Auditors under fire following Lehman revelations

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.

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.
 

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Comments
Ermintrude's picture

The Auditing Profession is a pretty worthless one

Ermintrude | | Permalink

I was an auditor - and reckoned to be a particularly good and thorough one.  I worked for the Audit Commission Wales - what a bunch of weary willies.  Despite a couple of fairly horrific finds that I made about the reliability of financial information, no controversial reports or findings were issued to the clients (public sector bodies).  But then, the clients chose the auditor, and "he who pays the piper calls the tune".  Upset the client, and you lose the contract - and therefore quite possibly your job.  Certainly you'll do no favours to your career.  When I left, bitterly dissillusioned, I reported my findings and opinions at the highest level within the Audit Commission.  That this report was not even acknowledged came as little surprise to me.  It dismays me, though, that the general public have a misplaced faith in the work of the Audit Commission.  There was a Radio 4 phone-in a few years back, where anonymous callers from the auditing profession phoned in with similar stories - i.e. the job not being done properly for fear of losing the client.  Shock!  Horror!  Forgotten about.............

A different perspective

Anonymous | | Permalink

We are told that the collapse of Lehman's spells trouble for the audit profession.

I beg to differ.  It spells trouble for one large firm who either (a) didn't do their job properly or (b) were blinded by the fees being paid.

Given that the biggest firms self-certify their audit quailty to the Institutes, is it any wonder that this sort of thing happens.

No doubt the rules will be tightened for the smaller firms, with more hoops to jump through, whilst those causing the trouble walk away.

Is it any wonder the profession is falling further into disrepute?

trouble

Ayesha Bham | | Permalink

Very interesting piece and a case that I agree spells not only trouble for the rest of us who are left to pick up the pieces whilst being tarred with the same brush but also more distrust!

From the man in the street

Anonymous | | Permalink

It is very simple

The man in the street should be able to rely upon the results of an audit to give a 'true & fair' representation of the company in question.

How can deliberately hiding liabilities (lying) be regarded as 'true & fair'?

Furthermore, as part of the process of assessing whether to invest in a company the accounts will be used as guidance on which to base an investment decision

If these accounts are a pack of lies and knowingly put together on this basis then the accountants are culpable

'.. manipulation of accounting transactions in attempts to cover up the bank’s losses ..'

Clearly EY must have known that Lehmans would not have got away with these figures in the US and that the only reason EY (or any UK firm) was chosen would be to circumvent the requirements of another country.

Frankly it is absolutely no use uttering the same old rhetoric '.. lean from mistakes ..' etc - EY should go the same way as Andersons; just shut them down

'.. Lehmans bankruptcy, which occurred in September 2008, was the result of a series of unprecedented adverse events in the financial markets ..' - simply means that EY were caught out cooking the books because of the global situation, otherwise they would have got away with it!

Hardly an ethical basis for remaining in business

True and fair view

Booksend | | Permalink

Someone has already raised the issue of a "true and fair view". This is the bedrock of an auditing and accounting standard. Is there any chance that adopting repo 105 can ever allow the accounts to show a true and fair view. Somehow I doubt it. Effectively repo 105 appears to be a device rather like the shell game, but where is the truth?

This brings me to another EY issue and that is validating tangible fixed assets. It has become apparent from the 2009 accounts of Enterprise Inns plc and Punch that the average value that has been placed on 15,000 pubs in the UK is about £725,000 against which those companies have borrowed about £525,000 per pub. From the figures they have produced, it is clear that some two years or more ago if each of those pubs were individually owned and operated the operator may generate as much as £78,000- £80,000 a year. Now it does not take a genius to recognise that with that level of profit for a single use pub a valuation of £725,000 does not stack up. What apparently has happened is that intangible income arising from internal wholesaling practices has been included to boost the valuation of the tangible asset. Presto a higher "apparent value" has been constructed against which substantial sums have been borrowed. Now the question is should EY have spotted this? They appear to be happy with it. But merging tangible and intangible assets has never been acceptable. As someone has already suggested "he who pays the piper calls the tune". But that has never been an accepted audit practice, has it?

