Fraud Files: Is Ernst & Young to Blame in Lehman Bros. Fraud?

New York Attorney General Andrew Cuomo has slapped Big Four audit firm Ernst & Young with civil fraud charges for its alleged role in the collapse of Lehman Brothers. The theory is simple: Lehman Brothers committed a massive accounting fraud, and E&Y went along with it when they signed clean audit opinions.

The press release from the Attorney General's office puts it nicely, saying that E&Y helped " . . .Lehman Brothers Holding, Inc. ('Lehman') engage in an accounting fraud involving the surreptitious removal of tens of billions of dollars of fixed income securities from Lehman's balance sheet in order to deceive the public about Lehman's true liquidity condition."

The clean audit opinions were a longstanding tradition, as E&Y audited Lehman brothers from 2001 until its bankruptcy filing in 2008. During that time, E&Y reportedly earned more than $150 million in fees from Lehman Brothers. The suit is asking for those fees to be returned, plus damages.

Too Big to Fail?

There is no shortage of opinions about the case. Those on the side of the attorney general say that E&Y should be held responsible, at least civilly, for not blowing the whistle on shady accounting practices at Lehman Brothers. It is alleged that E&Y helped cover up the ailing financial condition of the company by sitting by while Lehman used "Repo 105" transactions to improperly make its balance sheet look better.

And those on the side of Ernst & Young are suggesting that the audit firm shouldn't be held responsible for the bad actions of Lehman Brothers. Some people are even saying that E&Y should be considered "too big to fail," saying that if we lose one of the Big Four, all hell could break loose because there just won't be enough large audit firms. (Let me assure those who subscribe to this notion that indeed, there are plenty of audit firms willing and able to step up and take on new clients.)

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E&Y's defense is straightforward. They say that the transactions in question were recorded in accordance with Generally Accepted Accounting Principles (GAAP), and the clean audit opinion was therefore justified. E&Y's attorneys will likely argue that when the Repo 105 transactions happened, the firm was not required under the accounting rules to disclose them. The auditors contend they did nothing wrong, and the collapse of Lehman was not their fault. They say the financial statements properly showed that Lehman Brothers was highly leveraged and operating in a very volatile and risky industry.

The truth behind the Repo 105 transactions might not be as simple as everyone wants to make it seem. Apparently, Lehman had to route Repo 105 transactions through a British affiliate because no law firm in the United States would offer a legal opinion on the accounting treatment Lehman wanted to use. A British law firm, however, approved Lehman's accounting treatment under English law.

Dig further, and you find that E&Y did not actually audit any of these Repo 105 transactions, according to the bankruptcy examiner's report. Even worse, E&Y told the examiner that it didn't even look at whether the volume of Repo 105 transactions was material to Lehman's balance sheet and net leverage ratio. E&Y personnel claimed that they only agreed to the accounting treatment applied to the transactions, but didn't actually look at the transactions themselves, their overall impact on the financial statements, and the real reason why they were used.

An "Accounting Gimmick"

According to the bankruptcy examiner, a strong argument can be made that the only reason Lehman Brothers used Repo 105 transactions was to manipulate the balance sheet. Internally, Lehman employees apparently referred to these transactions as an "accounting gimmick" and a way to manage the balance sheet. And that trick was apparently a house of cards that would inevitably fall.

Should the auditors be held responsible for the bad actions of Lehman Brothers? It's not an easy question to answer, but based on the above, my gut reaction is that E&Y didn't do enough.

Simply signing off on a theoretical accounting treatment, and not examining any of the transactions or their materiality to the financial statements doesn't seem to meet the professional standards to which auditors must adhere. Auditors must have sufficient, competent evidence to support their audit opinions, and that seems to be lacking in the Lehman Brothers case.

Audits offer a relatively low level of assurance on the financial statements. Put kindly, audit reports are of limited usefulness for a whole slew of reasons, and they're only useful in any respect when the audit is done right. The investing public really can't rely on auditors' reports to give them much comfort, and the case of Lehman Brothers is a prime example of why.