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Auditors under fire following Lehman revelations

The controversy surrounding the demise of Lehman Brothers once again spells trouble for the auditing profession.
How was an investment bank such as Lehman Brothers allowed to collapse? Have lessons not been learned from the
other well-publicised corporate disasters, such as Enron? Are auditors really to blame for disasters?

Lots of questions are asked when corporate disasters occur and once again, the audit profession is in the spotlight
for all the wrong reasons.

What went wrong at Lehmans?
The report into the collapse of Lehman Brothers cites manipulation of accounting transactions in attempts to cover
up the banks losses. These tactics, referred to as Repo 105 transactions, were essentially tactics to achieve off
balance sheet finance. Reports suggest that by the time Lehman Brothers imploded, $25 billion in capital was
actually supporting $700 billion of assets which had associated liabilities. This resulted in a gearing ratio which was
considered exceptionally high.

Lehman Brothers were coming under increasing pressure to reduce their gearing (referred to in reports as leverage)
and the bulk of their 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 also financed by borrowings which meant
that, in realistic terms, Lehman Brothers could not easily reduce its gearing levels.

The use of Repo 105 was later to become a crucial tactic when the credit crunch arrived as the bank was trying to
survive in a particularly difficult financial market. The phrase Repo derives from the word 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 they then bought back about seven to ten days later.

The substance of such a transaction would ordinarily result in the assets remaining on the companys balance sheet.
However, reports suggest that the value of these assets were valued at 105% or more of the cash received and as a
result, the sale of these assets were classed as revenue. This resulted in a much less risky balance sheet being
reported and, on the face of it, appeared that gearing levels were reducing.

In the first two quarters of 2008, it transpired that Lehman Brothers was hiding $50 billion of assets from its
investors and stakeholders in attempts to maintain favourable ratings from the credit rating agencies. Reports
suggest that for the second quarter of 2008, Lehmans reported a gearing ratio of 12:1 when, in actual fact, it should
have reported a gearing ratio of 13:9.

The audit-related problem
The problem Ernst & Young are now facing is justifying why they allegedly took no steps to question or challenge the
non-disclosure of Lehman Brothers use of $50 billion worth of temporary, off balance sheet finance transactions.
Reports also suggest that a senior vice president also raised questions relating to these transactions as early as May
2008.

Reports state that Ernst and Young say:

Lehmans 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 Lehmans financial statements for that year were fairly presented in accordance with Generally
Accepted Accounting Principles (GAAP), and we remain of that view.


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Seemingly, reports suggest that Ernst and Young knew about the tactics employed at Lehman Brothers but failed to
monitor the banks usage of Repo 105. William Schlich, partner at Ernst and Young said that his firm did not
approve Repo 105 but became comfortable with the policy for purposes of auditing financial statements. Repo
105 is controversial accounting tactic, and Lehman Brothers had manipulated it to such an extent that it rang the
death knell for the bank but management failed to hear it.

There is now potential for Ernst and Young to face proceedings for malpractice for failing to challenge the lack of
disclosure of the off balance sheet finance tactic. Moreover, Ernst and Young now face justifying why Mr Schlich had
failed to investigate claims brought to his attention by the senior vice president.

Are auditors to blame?
Clearly in this case, lots of critics blame the audit firm and whilst Ernst and Young may stand by their defence that
the financial statements were presented in accordance with GAAP, questions are being asked as to whether the
audit evidence supports the actual opinion given by Ernst and Young. The reduction of 0.9 in the gearing ratio for
the second quarter of 2008 was allegedly material to the financial statements and thus sufficient attention should
have been devoted to such an area which would have rang alarm bells into the inappropriate excessive use of Repo
105 tactics.

Reports suggest that the banks chief executive, Dick Fuld was fearsome and therefore it could well be the case that
nobody dared to question the use of, what Lehman Brothers employees termed, accounting gimmicks.

In 2002 we saw the collapse of Arthur Andersen due to the practices employed there insofar as pressure being
placed on the audit firm by its high profile and powerful clients. Indeed, the collapse of Lehman Brothers has similar
traits but whilst illegal activities were being undertaken in the Arthur Andersen case, Repo 105 is still a legitimate
accounting tool and one which Lehman Brothers placed a disproportionate amount of reliance on to manipulate its
financial statements.

International Standards on Auditing detail the framework that auditors are required to follow. However, the mere
existence of ISAs does not make an auditor a good auditor as procedures must be responsive to the assessed levels
of risk, and the auditor should tailor procedures accordingly. Clearly in Lehman Brothers case, the excessive use of
Repo 105 should have been classed as a high risk area where the auditors should have focussed their attention.

Fraud
The case involving Lehman Brothers illustrates a case of fraudulent financial reporting, where financial statements
were manipulated to achieve a desired result. Fraud issues have always been a topical area where the auditing
profession is concerned, but where does the auditors responsibility end in relation to fraud? Is the responsibility for
the detection of fraud being passed to the auditor?

The responsibility for the prevention and detection of fraud, whether actual fraud or fraudulent financial reporting,
rests with management. Auditors do not have a direct responsibility to detect fraud, however this is not a get out of
jail card for auditors. Indeed, audit procedures should be designed in such a way that they would be reasonably
expected to detect a material fraud, and certainly here in the UK we have ISA 240 (UK and Ireland) 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 it is this view that Ernst and Young
are standing by.


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Unfortunately the inherent limitations of an audit means that there are occasions where audit procedures have been
considered sufficient and the audit evidence gathered does support an unqualified opinion, but yet a material fraud
might not be discovered by the auditors. Provided auditors can demonstrate that they designed their procedures in
such a way that they could reasonably be expected to detect a material misstatement due to fraud, then it would be
generally accepted that blame cannot rest at the auditors door. Whether Ernst and Young can demonstrate that the
audit procedures they implemented and the evidence they have gathered can support their view remains to be seen.

Steve Collings FMAAT ACCA DipIFRS is the audit and technical manager at LWA Ltd and a partner in
AccountancyStudents.co.uk. He is also the author of The Core Aspects of IFRS and IAS and lectures on financial
reporting and auditing issues.