Home > Risk > Lehman – question for US GAAP/GAAS experts

Lehman – question for US GAAP/GAAS experts

Questions for the financial reporting and auditing experts. Without commenting on the specific facts and circumstances in the Lehman case, do you see a collision between technical GAAP compliance and ‘fair presentation’? Do GAAP/GAAS require companies to modify compliance with GAAP to avoid results and financial condition that are material misstatements?Here are the relevant sections from Examiner’s report. On page 954, there is this: 

Asked whether, as part of its responsibility to ensure Lehman’s financial statements were not materially misstated, Ernst & Young should have considered the possibility that strict technical adherence to SFAS 140 or any other specific accounting rule could nonetheless lead to a material  misstatement in Lehman’s publicly Schlich refrained from comment”   

On page 964:  

Even if Lehman’s use of Repo 105 transactions technically complied with SFAS 140, financial statements may be materially misleading even when they do not violate GAAP. The Second Circuit has explained that “GAAP itself recognizes that technical compliance with particular GAAP rules may lead to misleading financial statements, and imposes an overall requirement that the statements as a whole accurately reflect the financial status of the company.”  GAAP’s ultimate goals of fairness and accuracy in reporting require more than mere technical compliance.” The court explained that “when viewed as a whole,” GAAP has no “loopholes” because its purpose, shared by the securities laws, is “to increase investor confidence by ensuring transparency and accuracy in financial reporting.” Technical compliance with specific accounting rules does not automatically lead to fairly presented financial statements. “Fair presentation is the touchstone for determining the adequacy of disclosure in financial statements. While adherence to generally accepted accounting principles is a tool to help achieve that end, it is not necessarily a guarantee of fairness.” Moreover, registrants are “required to provide whatever additional information would be necessary to make the statements in their financial reports fair and accurate, and not misleading.”   

This view is echoed in an SEC enforcement order, concluding that GAAP compliance does not excuse a misleading or less than full disclosure regarding a transaction, especially if the transaction’s purpose is “the attainment of a particular financial reporting result.” “[E]ven if the transactions comply with GAAP, the issuer is required to evaluate the material accuracy and completeness of the presentation made by its financial statements.” Issuers must “ensure that the way they publicly portray themselves discloses, as required, the material elements of [their] economic and business realities and risks.”   

I have personally been involved in one situation, at a company that no longer exists, where the auditors advised in favor an accounting treatment to comply with GAAP (a write-off of deferred tax assets) but admitted the results and financial condition would then be materially misstated. I was told there was no ‘true and fair’ presentation requirement – which the above sections appear to dispute.  Expert insights would be appreciated.  

  1. March 13, 2010 at 8:01 AM


    The debate between technical compliance with “rules” as GAAP is presented and the use of judgment according to principles as IFRS is represented is the essence of the disagreement over whether IFRS will improve financial reporting for US based companies. As we can see from Lehman, compliance with technical rules, if that is the case, did nothing to support true and fair presentation of the actual impact of the accounting policy decisions. But I think that this is a red herring. The bigger sin is inadequate disclosure what it was they were doing so investors and counterparties (if they did not know) could come to their own conclusions..

    “In  addition  to  its  material  omissions,  Lehman  affirmatively  misrepresented  in  its  financial 
    statements  that  the  firm  treated  all  repo  transactions  as  financing  transactions  –  i.e.,  not  sales – for financial reporting purposes.”Page 735

    EY’s sin, it seems, was to go along with this. They are also accused of keeping a whistleblower’s report of the transactions from the Audit Committee.

    No one here was looking out for fair presentation, informed disclosure, to the shareholders. They were all looking out for their own self-interest.

  2. nmarks
    March 13, 2010 at 8:03 AM

    Francine, thanks for the comment. In your view, is there a requirement in GAAP to provide financial statements that provide a fair representation – one that might trump pure technical compliance? Or is that simply a rule that the courts may apply in actions before them?

    • March 13, 2010 at 8:11 AM


      On such a technical issue, I defer to my guru Tom Selling who talks about “presented fairly” quite a bit on his blog, The Accounting Onion.


