The Hindu Business Line : Accounting for greed?

A Sanskrit proverb translates as “If you forsake a certainty for an uncertainty, you will lose both the certainty and the uncertainty”. Any medical practitioner worth his fees would advise you that anything in excess is harmful. Enron, WorldCom, Parmalat, AIG, Merrill Lynch, Lehman Brothers and probably scores of others are certainly victims of not adhering to these sayings.

Heavy balance sheet

The balance sheet of Lehman Brothers as filed in the 10-Q with the Securities and Exchange Commission ( SEC) for the quarter ended May 31, 2008, made for interesting reading. Total assets were $639,432 million while the liabilities excluding share capital was $613,156 million reflecting that they were operating on little capital.

The cash flow statement starts off with negative income of $2,285 million and reflects -$17,899 million used in operating activities, -578 million in investing activities and $17,704m for financing activities, thanks largely to a large issue of long-term borrowings.

While the liabilities largely comprised borrowings which had to be returned, the assets consisted of collaterised agreements worth 394,526 securities purchased whose value was apparently not that much. The company had adopted the provisions of SFAS No. 157, Fair Value Measurements (SFAS 157), in the first quarter of 2007. SFAS 157 defines fair value, establishes a framework for measuring fair value, establishes a fair value hierarchy based on the quality of inputs used to measure fair value and enhances disclosure requirements for fair value measurements.

SFAS 157

While SFAS 157 does not prescribe which valuation technique the company should use to measure the fair value of an asset or a liability, SFAS 157 does require the Company to select an appropriate valuation technique for the market conditions and for which sufficient, reliable data inputs are available.

SFAS 157 distinguishes between inputs that are based on market data obtained from independent sources and inputs that reflect assumptions from one market participant as to actions of other market participants and emphasises that valuation methodologies maximise inputs based on market data.

A determination of what constitutes “observable market data” requires significant judgment. Lehman Brothers appear to have failed in this judgement because the Form 10-Q also discloses litigation against the company.

The plaintiffs allege that Lehman Brothers Holdings materially overvalued its position, maintained inadequate reserves, and did not prepare its financial statements in accordance with US generally accepted accounting principles (US GAAP).

It is apparent that Lehman Brothers over-traded in sub-prime and other collaterised agreements and adopted a comfortable valuation technique.

It has to be accepted that SFAS 157 or any other standard cannot prescribe watertight rules to account for the aftermath of greed and gluttony. But they certainly would prescribe standards whereby one can make out a highly one-sided balance sheet with some analysis when one sees it.

(The author is a Hyderabad-based chartered accountant.)

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