There were gasps of shock from senior auditors this week as they read Anton Valukas’ account of Lehman Brothers’ collapse and the role accounting allegedly played in distorting the bank’s position.
“It beggars belief,” said one, while another said it should lead to a “rethink of the basic principles of financial reporting”.
The report was unsealed on Thursday afternoon by New York’s Southern District Bankruptcy Court. Within hours, the key accusations in the 2,200 page had hit the newswires.
It missed the early newspapers in London, but was picked up widely on the internet. The morning was filled with incredulity and some cogitation over the series of revelations. By midday, reports emerged that funds were funnelled through Lehman’s UK arm. By the end of the day, there was talk of litigation from creditors and criminal charges for directors.
By the following Monday, the accusations spurred the UK reporting regulator, the Financial Reporting Council into action. In a carefully worded statement the body said it would “ascertain the facts on how the ‘Repo’ transactions were accounted for and audited in the UK” and had “asked Ernst & Young to provide further information in relation to what happened in the UK.
E&Y said it would “co-operate fully” with all the requests.
Valukas’ report’s most sensational allegations came in volume three, which centred on the use of a particular type of transaction known as Repo 105. The phrase is already working its away into the accounting lexicon of shameful practices.
But it would have been well known to senior management at Lehman, according to Valukas’ report. Each morning, between April 2008 through to September 2008, they were handed a report titled Balance Sheet and Disclosure Scorecard.
Sitting amid global and regional net balance and cash capital schedules was a line which tracked the use of Repo 105 transactions.
Repo transactions are not particularly controversial. They are often used to
raise short-term capital by loaning assets in return for cash, with an
accompanying agreement that the assets will be repurchased down the track.
These types of transaction are commonplace. Lehman’s accounting treatment was not.
Within Lehman, Repo 105 transactions were structured to remove risky assets and liabilities from its balance sheet. An asset worth $105 would be exchanged for a loan worth $100. The disparity in price meant Lehman could book the transaction as a sale because it had lost “control” of the asset.
By booking the transaction as a sale it could remove the assets from its books for seven to ten days, and artificially improve its balance book’s health.
Regulators say they expect a degree of “balance sheet window dressing” from banks before result time, but Valukas claims the amounts Lehman was transferring distorted its position.
Lehman’s use of Repo 105 transactions more than doubled in the span of five reporting periods, from approximately $24bn (£15.8bn) in the fourth quarter of 2006 to $49.1bn and $50.4bn in the first and second quarter of 2008. This led Valukas to his next question – where was the auditor?
Ernst & Young (E&Y) points out that its last full audit was for the fiscal year ending 30 November 2007. It also makes clear Lehman’s collapse was the result of “a series of unprecedented adverse events in the financial markets”.
Valukas, however, lays some blame at E&Y’s feet. He believes the firm failed to take proper action when made aware about Lehman’s failure to disclose the timing and volume of its Repo transactions. E&Y, however, has not officially revealed the extent of its awareness of Repo 105 transactions.
Valukas points to a number of auditing standards, and specifically E&Y’s engagement letter of 15 May 2007 where the firm warns that: “If we determine that there is evidence that fraud or possible illegal acts may have occurred, we will bring such matters to the attention of an appropriate level of management.”
Auditors in the UK have pointed out that E&Y’s defence may have some substance. The strict rules which make up the US accounting system meant Lehman were able to use a treatment which was legal. And E&Y is reported to have said it viewed the repo transactions from only a “theoretical” point of view.
When E&Y says it’s report was “fairly presented in accordance with GAAP”, this may well be the case.
Despite protestations, the potential liability may have larger implications for E&Y. PwC, representing creditors of Lehman’s UK arm, could sue E&Y, setting the stage for a long court room drama between two of the top four global audit firms, over the world’s largest corporate collapse.
On Friday, senior PwC figures close to the administration said they had yet to make a decision but were poring through the report.
It remains unclear what role E&Y’s UK arm played in the audit, however, the report mentions that funds for the Repo 105 transactions ran through the Lehman’s UK-based arm – Lehman Brothers International (Europe).
Any questions over the UK auditors’ conduct may lead to an investigation by the accounting watchdog, The Accountancy and Actuarial Discipline Board, which is understood to be looking at the report.
The lines between what E&Y knew, what they could have known and what they should have known, will all feature centre stage as the saga unfolds.
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