Lehman’s Auditor Goes Blind From the Cooking: Jonathan Weil                                                March 17, 2010, 9:20 PM EDT                                                                                                                                                                                                                                                               
                                                                                       
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March 18 (Bloomberg) -- Ernst & Young LLP, theBig Four auditor that failed to keep Lehman Brothers from misleadinginvestors about its financial condition, still can’t get its factsstraight.
Last week, after Lehman’s bankruptcy examineraccused E&Y of malpractice in a report on the investment bank’scollapse, the accounting firm issued a brief statement standing by itsaudit work and offering up its best defense.
“After an exhaustive investigation, the examinermade no findings in his report that Lehman’s assets or liabilities wereimproperly valued or accounted for incorrectly in Lehman’s November 30,2007, financial statements,” E&Y said, referring to the last fiscalyear for which it performed a full-fledged audit of Lehman’s books.
     Part of that statement is a half-truth. The other part stretches the truth past the breaking point.
It’s true the examiner, Anton Valukas, didn’t findthat Lehman’s assets or liabilities were improperly valued at the endof 2007. One thing E&Y left out: Valukas did find evidence thatLehman used unreasonable asset values for the first and second quartersof 2008, including one investment he said was overvalued by as much as$500 million.
E&Y issued signed opinion letters for bothquarters. Those letters, which Lehman disclosed in its financialfilings, said the firm had reviewed Lehman’s financial statements andfound nothing wrong.
                      ‘False and Misleading’
As for the other part of E&Y’s statement,Valukas’s report did show instances where Lehman’s accounting wasincorrect. Specifically, Valukas concluded that the footnotes toLehman’s 2008 quarterly financial statements contained “false andmisleading” statements about certain repurchase agreements known withinLehman as Repo 105 deals. The footnotes to Lehman’s year-end 2007financials “contained essentially the same statements,” he said.
Those are accounting errors -- even if Valukasdidn’t 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 inadequatedisclosures, then the financial statements are incorrect, too, and theauditor isn’t allowed to provide a clean opinion on them, under U.S.auditing standards.
Lehman used Repo 105 deals to move $38.6 billion ofsecurities off its year-end 2007 balance sheet, typically for about aweek, and temporarily reduce its debt. It got the assets off its booksby treating the transactions as sales rather than financings foraccounting 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.)
                          Not Disclosed
Valukas didn’t opine on whether the sale treatmentwas proper. However, he criticized Lehman for falsely describing thetransactions in its year-end footnotes as financings, not as sales.Nowhere did Lehman disclose its Repo 105 activity, not even in thefootnote where it was supposed to identify its off- balance-sheetliabilities.
In concluding E&Y could be found liable formalpractice over its 2007 audit, Valukas said there is “sufficientevidence for a trier of fact to conclude that Ernst & Young knew orshould have known that those statements were materially misleading andfailed to provide necessary disclosures concerning Lehman’s use of Repo105 transactions.”
Lehman’s Repo 105 deals were even larger during thefirst and second quarters of 2008, and the company used the same falseand misleading footnote statements. Valukas said this also could begrounds for a malpractice claim against E&Y. While quarterlyreviews are narrower in scope than yearly audits, auditors can faceliability for failing to perform them properly.
                         Stands by Work
An E&Y spokesman, Charles Perkins, denied thatthe firm had mischaracterized Valukas’s findings. In an e-mail, hesaid, “we do not see any language” in Valukas’s report “concerning anincorrect accounting for the assets and liabilities” at the end ofLehman’s 2007 fiscal year. He said E&Y stands by its 2007 auditopinion and subsequent quarterly review letters.
So, by E&Y’s twisted logic, it would be possiblefor a company to lie in its financial statements about its off-balance-sheet liabilities, and still manage to account correctly forthem in the same financial statements. Imagine that.
E&Y’s worst offense may be that the firm knewabout the Repo 105 deals before Lehman imploded and failed to tell thedirectors on Lehman’s audit committee. A Lehman executive, Matthew Lee,alerted E&Y auditors in June 2008. But they did little in response,said Valukas, who identified this, too, as grounds for a malpracticeclaim.
                            Long List
The Lehman disaster adds to a long list of E&Yscandals. Among the lowlights, four former E&Y executives receivedprison sentences this year for selling illegal tax shelters.
Last December, the Securities and ExchangeCommission fined E&Y $8.5 million and censured six of its currentand former partners for professional misconduct over their roles inapproving fraudulent financial statements by Bally Total FitnessHolding Corp. Those partners, who neither admitted nor denied theaccusations, included the head of E&Y’s national office, RandyFletchall. He remains at the firm and now is vice chairman for qualityand risk management, Perkins said.
Last year, E&Y agreed to pay $109 million tosettle investor lawsuits over its audits for HealthSouth Corp., whichdisclosed a massive accounting fraud in 2003.
In 2004, the SEC suspended E&Y from acceptingnew audit clients for six months because it had entered ajoint-marketing agreement with PeopleSoft Inc., an audit client, inviolation of auditor-independence rules. In 1999, E&Y reached a$335 million settlement with investors over its audits for CendantCorp. after an accounting fraud there.
     With that kind of track record, it’s a wonder anyone would accept anything this firm says at face value again.
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--Editors: Laurence Arnold, James Greiff.
To contact the writer of this column: Jonathan Weil in New York at jweil6@bloomberg.net
To contact the editor responsible for this column: James Greiff at jgreiff@bloomberg.net