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 the other well publicised corporate disasters such as Enron? Are auditors really to blame for disasters?

 

Lots of questions are asked when corporate disasters occur and once again, the audit profession is in the spotlight for all the wrong reasons.

 

 

The 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. Reports suggest that by the time Lehman Brothers imploded, $25 billion in capital was actually supporting $700 billion of assets which had associated liabilities. This resulted in a gearing ratio which was considered exceptionally high.

 

Lehman Brothers came under increasing pressure to reduce its gearing (referred to in reports as ‘leverage’) and 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 also financed by borrowings which meant that, in realistic terms, Lehman Brothers could not easily reduce its gearing levels.

 

The use of Repo 105 was later to become a crucial tactic when the credit crunch arrived as the bank was trying to survive in a particularly difficult financial market.  The phrase ‘repo’ derives from the word ‘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 they then bought back about seven to ten days later.

 

The substance of such a transaction would ordinarily result in the assets remaining on the company’s balance sheet. However, reports suggest that the value of these assets were valued at 105% or more of the cash received and as a result, the sale of these assets were classed as revenue. This resulted in a much less risky balance sheet being reported and, on the face of it, it appeared that gearing levels were reducing.

 

In the first two quarters of 2008, it transpired that Lehman Brothers was hiding $50 billion of assets from its investors and stakeholders in attempts to maintain favourable ratings from the credit rating agencies. Reports suggest that for the second quarter of 2008, Lehmans reported a gearing ratio of 12:1 when, in actual fact, it should have reported a gearing ratio of 13:9. 

 

 

The problem Ernst & Young is now facing is justifying why it allegedly took no steps to question or challenge the non-disclosure of Lehman Brother’s use of $50 billion worth of temporary, off balance sheet finance transactions. Reports also suggest that a senior vice president also raised questions relating to these transactions as early as May 2008.

 

Reports state that Ernst and Young say:

 

“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”.

 

Reports seem to suggest that Ernst & Young knew about the tactics employed at Lehman Brothers but failed to monitor the bank’s usage of Repo 105. 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 failed to hear it.

 

There is now potential for Ernst & Young to face proceedings for malpractice for failing to challenge the lack of disclosure of the off balance sheet finance tactic. Moreover, Ernst & Young now face justifying why Mr Schlich had failed to investigate claims brought to his attention by the senior vice president.

 

 

Clearly in this case, lots of critics blame the audit firm and whilst Ernst & Young may stand by its defence that the financial statements were presented in accordance with GAAP, questions are being asked as to whether the audit evidence supports its 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 an area which would have rang alarm bells into the inappropriate excessive use of Repo 105 tactics.

 

Reports suggest that the bank’s chief executive, Dick Fuld was ‘fearsome’ and therefore it could well be the case that nobody dared to question the use of what Lehman Brothers employees termed as ‘accounting gimmicks’.

 

2002 saw the collapse of Arthur Andersen due to the practices employed there insofar as pressure being placed on the audit firm by its high profile and powerful clients. Indeed, the collapse of Lehman Brothers has similar traits but whilst illegal activities were being undertaken in the Arthur Andersen case, Repo 105 is still a legitimate accounting tool and one which Lehman Brothers placed a disproportionate amount of reliance on to manipulate its financial statements.

 

International standards on auditing detail the framework that auditors are required to follow. However, the mere existence of ISAs does not make an auditor a ‘good’ auditor as procedures must be responsive to the assessed levels of risk, and the auditor should tailor procedures accordingly. Clearly in Lehman Brothers case, the excessive use of Repo 105 should have been classed as a high risk area where the auditors should have focussed their attention.

 

 

The Lehman Brothers case illustrates how financial statements can be manipulated to achieve a desired a result. Fraud issues have always been a topical area where the auditing profession is concerned, but where does the auditor’s responsibility end in relation to fraud? Is the responsibility for the detection of fraud being passed to the auditor?

 

The responsibility for the prevention and detection of fraud - whether actual fraud or fraudulent financial reporting - rests with management. Auditors do not have a direct responsibility to detect fraud, however this is not a ‘get out of jail free’ card for auditors. Indeed, audit procedures should be designed in such a way that they would be reasonably expected to detect a material fraud, and certainly here in the UK we have ISA 240 (UK and Ireland) 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 that they designed their procedures in such a way that they could reasonably be expected to detect a material misstatement due to fraud, then it would be generally accepted that blame cannot rest at the auditor’s 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.