So it comes back to that central plank, "TRUE AND FAIR VIEW" and it seems clear that neither repo 105 or the merging of tangible and intangible assets satisfy that requirement. The FRC may say they are taking note but recent correspondence tends to suggest that although their doctrine is that "TRUE AND FAIR VIEW" trumps all accounting standards, it would appear that they are prepared to accept the apparent merging of tangible and intangible assets as satisfactory.

Nice try but...

Anonymous | | Permalink

Aren't E&Y (like all other auditors) supposed to reassess the financial statements at the date that they are signed off by the auditor?

Regardless of whether or not a Repo 105 was a valid accounting entry at the year-end, this presumably would not have been in place at sign-off.  This woudl have created a potentially reportable event if it was so significant as to raise doubt whether Lehman was operating within it's gearing requirements.

Auditors to blame?

Anonymous | | Permalink

 One very senior auditor I spoke to said that its a myth that an audit will pick up fraud unless its blatant and obvious. When management decides to hide and are good at it (and we presume a large org will have very good accountants) auditors have no chance.

Hence the extensive qualification in the audit statement.

Yes it will make auditors life more difficult, risky and not as profitable as no doubt a raft of new legislation will follow and be forced on the profession even when auditing small companies.

I sold my practice for a number of reasons but onerous requirements was one of them.

Lehmans and audits generally

fionamcke | | Permalink

 EY were aware that the Repo 105 situation existed so it would seem that 'true & fair' overide might apply. But also what about 'going concern'?

On a wider basis shouldn't true & fair have applied to all the financial institutions that over-reached themselves? Wasn't it all down to this 'off balance sheet' activity? Also where was Sarbannes Oxley in all this?

I do agree though that if senior management decide to behave fraudulently it is very difficult for auditors to detect.

Agreements to Repurchase are disclosed on broker's balance sheet

mrtrub | | Permalink

-- MoFromMelb

All large brokers use repurchase agreements as a form of finance.  And all large brokers disclose the total of repurchase agreements in footnotes to the balance sheet, and include liabilities under repurchase agrements in total liabilities.

If the auditors failed to detect the repurchase agreements, they may or may not have been negligent, depending on the skill of the fraudsters.  But to deliberately fail to disclose them, & give an incorrect total for repurchase agreements,  makes the auditors responsible parties to fraud, and criminals. 

The claim can be made that there was no duty to classify a repurchase agreement at less than full value as a loan, but surely nearly all secured loans made in good faith are at less than total value of security, and nobody claims money received under an ordinary commercial mortgage as sales revenue.  In addition, the notes to the balance sheet disclose total repurchase agreements, & there is a duty NOT TO FALSIFY TOTALS, whatever the auditor's opinion of the commercial reality.

We must distinguish between the duties of the hundreds of partners in the firm, who knew nothing, and the auditors responsible.  If the market regulators fail to obtain a conviction where an important accounting total is falsified like that, no intelligent investor will purchase securities except at a huge risk premium, because of the high fraud risks. 

Lehman's collapse

Anonymous | | Permalink

The only information I have, and presumably every one else here has is what is raised in the newspapers, with the sunday times having two contradictory articles about the matter.  While I do not have any personal direct knowledge of US Gaap or of this particular area, and therefore could well be wrong, I am led to believe by others who do profess to know, that:

1 there is no true and fair override in respect of US Gaap and in particular repo 105, either it is allowed, or it isn't, there is no grey area

2 there is a legal opinion which says that it is allowable under US gaap, on which I presume EY are entitled to rely

3 this is a regular device used extensively in the US, although I am given to understand that it is not allowable under UK or International financial reporting standards, although there has been a suggestion that the relevant IFRS should be amended to allow it.  Hence it isn't an unusual practice in the US.

Accordingly, apart from the presumably unusual size of the transactions, EY would not, I would have thought, have needed to raise it with the audit committee.

