Lehman, Ernst & Young and accounting

You all by now know that the US bankruptcy examiner’s report on Lehman has alleged that Ernst & Young was negligent in it’s audit of the bank.
The allegation hinges on how to deal with so called repo 105, dubbed an “accounting gimmick” by one insider, according to the report. These were the transactions that moved around vast sums of money as Lehman battled to maintain its financial health.
The report says: “Lehman regularly increased its use of repo 105 transactions in the days prior to reporting periods to reduce its publicly reported net leverage and balance sheet.”
Normal repo transactions are common place and involve financing in which assets are exchanged for cash with a clause committing the original owners of the asset to buy them back at some given time in the future.
In the normal run of things this is not a problem. But, because it is “financing”, the assets remain on the balance sheet of the owner – because they are always coming back.
In Lehman’s repo 105 transactions this manoeuvre was booked as a “sale” – as if the bank had given up ownership of the assets entirely. They therefore came off the balance sheet, even though they were bought back several days later.
This had the effect of improving the condition of Lehman’s balance sheet, reducing the bank’s leverage and maintain confidence in its future.
Here’s how the accounting reasoning work. Lehman would sell assets worth 105% of the cash they take in return – or less than they are worth. Because they receive less they are deemed to have lost control of the asset because they do not have the money to buy the assets back on the open, should they be forced to do that. Loss of control equals a sale which, in turn, equals assets that can come off the balance sheet.
The question the US authorities will have to answer is whether Lehman was involved in something that could be defined as genuine sales, or was there no economic substance to them? In three sales the bank raised £38bn in Q4 2007, $49.1bn in Q1 2008 and $50.4bn in Q2 the same year. On each occasion the report claims the bank’s net leverage was sigificantly reduced.
It is clearly the accounting treatment of the transaction at stake not the transaction itself.
And that makes it acutely difficult for the auditor Ernst & Young.
The firm has already begun a defence. But the spotlight on its consideration of these transactions is unlikely to go away quickly. All manner of public authority in the US will be looking at the examiner’s report and working out its implications.
Creditors of Lehman’s will also inspect the report along with the administrators who have been trying to recover money for those who lost out when the bank collapsed.
Today may be the first day, of what may prove to be a long and drawn out saga for E&Y who, perhaps not for the last time, begun defending this audit.
E&Y’s position is made more complicated by the size of Lehman which claimed assets of $700bn but reduced its balance sheet by $60bn in the run up to its collapse. In 2008 the bank reported losses of almost $7bn alone. During the course of the same year the bank’s share price collapsed dramatically by more than 90%.
All of this adds up to a very uncomfortable position for the auditor.