E&Y "negligent" in Lehman audits, report claims

Big Four auditors Ernst & Young were “professionally negligent” in allowing collapsed bank Lehman Brothers to use off balance-sheet devices in the years before its collapse, a sensational report into the bank’s demise has claimed.

In a report prepared, for the United States Bankruptcy Court, examiner Anton Valukas claims Ernst & Young, allowed key reports to go unchallenged as senior executives channeled fund through an off balance sheet vehicle known as Repo 105

In a statement reported on the BBC's website the firm said: "Our last audit of the company was for the fiscal year ending November 30, 2007. Our opinion indicated that Lehman's financial statements for that year were fairly presented in accordance with US Generally Accepted Accounting Principles, and we remain of that view."

According to the report, Lehman’s recorded Repo 105 transactions as sales rather than financing transactions, which meant accounting rules did not require Lehman to record the liabilities arising from the cash borrowings.

Valukas claims the transactions to temporarily remove securities inventory from its balance sheet, usually for a period of seven to ten days, to create a materially misleading picture of the firm’s financial condition in late 2007 and 2008.

Lehman’s net leverage ratio for November 30, 2007 was 16.1x. Without the balance sheet benefit of Repo 105 transactions, Lehman’s net leverage ratio would have been 17.8x, according to the report.

Repo transactions involve the owner of financial assets swapping them in return for cash but with an agreement to buy them back at a future date. They are a common way of raising short-term financing. The deals are classed as " financing" and therefore the assets remain on the balance sheet because the owners are deemed to have retained control of them.

In Lehman's case the repo deals were booked as sales because the bank could claim to have lost control of the asset, even though they bought them back later.

Loss of control was based on the idea that Lehman took less cash than its assets were worth (in Lehman's case the bank offered assets worth 105% of the cash it received , hence the name of the transaction - Repo 105). As a result Lehman would not have enough money to buy the assets back on the open market. Control of the asset is, therefore, lost and Lehman could take the assets off the balance sheet until they were bought back.