      “If you are interested in how “presented fairly” was birthed and interpreted in the past, I highly recommend an article by accounting historian Stephen Zeff, entitled The Primacy of “Present Fairly” in the Auditor’s Report. My own reading of Steve’s article indicates he believes that accounting alternatives ultimately selected from nonauthoritative sources should not be a free choice, but should be constrained by fair presentation. Accordingly, Steve’s proposal for changing the audit report would also focus on whether the rules of GAAP were followed; but, in addition, he would have the auditor provide a separate opinion as to whether the financial statements were presented fairly.

      As for me, I would say, ‘eternal rest grant unto “presented fairly,”‘ to what has utlimately come to be, at best, a noble sentiment. If there ever was a practical use for the term, it’s ancient history by now. “

  3. nmarks
    March 13, 2010 at 8:29 AM

    Hmm. If the company is required to comply with GAAP in its financial statements, but rectify the departure from ‘fair presentation’ through disclosures (see above – “required to provide whatever additional information would be necessary to make the statements in their financial reports fair and accurate, and not misleading”), then I can see a mess would result. The disclosure would not only have to describe the accounting treatment but probably also have to restate the financials (non-GAAP).

    Do I have this correct?

  4. Harish
    March 13, 2010 at 11:13 AM

    What I am really curious about is what made the other banks lend 50billion dollars to a failing banks when all banks were in the same situation. Remember, that’s when the time Goldman Sachs, AIG, and likes were in similar situations.

    So if the Fed Reserve of New York gave out the 50 billion, that means they knowingly pumped up Lehman’s books.

  5. Harish
    March 13, 2010 at 11:36 AM

    I guess I am not the only one who’s thinking about US gov’s involvements.


    Dylan Ratigan offered one of the best explanations we’ve seen of the Repo 105 practice on yesterday’s show. He concludes by noting that the report “stops just short of suggesting [the financia crisis and transfer of wealth from the bailouts was] by no means an accident but instead one of the greatest crimes ever perpetrated by a group of people and enabed by the US governent.”

  6. Lalit
    March 17, 2010 at 1:56 AM

    Dear Mr.Marks, As a student of accounting(and definitely not as an expert)i believe that the financial statements should portray a true and fair view of the financial state of affairs of the company.The Requirement of the Substance over form doctrine also stipulates that that the financial statements reflect the financial reality of the entity rather than the legal form of the transactions and events which underlie them.So given this fact, i believe that “True and fair presentation” should have taken precedence over technical compliance with GAAP especially in a situation where compliance leads to misreporting.

  7. March 17, 2010 at 6:42 PM

    Very interesting blog post and comments!

    Here is an additional cite that may be of interest, on the subject of technical compliance with GAAP vs. overall fair presentation:

    Footnote 95 in the SEC’s Report to Congress on Principles-Based Accounting (2003) http://www.sec.gov/news/studies/principlesbasedstand.htm states:
    Section 302 of the Sarbanes-Oxley Act (Pub. L. No. 107-204, 2002) and the SEC’s rules (Release No. 33-8124, “Certification of Disclosure in Companies’ Quarterly and Annual Reports,” August 29, 2002) require CEOs and CFOs to certify that the company’s financial statements and other financial information present fairly financial condition and results of operations of the company. Additionally, U.S. auditing standards require consideration of the meaning of “present fairly in accordance with GAAP.” AU §411 contains a discussion of the auditor’s responsibilities in this area and these standards offer some worthwhile advice about fair presentation per se. In particular, the auditor should consider whether:

    The accounting principles that were applied and selected have general acceptance

    The accounting principles are appropriate in the circumstances

    The financial statements and notes are informative of matters affecting their use, understanding, and interpretation

    The information presented is classified and/or summarized correctly (that is, not too detailed or not too condensed)

    The financial statements reflect underlying transactions and events in presenting the financial position, operations, and cash flows within a range of acceptable limits.

    Additionally, ASR No. 4 states that:

    Where financial statements filed with the Commission . . . are prepared in accordance with accounting principles for which there is no substantial authoritative support, such financial statement will be presumed to be misleading or inaccurate despite disclosures contained in the [auditor’s report] or in the footnotes . . .

    Stated differently, when the registrant fails to apply accounting principles with substantial authoritative support, no amount of disclosure can cure the problem. The corollary to that is also important. The other side of that coin says that even if the accounting is appropriate, without complete and transparent disclosure, the company’s filing is still deemed to be deficient.

    NOTE: I have not checked to see if the cites above are still current, but I assume language in the ASR (Accounting Series Release) is still applicable, or that language close to it would be.

