Lehman and EY: Maybe I spoke too soon...

In my Fraud Examination yesterday we talked about how the audit profession appears to have learned from the last economic crisis when it was heavily criticized for inadequate audit work in the frauds that came to light around the turn of the millennium. My comment was that so far, it appears that the fingers of blame for the fiascoes leading to the "Great Recession" were not pointing much toward the audit profession. Some potential exceptions include the Madoff feeder fund audits and the New Century/KPMG situation but I concluded that the auditor finger pointing is not nearly as serious this time as it was at the turn of the millennium.

Today I'm wondering if I should have waited a few hours to make such a comment since a new report was issued about the time I was in class yesterday. This report details the Lehman Brothers collapse and is very critical of EY's audits.

(You can read the 2,200 page report online; I've search for Ernst and found the examiner is very critical of the EY's audits. Also, there are numerous articles about the report and EY's role in the collapse including the WSJ and Huffington Post.)

Suffice it to say that this report says EY failed to meet professional auditing responsibilities. The issue revolves around inappropriate repurchase transactions, known as Repo 105 transactions, used to make Lehman look like it was in better condition than it really was. The report says that Lehman used these Repo 105

... transactions to temporarily remove $50 billion of assets from its balance sheet at first and second quarter ends in 2008 so that it could report significantly lower net leverage numbers than reality.

Lehman did so despite its understanding that none of its peers used similar accounting at that time to arrive at their leverage numbers, to which Lehman would be compared...

The examiner alleges that EY was told about concerns that these transactions were inappropriate but they failed to report the concerns to the Board or to adequately investigate the propriety of the transactions.

One of many damaging quotes from the report is:

There are colorable claims against Lehman's external auditor Ernst & Young for, among other things, its failure to question and challenge improper or inadequate disclosures in those financial statements.

The report explains:

In May 2008, a Lehman Senior Vice President, Matthew Lee, wrote a letter to management alleging accounting improprieties; in the course of investigating the allegations, Ernst & Young was advised by Lee on June 12, 2008 that Lehman used $50 billion of Repo 105 transactions to temporarily move assets off balance sheet and quarter end.

The next day ‐- on June 13, 2008 ‐- Ernst & Young met with the Lehman Board Audit Committee but did not advise it about Lee's assertions, despite an express direction from the Committee to advise on all allegations raised by Lee.

Ernst & Young took virtually no action to investigate the Repo 105 allegations. Ernst & Young took no steps to question or challenge the non‐disclosure by Lehman of its use of $50 billion of temporary, off‐balance sheet transactions.

Colorable claims exist that Ernst & Young did not meet professional standards, both in investigating Lee's allegations and in connection with its audit and review of Lehman's financial statements.

My guess is that now that the report has been out for more than half a day now, 25 or more class action lawsuits have been filed against EY. A report this critical is an invitation to file such lawsuits.

I was hoping that since these particular transactions were not part of last annual audit opinion (since Lehman imploded before the 2008 financial statements were issued), that EY's role may be limited. However, it appears that the transactions date back to the 4th quarter of 2007 and affected the amounts that were audited by EY (see chart at this link). In addition, quarterly 2008 filings that were reviewed by EY were involved. As such, the question to be resolved is what should EY have done when told about these transactions? Apparently, the examiner felt they didn't do their job.

This report is definitely unsettling and the ultimate responsibility of EY in the Lehman situation will likely take months, or even years, to determine. In the meantime, I'll be more careful with my comments about the audit profession's role when the next round of economic turmoil comes to light.