The Art of Illusion: Look for What's Not on the Page


ACFE Regent Bruce G. Dubinsky, CFE, CPA, CVA; and Tiffany Gdowik, CFE

“The essence of lying is in deception, not in words.”
— John Ruskin 

Extrapolating the words of John Ruskin, a 19th-century British social thinker, I often say, “It’s not what’s on the page that matters; it’s what’s not on the page that matters.” As fraud examiners, we have been taught to gather documents, review information, interview subjects and then draw our conclusions. While that approach will detect the simplest of frauds, it won’t detect the type of complex financial frauds that are increasingly making headline news.

I’ve worked on some of the world’s largest frauds — including the Bernie Madoff Ponzi scheme, Parmalat, Lehman Brothers and International Brotherhood of Teamsters. In the Lehman Brothers case, the company used “accounting gymnastics” to manipulate the company’s financial statements during the 2005-2008 financial meltdown — the most devastating since the Great Depression. 


In 2008, Lehman Brothers’ shaky balance sheet and falling profits left the firm in dire financial peril. It desperately needed to create the illusion that it was healthier than it actually was. Lehman used what appeared to be a normal financial instrument in the banking world — a repurchase agreement (a repo) — to book billions of dollars of transactions. A repurchase agreement is a form of short-term borrowing for banks and other dealers typically using government securities. The bank sells the government securities to an investor (many times another bank), usually on an overnight basis, and buys them back the following day. In Lehman’s case, the company did it to exploit an accounting rule that was meant to give principled guidance to determine when a repo was a true short-term financing method versus a sale of a financial instrument. The latter desired treatment as a “sale” allowed Lehman to slyly portray its financial condition as rosy when it wasn’t.

Interestingly, investigators didn’t discover the illusion created by Lehman by looking at what was on the page (i.e. the entries in the accounting system). The accounting entries, which seemed straightforward, generated little to no alarm. The debits and credits were to the proper accounts. The explanation accompanying the entries also seemed normal. In fact, a review by even the most skilled auditor or fraud examiner would, in and of itself, have revealed nothing. Rather, investigators exposed the company’s deceptive behavior by looking at what was literally not on the page. The key to uncovering the ploy was to first obtain an understanding of what Lehman’s financial perils were at that time.

Lehman had unusually high amounts of leverage (debt to finance its assets) on its balance sheet, and the public markets were responding negatively. The company spent a considerable amount of time and effort trying to calm the markets during its investor calls. So, the first “red flag” came in the form of a question: Why was Lehman spending so much time focused on de-levering its balance sheets? Its access to public capital was critical to its continued survival. With investor panic running rampant, it had to create the illusion that it wasn't a house of cards but rather a solid financial institution with a sound balance sheet.

So how did Lehman create the delusion? It simply used the chameleon approach: make something that’s really one thing look like something else. Lehman took repos that were really short-term loan transactions and made them look like they were sales of financial product inventory (e.g. U.S. treasuries and certain equities). By knowingly exploiting that U.S. accounting rule and specifically structuring the repos to fail the requisite treatment as a repo financing, Lehman was able to disguise itself as a financially healthier institution.

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Lehman Brothers: Accounting Left to Interpretation


By Mandy Moody, CFE
ACFE Social Media Specialist

Lehman Brothers: a name synonymous with bankruptcy and the worst financial crisis since The Great Depression. Founded in 1850 as a small cotton trading business by a German immigrant and his two brothers, Lehman grew into one of the largest investment banks on Wall Street. Its reputation, however, far exceeded what hid behind a dark veil of altered quarterly and annual filings. As Bruce Dubinsky, CFE, CPA, CVA, Managing Director of Duff and Phelps, LLC, and ACFE Regent, conveyed today, “It’s not about what you can actually see on the page; it’s about what’s not there.”

So, how did this once 42-time “Best in Class” award-winner for excellence in prime brokerage and the No. 1 prime broker in Japan and Europe end up filing for Chapter 11 bankruptcy protection? Dubinsky explored this question and Lehman’s hard fall from grace in his breakout session, “Repo 105/108 Transactions: The Anatomy of Accounting Deception.”

 “Lehman recognized a loophole in the accounting standard language regarding repurchase agreements (repos) and took advantage of it,” Dubinsky said. “Liabilities were not recorded for these asset transactions, but rather assets were taken off its balance sheet and the cash received was then used to repay other debt, effectively lowering its leverage.” Repos are agreements where one party (the transferor) transfers an asset to another party (the transferee) as collateral for a short-term borrowing of cash, while concurrently agreeing to repay the cash plus interest and take back the collateral at a specific point in time. Essentially, they were low-risk, short-term loans that were used all of the time.

Dubinsky pointed out that these repos, Repo 105 and 108 specifically, gravely distorted Lehman’s leverage and even reduced it because it was paying off debt at the end of every quarter. However, consumers, the SEC and shareholders were unaware of the actual state of the company because they didn’t see the money that was paid back for the repurchase agreements at the beginning of every quarter, increasing their debt and leverage.

Lehman Brothers was able to complete their due diligence by finding a legal firm that would give the okay to these sales despite the accepted accounting standards in the U.S. “No law firm in the U.S. wanted to give an opinion on what they wanted, so Lehman’s went opinion-shopping," Dubinsky said. "They traveled across the pond and found a U.K. law firm to provide the opinion letter they needed.”

Once they received the sign-off from a law firm, Lehman began to accumulate a massive amount of debt. It didn't take long for it to add up when they were selling securities valued at 105 percent and 108 percent for only 100 percent of the price. According to Dubinsky, in May of 2008 alone Lehman Brothers sold $50 billion worth of repos. It is no surprise that when they declared bankruptcy only months later they were $615 billion in debt.

So, what happened, you may wonder? Lehman was one of the largest banks not bailed out by the U.S. government and after the accounting examinations, the Securities and Exchange Commission decided not to indict anyone. But, according to Dubinsky, the takeaways are clear. “To say that there were mistakes made would be easy as, ‘Hindsight is 20/20.’ However, we can hope that executives, auditors and regulators alike will learn from Lehman’s example and apply this insight going forward to whatever accounting issues and market conditions come next.”