That’s, of course, assuming there are ambiguities.  Given that Lehman’s transactions have no business purpose and were designed merely to deceive the investment community, maybe ambiguity is not the issue to debate.

FAS 140 dealt with accounting for the transfer of financial resources.  Essentially, the board said that such a transaction should be treated in either of two ways.  If the transfer shifted control of the resource to another entity, then one should account for the transaction as a sale.  The cash is recorded, the financial resource is taken off the books, and a gain or loss is recorded.  If the transfer does not shift control of the resource to another entity, then one should account for the transaction as a secured borrowing.  The cash is recorded, but the firm also records a liability.  No gain or loss is recorded; and the financial resource stays on the books.

(As an aside, I find it frustrating that virtually all reporters misstate the accounting issue.  Consider this sentence as an example.  “The transactions allowed Lehman to temporarily remove some $50 billion in assets from its balance sheet, presenting a stronger financial picture than existed.”  If they would only use some common sense.  If one applies for a mortgage on a house he or she is buying, do you think the bank will be impressed if they show less assets?)

FAS 140 goes on to spell out some criteria for assessing whether control has been transferred.  Paragraph 9 spells out these criteria:

“The transferor has surrendered control over transferred assets if and only if all of the following conditions are met:

a. The transferred assets have been isolated from the transferor—put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership (paragraphs 27 and 28).

b. Each transferee (or, if the transferee is a qualifying SPE (paragraph 35), each holder of its beneficial interests) has the right to pledge or exchange the assets (or beneficial interests) it received, and no condition both constrains the transferee (or holder) from taking advantage of its right to pledge or exchange and provides more than a trivial benefit to the transferor (paragraphs 29−34).

c. The transferor does not maintain effective control over the transferred assets through either (1) an agreement that both entitles and obligates the transferor to repurchase or redeem them before their maturity (paragraphs 47−49) or (2) the ability to unilaterally cause the holder to return specific assets, other than through a cleanup call (paragraphs 50−54).”

For me, the third condition nixes the sale-accounting executed by Lehman.  The asset was coming back to the firm, so it should have employed the accounting for a secured borrowing.

But, Lehman Brothers treated these transactions as sales and Ernst & Young agreed.  Did E&Y screw up or did its partners believe there was enough ambiguity in the rules to allow managers to choose gain accounting?  Either FAS 140 is ambiguous or it is not.  If so, we need to tighten the rules considerably, as I discuss below.  If not, then society needs to hold some Lehman managers and some E&Y partners accountable.

I wonder whether the FASB could save its face and its political hide if it just simplified the accounting.  It could require business enterprises to record the transaction as a secured borrowing in all cases where the financial asset returns to the firm and in all cases where there is even the possibility of its return.

The SEC could help as well.  It should require all firms who account for a transfer of a financial asset as a sale and then receives it back, in part or repackaged in any way, to issue an 8-K.  Managers would have to display for the entire world to see any and all phony sales of financial assets, and they would have to explain why they did not account for the transaction as a secured borrowing.

Last, let us note that the problem would be compounded exponentially if principles-based accounting were in place in the U.S.  How could anybody fault Lehman Brothers in a regime of principles-based accounting?  The managers could always retort that they were following the me-first principle.

This essay reflects the opinion of the author and not necessarily the opinion of The Pennsylvania State University.

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J. EDWARD KETZ is accounting professor at The Pennsylvania State University. Dr. Ketz's teaching and research interests focus on financial accounting, accounting information systems, and accounting ethics. He is the author of Hidden Financial Risk, which explores the causes of recent accounting scandals. He also has edited Accounting Ethics, a four-volume set that explores ethical thought in accounting since the Great Depression and across several countries. He is the co-author of a monograph, Fair Value Measurements: Valuation Principles and Auditing Techniques (with Mark Zyla, Managing Director, Acuitas, Inc.) published by BNA in 2007.