What Were the Organizational Factors That Led to Problems at Kidder, Peabody & Co.?

1. What were the organizational factors that led to problems at Kidder, Peabody & Co.?

There were several organizational factors that led to the collapse of Kidder, Peabody & Co. First of all, although a CEO does not need to know every single detail of the work done at a company, the fact that the CEO Michael Carpenter had no experience in brokerage, he was involved in leveraged-buyout loans and takeover deals previously. If he had, maybe he could have seen the alarming signs earlier. Also, although Cerrullo, Bernstein and Mullin were all supervisors of Jett in some form through his time at the firm, none of them had the capacity or care to verify Jett's job. The fact that someone is creating a large profit for himself and his managers should not mean that his work should not be checked. Another factor was the lack on effective internal auditing mechanism. Management is responsible to establish a reliable internal auditing system and no employee should be able to resist internal auditing requirements in any way and management is responsible to employ auditors who have the capacity to go deep in the areas of audit.

2. Try to understand the accounting for strips and recons. Construct accounting entries to illustrate how to account for a $1,000,000 recon to be settled on the transaction date. What is the effect of this transaction on the balance sheet and income statement?

In the case a reconstitution is described to be like "going to the bank with a dollar and receiving four quarters in return" meaning that it should not have an impact on the overall income statement as there is no profit or loss in the transaction. But in reality, the recon of $1M will change the inventory of the bonds on the transaction date. The inventory of STRIPS would go down $1M on the transaction date and the inventory of bonds would go up $1M on the transaction date.

3. Similarly, construct accounting entries to illustrate how to account for a $1,000,000 recon to be settled one month in the future. Assume a discount rate (say 1% per month). What is the effect of this transaction on the balance sheet and income statement?

Kidder Peabody's system values the STRIPS at the market value at transaction date and values bonds at settlement date. This causes the system to see a loss for a STRIP or gain for a recon.

If a recon for $1M is going to settle in one month and if there is a discount rate of 1%/month, then discounted value of the bond in the future(one month later in this case) will be $990,000.

Bonds will be $1M at settlement date.

The transaction will have no effect on the balance sheet as the "unrealized" difference is offset over time in small daily doses as the settlement date approaches and STRIP is valued back again at maturity date.

4. How would you assess the risk exposure for Kidder Peabody? Based on your analysis, should senior managers have been able to anticipate the problems described in the case?

Due to several reasons Kidder Peabody was exposed to a high level of risk. The fact that the upper management was not familiar with the business details was a risk point. Apparently good background does not always mean integrity and effectiveness at work