The controversy surrounding the demise of Lehman Bros. spells trouble for the audit profession as it, once again, finds itself in the spotlight for all the wrong reasons. How was such a large investment bank allowed to collapse? Have lessons not been learned from previous corporate disasters such as Enron?
What went wrong at Lehman?
The court report
into the collapse of Lehman 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 imploded, $25 billion in capital was actually supporting $700 billion of assets, which had associated liabilities resulting in an exceptionally high gearing ratio.
Lehman came under pressure 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 gimmick 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 10 days later.
Such transactions ordinarily would result in the assets remaining on the company’s balance sheet. According to the forensic report, these assets were valued at 105 percent or more of the cash received and, as a result, the sales were classed as revenue. Consequently, the balance sheet appeared as though gearing levels were reducing.
In the first two quarters of 2008, Lehman concealed some $50 billion of assets from its investors to maintain favorable ratings from credit rating agencies. For the second quarter of 2008, Lehman 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 $50 billion 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.
E&Y responded: "Lehman’s 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 Lehman 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 E&Y, said that his firm did not approve Repo 105 but “became comfortable with the policy for purposes of auditing financial statements.” Repo 105 is a controversial accounting tactic, and Lehman 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 court report is practically an open invitation to bring proceedings against E&Y for malpractice in failing to challenge the lack of disclosure of the off balance sheet finance tactic. Moreover, E&Y must now justify 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. E&Y may stand by its defense 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 described as fearsome and nobody dared question the use of what Lehman 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 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 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 to procedures accordingly.
The Lehman case illustrates how financial statements can be manipulated to achieve a desired 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 there is 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 E&Y is standing by.
Unfortunately, the inherent limitations of an audit means 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 E&Y can demonstrate that the audit procedures it implemented and the evidence it has gathered can support that view remains to be seen.
About the author:
Steve Collings FMAAT ACCA DipIFRS, wrote this report for our sister site, AccountingWEB.co.uk. Collings is the audit and technical manager at LWA Ltd. and a partner in AccountancyStudents.co.uk. He also is the author of The Core Aspects of IFRS and IAS and lectures on financial reporting and auditing issues.