  8. March 18, 2010 at 5:59 AM

    In my earlier comment above, I noted I had not checked on status of the cites in the SEC report published in 2003. I see now that acccording to Tom Selling, in his blog post linked further above by Francine McKenna in Comment #3, he notes that as part of the FASB Codification going live in 2009, the AICPA ‘excised’ AU 411 from auditing literature. However, he notes, there are separate SEC rules about ‘curing’ accounting that is in compliance with GAAP, but the issuer believes the technical compliance with GAAP is not ‘fair presentation’ – the ‘cure’ for this is through disclosure. The pertinent excerpts from Tom’s blog post are copied below.

    FASB Throws “Present Fairly” Under the Bus
    Let’s first talk about what the FASB did to “present fairly.” SFAS 168 established the FASB’s Accounting Standards Codification as the principle source of authoritative GAAP; and essentially compressed the “GAAP hierarchy” into a dichotomy: “authoritative” (to which SEC literature is added for public companies) and everything else — although in rare circumstances, one might apply a “grandfathered” accounting standard not included in the Codification.
    In tandem with the Codification going live, the AICPA excised AU Section 411, The Meaning of “Present Fairly in Accordance with Generally Accepted Accounting Principles” from its own codification of auditing standards (which the PCAOB took into its own home, so to speak). So, the situation we now have is this: while the phrase “presented fairly” survives in the standard auditor’s report language (see AU Section 508), there is nothing to tell auditors, much less users, what it is supposed to mean. Weird, but true.
    Under the Bus with Rule 203
    Finally, there is this annoying and never-used rule in the audit literature, the gist of which states that if the auditor finds that strictly following the rules of GAAP would make the financial statements misleading, the auditor has permission to bless financial statements that do not comply with GAAP. That would be Rule 203 of the Code of Professional Conduct.
    But, if the audit report were focused solely on whether the client followed the rules, then we can throw Rule 203 under the bus with “fairly present.” If the financial statements actually were misleading Exchange Act Rule 12b-20 places responsibility on the issuer to provide information somewhere in the filing to cure the problem. Thus, the focus need not be on the auditor.

  9. nmarks
    March 18, 2010 at 6:10 AM

    My thanks to Edith for an excellent contribution to the discussion – a lot of valuable information.

    I, and others that I have spoken to, have seen the situation where the CPA partners insist on technical compliance with the rules and management does not believe there is fair presentation as a result. In one case, mentioned above, with the concurrance (and encouragement) of the auditor no disclosure was made. In others, some minimal discussion was made to clarify. But neither management nor the auditor wanted to air their apparent disagreement in public.

    What I have not seen, and am interested in others’ experiences, is where the roles are reversed: management is insisting on technical compliance and the CPA firm ir or should be asking for fair presentation, with appropriate disclosures!

  10. Sheila Keefe
    March 18, 2010 at 7:07 AM

    Great comments! Very well researched and supported. It’s obvious auditors have enough guidance on how to balance the needs of presenting in conformity with GAAP and presenting fairly. What makes it hard for auditors to apply the guidance in practice is the auditor’s dependence on management to get the next years audit. As the Going Concern blog quoted Goldstein, perhaps the top 5 shareholders should hire the auditors. Then, auditors would be free to make these nuanced judgments, and public trust could be restored without more cumbersome, expensive rules.

  11. nmarks
    March 19, 2010 at 6:18 AM

    The AICPA has just released a white paper on internal control. You can download it at http://r.smartbrief.com/resp/vbkEvhdtiblHmjCibSzoCicNSfaX.

    It includes a definition of “fair presentation” that makes interesting reading:

    Fair presentation is defined as follows:
    • The accounting principles selected and applied have general acceptance.
    • The accounting principles are appropriate in the circumstances.
    • The financial statements are informative of matters that may affect their use, understanding, and interpretation.
    • The information presented is classified and summarized in a reasonable manner (that is, it is neither too detailed nor too condensed).
    • The financial statements reflect the underlying transactions and events in a manner that presents the financial position, results of operations, and cash flows within a range of acceptable limits (that is, limits that are reasonable and practical to attain in financial statements).

    Also inherent in fair presentation is the concept of materiality.

  12. June 15, 2010 at 1:58 PM

    Wow I’m literally the first comment to this awesome read.

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