to the mortgage crisis.  Companies that had valued assets at cost had no way of telling that their assets were actually worth lower prices than the cost price, due to the mortgage crisis.  However, this will be discussed later in the paper.

Lehman Brothers.

            This is a company that began operations in 1850, and provides financial services to municipalities and governments, corporations, institutions and individuals who are wealthy, all over the world.  Among the services that it deals with are research, trading, investment banking, fixed income and equity sales, investment and asset management[3].  The company has its headquarters in New York, though Tokyo and London are other regional headquarters.  The growth of this firm is comparable to US growth, and has grown to achieve international prominence and prosperity.  The firm started operations as a single shop opened by Henry Lehman in Montgomery, Alabama.  After six years, his brothers Mayer and Emmanuel joined him.  Together, they have ensured that the firm grew to be a worldwide financial power.

            However, in 2007, the firm began experiencing financial crisis which was partly attributed to the mortgage crisis in the US.  The crisis forced it to close BNC Mortgage, its sub-prime lender.  The closure affected over 1000 individuals in more than 20 locations.  It also led to $25 million chargeable as tax, and a further decline in goodwill valued at $27 million.  According to Lehman, market conditions that were considered to be poor demanded reduction in capacity and resources, by the firm in the mortgage sector.

            In 2008, the firm further faced financial losses due to the mortgage crisis that was continuing.  The losses were attributable to high investment in the mortgage industry, and retaining the mortgages yet the industry was in near-collapse.  During the second quarter of the same year, the firm made $2.8 billion in losses.  This forced it to sell assets worth $6 billion to cover the loss.  The market had by now lost goodwill in the firm and by June, the value of the stocks for Lehman had gone down by 73%, which was largely due to the mortgage situation.  By August, the company was forced to lay off 1500 employees, or 6% of the total number of employees.  In September, the board of the company filed for bankruptcy due to loans amounting to over $600 billion.

Use of GAAP accounting standards.

            The collapse of Lehman Brothers is as a result of a combination of factors that worked against it.  One of the major factors was poor policies that were used in spite of presence of the financial crisis that was facing the US.  The policies used were very aggressive and they disregarded the principle of prudence, which anticipates losses.  Other factors that caused the collapse of the firm include market complacency, lack of transparency and bad regulations.

            One of the poor policies that were used by most investment banks, and which is a major cause of the mortgage crisis, is the giving of subprime mortgages without due considerations on the principle of prudence[4].  The banks gave mortgages to people they knew would not afford to pay them back in a bid to acquire the collateral and charge high interests on the loans.  Lehman Brothers was one such company, and this was a result of using GAAP accounting standards.  As previously stated, GAAP has one weakness of disregarding prudence principle.  This was arguably the major factor that caused the downfall of many investment banks, including Lehman Brothers.

            The pricing of stocks and securities was another major factor that caused the collapse of Lehman Brothers.  Lehman Brothers used GAAP accounting standards in its financial accounting.  As earlier stated, this approach values investments and assets based on the historical cost.  The mortgages that were handled by Lehman Brothers were therefore priced according to the acquisition cost.  This was detrimental to the firm, since fixing prices using this approach does not recognize the current rates in the market.  As a result of this, whereas values of mortgages and securities were falling due to the mortgage crisis, Lehman Brothers did not adjust their mortgage prices to reflect this[5].  As a result, the securities and mortgages that were being held were actually worth much lesser than this firm thought.  After the company realized this mistake, it was too late to make any amendments since it held high proportions of mortgages, which had little value and made it difficult to dispose of it.

Conclusion and recommendation.

            Lehman Brothers should have used the IFRS system of accounting which recognizes the values of assets according to the real market prices.  The FAS 157 is the best approach in valuing assets, since it ranks the market price information according to its reliability[6].  For instance, information from the stock exchange is most credible, while information from data which cannot be observed or corroborate is ranked as the least reliable.  If Lehman Brothers had used this approach, the firm would have realized that the value of the mortgage was lesser, and it would have changed the lending practices to account for this factor.  The firm should also have applied the principle of prudence, which anticipates losses.  This principle would not have allowed this firm to give mortgage to people it knew would not be able to pay back.  There is however hope in the US economy after $700 billion was pledged by the government to address the crisis, and the announcement of the shift to IFRS system of accounting.

Bibliography.

Aizenman, Joshua & Pinto, Brian. 2005. Managing Economic Volatility and Crises: A Practitioner’s Guide. London: Cambridge University Press.

Bazerman, Max & Neale, Margaret. 1999. Negotiating Rationally. New York: Free Press.

Gongloff, Mark. A FAS 157 Primer. Wall Street journal, 15 November, 2007.

Jaffee, David. 2008. The US subprime mortgage crisis: Issues raised and lessons learned. Retrieved on November 21, 2008 from <growthcommission.org>.

Nelson, King. 2008. Fair value accounting for commercial banks. Accounting review. JSTOR.

Plantin, Grace. 2007. Fair value accounting and financial stability. Journal of financial accounting. Retrieved on November 21, 2008 from <papers.ssrn.com>.

[1]             Aizenman, Joshua & Pinto, Brian. 2005. Managing Economic Volatility and Crises: A  Practitioner’s Guide. (London: Cambridge University Press), 21-23.
[2]          Nelson, King. 2008. Fair value accounting for commercial banks.  (Accounting review.  JSTOR), 54-67.
[3]               Bazerman, Max & Neale, Margaret. 1999. Negotiating Rationally. (New York: Free Press), 44-56.
[4]               Jaffee, David. 2008. The US subprime mortgage crisis: Issues raised and lessons learned.  (Retrieved on  November 21, 2008 from <growthcommission.org>), 43-55.
[5]          Gongloff, Mark. A FAS 157 Primer. (Wall Street journal, 15 November, 2007), 15.
[6]             Plantin, Grace. 2007. Fair value accounting and financial stability. Journal of financial accounting. (Retrieved  on November 21, 2008 from <papers.ssrn.com>), 23-35.

Cite this IFRS and GAAP and how it affected Lehman Brothers

IFRS and GAAP and how it affected Lehman Brothers. (2016, Oct 15). Retrieved from https://graduateway.com/ifrs-and-gaap-and-how-it-affected-lehman-brothers/

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