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It made the biggest bankruptcy in the US and was one of the major factors contributing to the global financial crisis in the late 2000s. With hindsight, we now know that Lehman Brothers had involved with several aggressive accounting practices in the run-up to its shocking collapse, including the use of the ‘Repo 105’ scheme, to present healthier financial information to the outsiders.
Requirements:
Write a report which covers the followings:
1. What is the ‘Repo 105’ scheme and how did it help Lehman Brothers’ financial statements look better? Based on your understanding of the relevant generally accepted accounting principles, do you think ‘Repo 105’ is an illegal accounting practice?( GIVE THE ADVANTAGES AND LIMITATIONS OF ‘REPO 105’ BASE ON PARTICULAR ACCOUNTING STANDARD), Why AUDITORS let them record as a sale if is illegal) USED OTHERS CASES TO ARGUE AND SUPPORT THE ANSWER.
2. Critically discuss three major motives for firms to manipulate their reported earnings. (Capital market, Regulatory intervention and Compensation motivations) Construct your answer with reference to real-life examples and well as the relevant literature on earnings management.
3. Do you believe that imposing more financial accounting regulations could prevent Lehman-like accounting scandals to happen again in the future? Back your answer with appropriate theories.Compare and contracse theory .
Theories to explain regulation
A, ‘free market’ perspective (Arguments supporting: ‘private economic based incentives’; ‘market for managers’ ;‘market for corporate take overs’ and ‘market for lemons’.
• B. Public interest theory,
• C. capture theory
• D. Economic interest group theory (private interest theory).
Special note: You are advised to use both appropriate real-life examples and academic sources to support your arguments.
SOME IDEAS FOR ANSWERING QUESTION 3.
1. Some main arguments supporting Regulations are listed below:
• Markets for information are not efficient and without regulation a sub-optimal amount of information will be produced;
• Whilst proponents of the ‘free-market’ approach may argue that the market on average is efficient, such on average arguments ignore the rights of individual investors, some of which can lose their saving as a result of relying upon some unregulated disclosures;
• Those who demand information can often do this as a result of power over scarce resources. Parties with limited power (limited resources) will generally be unable to secure information about an organisation, even though that organisation may impact upon their existence;
• Investors need protection from fraudulent organisations who may produce misleading information, which due to information asymmetries, cannot be known to be fraudulent when used;
• Regulation leads to uniform methods being adopted by different entities, thus enhancing comparability.
• There was also a view that major adverse events such as the Great Depression were due to the fact that financial information being provided about particular entities was misleading and did not enable readers to be aware of impending problems. Whether a ‘better’ system of accounting could have reduced the likelihood of events such as the Great Depression is, however, a highly debatable point.
2. Arguments in favour of eliminating regulation are often referred to as ‘free-market’ arguments.
Advocates of a ‘free-market’ approach typically base their arguments on an assumption that markets (such as capital markets, labour markets, product markets) are efficient and that the markets will provide various incentives and penalties to ensure that managers, on average, do as the market expects. For example, if the capital market expects an entity’s managers to provide information, and the managers elect not to, then the market might penalise the entity by charging a higher price for funds advanced to the entity (to compensate the investors for the higher risk that they face as a result of having limited access to information to enable them to monitor their investment). Further, it is also believed by some people that the absence of information probably implies that the reporting entity has bad news that it has elected not to disclose (it is a ‘lemon’). There are also a number of other arguments that have been advanced to support a ‘free-market’ approach to providing accounting information. These include:
Accounting information is like any other good and people (financial statement users) will be prepared to pay for it to the extent it has use. This will, it is assumed, lead to an optimal supply of information by entities;
Because users of financial information typically do not bear its cost of production, regulation will lead to over-supply of information (at cost to the producing firms) as users will tend to overstate the need for the information;
Regulation typically restricts the accounting methods that can be used. This means that some organisations will be prohibited from using accounting methods that management believe best reflect their particular performance and position. This is considered to impact the efficiency with which the firm can inform the markets about their operations. This will have implications for the costs involved when a firm needs to attract investment capital.
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