Posted: January 10, 2011 in General
Tags: , , ,

New York’s attorney general, Andrew Cuomo, has filed a lawsuit against Ernst & Young (one of the Big Four auditing firms) over the collapse of Lehman Brothers. The civil case is built on claims of professional negligence and it seeks damages equalling all the audit fees E&Y has earned from Lehman ($150m) plus an unspecified amount. While the penalty itself is of insignificant magnitude (it is less than one percent of E&Y’s global revenue and will most likely be covered by insurance), the action highlights a rather contentious issue – that of an auditor’s liability.

Deep-pocketed auditors often serve as scapegoats because there is little chance of wrangling money out of those who are truly responsible. Should the case go to trial, the jury’s behaviour will be (at best) unpredictable. Their lack of understanding of the technical nature of the case at hand, fuelled by the emotional baggage that still lingers in the aftermath of the financial crises, coupled with the outrage at having to serve jury duty in the first place does not bode well for the auditors.

Auditors are commonly perceived as the watch dogs of the financial world. They recount bricks and pennies, and are paid quite handsomely for doing so. However, they are not detectives. Their primary role is not to prevent or detect fraud. Auditors are paid to express an opinion – not a guarantee – that the financials are fairly presented in all material aspects. The International Standards on Auditing (S 240) require auditors to obtain reasonable assurance (as opposed to absolute assurance) that the financial statements are free from material misstatements. I think this is the part that most people fail to recognize and accept.

The Lehman Brothers used Repo 105 to temporarily undermine its liabilities and reduce leverage long enough to ensure that the balance sheet does not look out of place to its investors. This methodology is in line with the American Generally Accepted Accounting Principles and complies with America’s Financial Accounting Standards Board. Ernst & Young has since been criticized for approving the Repo 105 transactions without examining enough transactions. In retrospect, perhaps they should have paid closer attention. However, one must keep in mind the size of Lehman Brothers and the number of transactions it processes on a daily basis. Auditors are not super-humans. With limited manpower, it is impossible to examine every transaction and scrutinize every detail.

If there is anything to be learned, it is that the accounting standards must be revised to ensure creative accounting maneuvers are kept to a minimum. The last thing we need is another Enron* debacle and the fall of a Big Four.

*Enron was an American energy, commodities, and services company that used special purpose entities to “cook the books”. Its bankruptcy also saw the demise of its auditors, Arthur Andersen, who used to be one of the Big Five audit firms.

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