This would all seem to indicate that while EY might have something to answer, it isn't quite what the newspapers are reporting, or necessarily as serious as the newspapers would have us led to believe, or even perhaps as serious as the court examiner has tried to set out

Unlucky E & Y

Anonymous | | Permalink

Ernst & Young are very unlucky!  They were the auditors of Equitable Life and now Lehman Bros. They don't half pick 'em; or do they pick E & Y! What future now for E & Y?

Ermintrude's picture

Audit Commission in Wales - under criticism in today's Welsh new

Ermintrude | | Permalink

........re the Plas Madoc Communities First project in Plas Madoc, Wrexham - which has received, and allegedly miss-spent some of, millions of pounds of public money since 2001. The AC, under the Auditor General for Wales Jeremy Colman (himself now under police investigation on child porn charges), were pressured into doing a proper investigation by Mandy Bostwick, a psychotherapist and community councillor for Coedpoeth, Wrexham - who was one who reported her concerns repeatedly.  Its people such as this woman, the whistle-blowers, who act in the best interests of the public.  Not the auditors - unless of course, they, too, whistle-blow.  But then who's going to listen?

Excellent - gets better with every new revelation

Anonymous | | Permalink

Turns out that EY were told about potential issues

'.. The Wall Street Journal reported that Matthew Lee, a Lehman employee for 14 years, was 'let go' in late June 2008 soon after he raised concerns with Lehman’s auditor, Ernst & Young, that the securities firm was temporarily moving $50 billion in assets off its balance sheet ..'

http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article7064147.ece

Oops! - One area when EY should definately not have left an 'audit trail'

Of course it remains to be seen how Lehmans found out about Mr Lee informing EY and whether EY broke a confidence by informing Lehmans - resulting in the 'whistle blower' being fired

.

Ayesha Bham | | Permalink

Seems odd when I showed my colleague this article who used to be an EY employee how unsurprised she was!

Window dressing

Anonymous | | Permalink

Hmmmmm!!

When I was engaged in auditing, some years ago, the practice of 'window dressing' in order to present a better balance sheet picture than was truly the case was specifically something one was looking out for and should such a clear and material a case of 'window dressing' have been found as was engaged in by Lehman Brothers by using 'Repo 105 transactions' then there would have absolutely no question that unless those transactions were reversed or at the very least clearly disclosed then the accounts would without a doubt have been qualified on the basis that they did not present a 'true and fair view'.

Has auditing practice really changed to the extent that such 'window dressing' is OK and the auditors are 'comfortable' with it? And if it has changed to that extent is the change an improvement? Or is it that my auditing was not at the 'rarified' level of Lehman Brothers, and of course most of the other banks who were not allowed to collapse because they were 'too big', and different rules apply at these stratospheric levels?

And talking of 'stratospheric levels' one wonders if the huge fees paid by these 'high rollers' to their auditors were actually for proper impartial audit work or were they simply stuffing the auditors mouths with gold so they would not open them and let the truth fall out. 

 

If not audit then what ?

mikewhit | | Permalink

An analogous exercise over say, a hospital, would be about flagging up dangerous and risky practices which could be improved by amending procedures, working practice etc. The more useful issues raised, the greater the value of the exercise.

Same would go for eg. a security audit of an IT department (execpt HMRC ;-)

Looks like Financial Auditing does not have the same remit - so should there be some audit-like process which does try to identify risk issues ?

Ermintrude's picture

In response to "If not auditing, then what" - Mikewhit

Ermintrude | | Permalink

.......a system that deals better, protects and involves, whistleblowers.  These are the individuals who risk a lot in the public interest.  They certainly aren't paid. Or bought.  Then forensic accountants who deal with the investigations.  And compensation for the whistle-blowers. 

Ernst & Young

Anonymous | | Permalink

Many years ago I worked for E & Y and this story does not surprise me one bit.   But then I think all the major firms are the same and E & Y are just unlucky that they got found out (like Andersons before them).  And then there are the firms that signed off the accounts of RBS and HBOS just before they went bust.

The phrase "Independent auditor" is an oxymoron - audits exist to pay for the vast sums partners in audit firms pay themselves and the even vaster pension funds they buid up.  Any risk to these and they will sign off anything.