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Auditors under fire following Lehman revelations

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Posted by Steve Collings in Financial reporting on Tue, 16/03/2010 - 10:04

• Large scale corporate disasters put auditors in the spotlight
• Why did Ernst & Young take no steps to question Lehman Brothers' unusual accounting practices?
• Ernst & Young says the financial statements were presented in accordance with GAAP
• How far should the blame rest with the auditors in this case?

The US court examiner’s report into the Lehman Brothers collapse implicated Ernst & Young in the bank’s downfall, but where does the auditor’s responsibility end in relation to fraud? Steve Collings reports.

The controversy surrounding the demise of Lehman Brothers once again spells trouble for the audit profession. How was such a large investment bank allowed to collapse? Have lessons not been learned from previous corporate disasters such as Enron? Once again, the audit profession is in the spotlight for all the wrong reasons.

What went wrong at Lehmans?

The US court report into the collapse of Lehman Brothers cites manipulation of accounting transactions in attempts to cover up the bank’s losses. These tactics, referred to as ‘Repo 105’ transactions, were essentially tactics to achieve off balance sheet finance. By the time Lehman Brothers imploded, $25bn in capital was actually supporting $700bn of assets which had associated liabilities, resulting in an exceptionally high gearing ratio.

Lehman Brothers came underpressure to reduce its gearing - referred to in reports as ‘leverage’. The bulk of its assets, according to the court-appointed examiner Anton Valukas, were primarily in the form of commercial real estate, which could not easily be sold. These assets were financed by borrowings which prevented Lehman from reducing its gearing levels.

So it resorted to the accounting "gimick" known as Repo 105.  "Repo" derives from "repurchase" because at the end of each quarter, Lehman sold some of its loans and investments temporarily for cash using short-term repurchase agreements which it then bought back seven to ten days later.

Such transactions would ordinarily result in the assets remaining on the company’s balance sheet. Accoring to the forensic report, these assets were valued at 105% or more of the cash received and as a result, the sales were classed as revenue. As a result, the balance sheet appeared as though gearing levels were reducing.

In the first two quarters of 2008, Lehman Brothers concealed some $50bn of assets from its investors to maintain favourable ratings from credit rating agencies. For the second quarter of 2008, Lehmans reported a gearing ratio of 12:1 when, it should have reported a gearing ratio of 13:9. 

The audit related problem

Ernst & Young now has to justify why it allegedly took no steps to question or challenge the non-disclosure of some $50bn worth of temporary, off balance sheet finance transactions. According to reports, a senior vice president also raised questions relating to these transactions as early as May 2008.

Ernst & Young responded: “Lehmans bankruptcy, which occurred in September 2008, was the result of a series of unprecedented adverse events in the financial markets. Our last audit of the company was for the fiscal year ending November 30, 2007. Our opinion indicated that Lehmans financial statements for that year were fairly presented in accordance with Generally Accepted Accounting Principles (GAAP), and we remain of that view”.

William Schlich, a partner at Ernst & Young, said that his firm did not ‘approve’ Repo 105 but “became comfortable with the policy for purposes of auditing financial statements”. Repo 105 is controversial accounting tactic, and Lehman Brothers had manipulated it to such an extent that it rang the death knell for the bank - but management and auditors failed to hear it.

The US court report is practically an open invitation to bring proceedings against Ernst & Young for malpractice in failing to challenge the lack of disclosure of the off balance sheet finance tactic. Moreover, E&Y must now justfy why Schlich failed to investigate claims brought to his attention by the bank's senior vice president.

Are auditors to blame?

Critics always blame the auditor and lawyers acting for wronged investors tend to look for the party with the deepest pockets. Ernst & Young may stand by its defence that the financial statements were presented in accordance with GAAP, but questions are being asked whether the audit evidence supports this view. The reduction of 0.9 in the gearing ratio for the second quarter of 2008 was allegedly material to the financial statements and therefore sufficient attention should have been devoted to such a high risk area. In short, the inappropriate and excessive use of Repo 105 tactics should have set the auditors' alarm bells ringing.

Reports suggest that the bank’s chief executive, Dick Fuld was ‘fearsome’ and nobody dared question the use of what Lehman Brothers employees called "accounting gimmicks".

It should be remembered that Arthur Andersen collapsed in 2002 as a result of practices that were encouraged by pressure placed on the audit firm by its powerful, high profile client. The collapse of Lehman Brothers has similar traits, but while the document shredding that did for Arthur Andersen was illegal (even though the conviction was quashed on appeal), Repo 105 is still a legitimate accounting tool. Unfortunately, it's one that Lehman Brothers used to manipulate its financial statements.

International standards on auditing detail the framework that auditors are required to follow. However, the mere existence of ISAs alone does not make a good auditor. The auditor's procedures must be responsive to the assessed levels of risk and be tailored procedures accordingly.

Fraud

The Lehman Brothers case illustrates how financial statements can be manipulated to achieve a desired a result. But where does the auditor’s responsibility end in relation to fraud? The responsibility for the prevention and detection of fraud - whether actual fraud or fraudulent financial reporting - rests with management. However, this central responsibility is not a "Get out of jail free" card for auditors. Indeed, audit procedures should be designed to detect a material fraud, and in the UK we have ISA 240 (UK and Ireland) to which auditors are required to comply.

The overall objective of an auditor should not be forgotten – they are required to express an opinion as to whether the financial statements give a true and fair view (or present fairly in all material respects). If the financial statements do give a true and fair view and the audit evidence gathered during the course of the audit supports this view, then clearly the opinion that should be expressed should be unqualified – this is this view that Ernst & Young is standing by.

Unfortunately the inherent limitations of an audit means that there are occasions where audit procedures have been considered sufficient and the audit evidence gathered does support an unqualified opinion, and yet a material fraud might not be discovered by the auditors. Provided auditors can demonstrate they designed their procedures in such a way that they could reasonably be expected to detect a material misstatement due to fraud, then the blame should not be laid at their door. Whether Ernst & Young can demonstrate that the audit procedures it implemented and the evidence it has gathered can support that view remains to be seen.

Lehman collapse: The story so far

Steve Collings FMAAT ACCA DipIFRS is the audit and technical manager at LWA Ltd and a partner in AccountancyStudents.co.uk. He is also the author of ‘The Core Aspects of IFRS and IAS’ and lectures on financial reporting and auditing issues.