Smacking Ernst & Young Feels Good, but It Won't Prevent Future Wall Street Meltdowns
Is Ernst & Young about to go the way of Arthur Andersen, the disgraced former auditor of Enron? According to the WSJ, New York state attorney general and governor-elect Andrew Cuomo is set to file civil charges against E&Y alleging that the accounting firm allowed its client, Lehman Brothers, to misrepresent its financial condition in the months before the investment bank collapsed in September 2008:
The suit... is part of a broader investigation into whether some banks misled investors by removing debt from their balance sheets before they reported their financial results to mask their true levels of risk-taking, a person familiar with the case said.The lawsuit would represent the first move to punish an auditor in connection with the financial crisis. At issue are so-called repo (for "repurchase) 105 agreements, which banks commonly used before the financial crisis to disguise their financial performance. Lehman used the accounting maneuver in 2008 to shuttle a total of nearly $100 billion on and off its balance sheet shortly before the company issued its earnings report for the first and second quarters. The purpose, it appears: to hide Lehman's enormous losses from the subprime bust.
According to a subsequent investigation by the bankruptcy court examiner assigned to investigate Lehman's failure, E&Y learned of the bank's repo deals in the spring of 2008, only months before Lehman filed for Chapter 11 protection. A Lehman senior vice president named Matthew Lee had alerted his superiors of the transactions and questioned whether they violated the company's code of ethics.
On orders from Lehman's audit committee, E&Y execs interviewed Lee to get at the bottom of his allegations. But they kept silent about the repo deals in reporting back to the panel. The accounting firm also later signed off on Lehman's second-quarter 10Q, which included a $50 billion repo deal. As the examiner concluded in his report:
There is sufficient evidence to support a determination by a trier of fact that Lehman's failure to disclose that it relied upon Repo 105 transactions to temporarilyE&Y now seems likely to pay the price for its role in those transactions. Recalling how Andersen crumbled in wake of the Enron revelations, the firm would almost certainly try to reach a settlement with Cuomo. Problem solved? Not by a long shot.
reduce the firm's net balance sheet and net leverage ratio was materially misleading.
As we learned in during the Enron affair, the real issue isn't whether large corporate auditors routinely avert their gaze from their customers' dubious accounting. Clearly, and even following the accounting reforms made under Sarbanes-Oxley, they sometimes do. The bigger concern is how Wall Street banks value their assets. The process isn't only permissive and opaque -- it's often downright incomprehensible. Bankers themselves, let alone auditors and government regulators, frequently don't have a clear idea of what's under the hood. That can make it next to impossible not only to keep the books, but also to manage risk.
It's also bad business. German researchers have found that banks that "manage" earnings using suspect accounting saw their cost of equity rise by up to 17.5 percent and trading volumes fall up to 5 percent. "The results-- show that investors punish banks for manipulating their earnings," they concluded.
So avoiding Lehman-style meltdowns is only partly a matter of punishing wayward auditors and stamping out accounting tricks like repo 105. It's also essential to clarify, and probably simplify, the rules of the road for valuing and accounting for corporate assets. We need brighter lines and stronger principles. Otherwise the Big Four could eventually be down to the Big Zero.
Image from New York Attorney General's Office
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