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Lehman Bros: The auditor’s dilemma, part 1

Lehman Brothers Collapse - The Auditor's Dilemma Anthony Harrington

This is the second of a series of QFINANCE blog posts on the Anton Valukas’s report on the collapse of Lehman Brothers. See also: Time for Sarbox to be rethought post-Valukas, by Ian Fraser; Just an accounting gimmick? by Anthony Harrington; and Repo 105, the case for the defense by Anthony Harrington.

According to Anton Valukas, the examiner appointed to look into the demise of Lehman Brothers, there are “colourable” claims against Lehman’s auditors, Ernst & Young, for allowing the company to “window dress” its accounts using a technique that removed over $50 billion in leveraged debt off Lehmans’ balance sheet for just long enough for it to present its quarter end accounts—a trick it pulled off at least three times in the period before its abrupt demise (for a detailed account of Repo 105 and Repo 108 transactions see part 2).

Since senior Lehman staff have told Valukas in no uncertain terms that there was “no substance” to these transactions and that their sole purpose was to present an edited and therefore “untrue and unfair” picture of Lehman’s position, the obvious question is: how did this get past the external auditors?

The UK Financial Reporting Council (FRC) was apparently sufficiently disturbed by Valukas’s comments concerning Ernst & Young’s audit of Lehman, to invite the firm in to explain its thinking regarding the Repo 105 transactions.

E&Y’s response to date has been to issue a statement reminding everyone that its last audit of Lehman was for the 2007 accounts and Lehman in fact failed in September 2008, long before E&Y had got into its stride auditing the relevant set of accounts for 2008. It states quite categorically that in its view the 2007 accounts were tickety boo, or in audit parlance “true and fair,” and 2008 with all it entailed was, well, not its problem since it had not yet had a chance to pronounce on the 2008 figures.

Given that E&Y picked up $31 million for auditing Lehman in 2007 and was reappointed as its auditor in 2008 this is not likely to be a position that attracts too much sympathy. Whether it will stand rigorous testing in any subsequent court action is now the key question. As one commentator remarked, mulling over the implications of this fiasco: “The real danger here is that the audit profession will make itself redundant.” What’s the point of an umpire if they hand the rule book over to the players?

Others have asked whether Lehman Brothers could turn out to be E&Y’s Enron, a reference to Arthur Andersen, once a leading big five audit firm, which imploded after the Enron scandal. None of this shows in E&Y’s calm statement, nor in its only public response to the FRC’s invitation, namely that it will “cooperate with anyone” on Lehman.

What seems plain is that Repo 105 (again see part 2 for a detailed explanation) is a legal technique in London, though not in New York. In London a Repo 105 transaction constitutes a sale, rather than a loan collateralized with assets. Technically, therefore, there is no obligation on the “seller” (borrower, in reality, since Lehman is turning long-term assets into current cash through the Repo 105 transaction) to record the fact in its books that it has a very real and present obligation to reverse the transaction in very short order. That just conveniently drops out of the book-keeping.

That this is hogwash should be plain as the nose on an auditor’s face. But the point, and it is not a trivial point, is that the hogwash in question is legal in London’s oh-so-light-touch regulatory regime. The auditor can therefore look at the transaction, scratch his or her head and say, “hey, that looks funny, but it’s legal in the forum in which it is being deployed, and besides, if we stamp on it, our client—the one who is paying us $31 million—will look very much more leveraged and exposed than they currently look. So what to do?” This is all speculation, of course. We do not actually know what reasoning E&Y adopted in considering these transactions, since the firm hasn’t yet “come clean” on its thinking here.

What is abundantly clear, however, is that E&Y is in a very different position, with respect to these transactions, following the Lehman Brothers failure, than it would have been in had Lehman been bailed out along with all the other failed US banks. From that standpoint E&Y’s judgment looks like a gamble that didn’t pay off. Quite what the fallout is going to be is at present very unclear, but what the firm has succeeded in doing is in demonstrating that the drive to prevent financial service companies and corporates generally from window dressing their accounts—a drive that built up quite a head of steam in the 1980s—still has a very long way to run in 2010.

Further reading for external auditing

Tags: auditing , Ernst and Young , fair-value accounting , Lehman Brothers , Repo 105 transactions , transparency , Valukas report
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