22 Mar 2010
Jonathan Weil
BLOOMBERG
Ernst Young (EY) LLP, the Big Four auditor that failed to keep Lehman Brothers from misleading investors about its financial condition, still cant get its facts straight. Last week, after Lehmans bankruptcy examiner accused EY of malpractice in a report on the investment banks collapse, the accounting firm issued a brief statement standing by its audit work and offering up its best defense.
“After an exhaustive investigation, the examiner made no findings in his report that Lehmans assets or liabilities were improperly valued or accounted for incorrectly in Lehmans Nov. 30, 2007, financial sfatements,” EY said, referring to the last fiscal year for which it performed a full-fledged audit of Lehmans books.
Part of that statement is a half-truth. The other part stretches the truth past the breaking point Its true the examiner, Anton Va-lukas, didnt find that Lehmans assets or liabilities were improperly valued at the end of 2007. One thing EY left out Valukas did find evidence that Lehman used unreasonable asset values for the first and second quarters of 2008, including one investment he said was overvalued by as much as US$500 million.
EY issued signed opinion letters for both quarters. Those letters, which Lehman disclosed in its financial filings, said the firm had reviewed Lehmans financial statements and found nothing wrong. As for the other part of EY”s
statement, Valukass report did show instances where Lehmans accounting was incorrect
Specifically, Valukas concluded that the footnotes to Lehmans 2008 quarterly financial statements contained “false and misleading” statements about certain repurchase agreements known within Lehman as Repo 105 deals.
The footnotes to Lehmans year-end 2007 financials “contained essentially the same statements,” he said.
Those are accounting errors – even if Valukas didnt use those precise words – and not just a disclosure problem, because the footnotes are an integral part of the financial statements. If the footnotes contain material misstatements or inadequate disclosures, then the financial statements are incorrect, too, and the auditor isnt allowed to provide a clean opinion on them, under US auditing standards.
Lehman used Repo 105 deals to move $38.6 billion of securities off its year-end 2007 balance sheet, typically for about a week, and temporarily reduce its debt. It got the assets off its books by treating the transactions as sales rather than fi-nancings for accounting purposes.
This let Lehman show lower leverage ratios. (Lehman put up collateral equal to 105 percent of the cash it received; hence, the name Repo 105.) Valukas didnt opine on whether the sale treatment was proper. However, he criticized Lehman for falsely describing the transactions in its year-end footnotes as financings, not as sales.
Nowhere did Lehman disclose its Repo 105 activity, not even in the footnote where it was supposed to identify its off-balance-sheet liabilities. In concluding EY could be found liable for malpractice over its 2007 audit, Valukas said there is “sufficient evidence for a trier of fact to conclude that Ernst Young knew or should have known that those statements were materially misleading and failed to provide necessary disclosures concerning Lehmans use of Repo 105 transactions.”
Lehmans Repo 105 deals were even larger during the first and second quarters of 2008, and the company used the same false and misleading footnote statements. Valukas said this also could be grounds for a malpractice claim against EY. While quarterly reviews are narrower in scope than yearly audits, auditors can face liability for failing to perform them properly.
An EY spokesman, Charles Per-kins, denied that the firm had mis-characterized Valukass findings. In an email, he said, “we do not see any language” in Valukass report “concerning an incorrect accounting for the assets and liabilities” at the end of Lehmans 2007 fiscal year. He said EY stands by its 2007 audit opinion and subsequent quarterly review letters.
So, by EY”s twisted logic, it would be possible for a company to lie in its financial statements about its off-balance-sheet liabilities, and still manage to account correctly for them in the same financial statements. Imagine that.
EY”s worst offense may be that the firm knew about the Repo 105 deals before Lehman imploded and failed to tell the directors on Lehmans audit committee. A Lehman executive, Matthew Lee, alerted EY auditors in June 2008. But they did little in response, said Valukas, who identified this, too, as grounds for a malpractice claim.
The Lehman disaster adds to a long list of EY scandals. Among the lowlights, four former EY executives received prison sentences this year for selling illegal tax shelters. Last December, the Securities and Exchange Commission (SEC) fined EY $8.5 million and censured six of its current and former partners for professional misconduct over their roles in approving fraudulent financial statements by Bally Total Fitness Holding Corp.
Those partners, who neither admitted nor denied the accusations, included the head of EYs national office, Randy Fletchall. He remains at the firm and now is vice chairman for quality and risk management, Perki ns said. Last year, EY agreed to pay $109 million to settle investor lawsuits over its audits for HealthSouth Corp., which disclosed a massive accounting fraud in 2003.
In 2004, the SEC suspended EY from accepting new audit clients for six months because it had entered a joint-marketing agreement with Peoplesoft Inc, an audit client, in violation of auditor-independence rules. In 1999, EY reached a $335 million settlement with investors over its audits for Cendant Corp, after an accounting fraud there.
With that kind of track record, its a wonder anyone would accept anything this firm says at face value again.
The writer is a Bloomberg News columnist. The opinions expressed are his own.
