Corporate Governance

The Accounting Industry and the Specter of Catatrophic Risk (Part 1)

By J Robert Brown Jr.

Andrew Cuomo, the Attorney General of NY (and soon to be governor), filed civil fraud charges against E&Y over auditing work done for Lehman Brothers.  The Complaint is here.  The concerns arose over the role played by the accounting firm in the use of "Repo 105" transactions by Lehman.  As the Complaint states:

• E&Y knew every significant aspect of Lehman's Repo 105 transactions, and knew that the Lehman financial statements violated Generally Accepted Accounting Principles ('GAAP'), which require that such statements (a) not be misleading, (b) fairly disclose the Company's financial position, and (c) not omit material information necessary to fairly present the financial position. As the public auditor for Lehman, E&Y had the absolute obligation to ensure that Lehman's financial statements complied with GAAP and did not mislead the public.  Instead of fulfilling this obligation, E&Y gave a clean opinion each year, erroneously stating that Lehman's financial statements complied with GAAP. E&Y sat by silently while Lehman deceived the public by concealing the Repo 105 transactions and misrepresenting the Company's leverage. By doing so, E&Y directly facilitated a major accounting fraud, and helped Lehman mislead the public as to its true financial condition. E&Y, which reaped over $150 million in fees from Lehman, must be held accountable for its role in this fraud.

The investigation is reported to have started after the bankruptcy examiner in Lehman issued a report on the failed investment bank.   Volume 3 discussed the use of the accounting treatment and concluded that:

• "There is sufficient evidence to support a determination by a trier of fact that Lehman's failure to disclose that it relied upon Repo 105 transactions to temporarily reduce the firm's net balance sheet and net leverage ratio was materially misleading.

As for the role of E&Y, the Report likewise concluded that "sufficient evidence exists to support colorable claims against Ernst & Young LLP ('Ernst & Young') for professional malpractice arising from Ernst & Young's failure to follow professional standards of care with respect to communications with Lehman's Audit Committee, investigation of a whistleblower claim, and audits and reviews of Lehman's public filings."  Volume 3, at p. 1027. 

The potential claims against E&Y have caused some to criticize the SEC for its "passive" approach to Lehman and the role played by E&Y.  Others have mostly shrugged and noted that bad behavior happens. 

The significance of the action by the NY Attorney General, however, goes well beyond the specifics of a single case.  It again raises serious systemic questions about the auditing industry.  The possible charges against E&Y recall the specter of Arthur Andersen back in 2002.  The charges resulted in the demise of the firm, reducing the number of large auditors from five to four.

Admittedly, Andersen confronted criminal charges, while the possible action against E&Y is civil. Nonetheless, it was a single government action that resulted in a less competitive industry.  Could the same thing happen again?  We address these concerns in the next few posts.

Full post as published by The Race to the Bottom on December 22, 2010 (boomark / email).