Why E&Y Must Survive Lehman Fallout

Last Updated Mar 15, 2010 9:02 AM EDT

The criticism of Ernst & Young's role in auditing Lehman Brothers' accounts is worrying. Enron's collapse brought down Arthur Andersen, reducing the Big Five global accounting firms to an even Bigger Four. The banking crisis cannot be allowed to reduce companies' choice yet further.

Ernst & Young oversaw the accounts that shuffled $50bn of transactions off the US bank's balance sheet to make Lehman look less leveraged. The audit firm says the move was both legal and met GAAP accounting standards, but that may not stop the bank's creditors demanding recompense.

When a company collapses there is no point suing it or its directors: creditors go after the advisers and professional firms who are still standing and have deep pockets. The report released by the US bankruptcy judge detailing Ernst & Young's role is the smoking gun sought by creditors planning class-actions.

And however good a defence Ernst & Young has, it is the potential impact on its reputation that could do the damage. That's what did for Andersen. Lehman chose a Big Four firm because a big bank wants its accounts endorsed by firm a with a reputation at least as good as its own. If E&Y's standing suffers, why will any top-company chairman select this firm rather than rivals?

Ernst & Young is already the smallest of the Big Four auditors, with 25 FTSE-100 companies compared with PricewaterhouseCoopers' 41, KPMG's 25 and Deloittes' 21. But it carries more weight among the next 250 largest UK companies, with a 20 per cent share -- and this quartet of accountants has not only a British monopoly but global audit domination. All four are international and no other firms have broken into their market.

So the company seeking a new auditor has nowhere else to go unless it is prepared to look outside the Big Four -- and only one FTSE-100 company has dared do that. If the monopoly comes down to a Big Three, then the company chairman considering changing accountants will have a choice of only two other firms - one of which might be retained by the company's main competitor or be the firm sacked in the last change.

Ernst & Young obviously hopes the Lehman link will leave it unscathed but it is scares like this that show the importance of having a wider choice of audit firms.

An anti-trust break-up of the big firms would be drastic. Barring clients from using their auditors for other accounting work might make them select smaller firms. Encouraging the creation of new firms and changing the ownership rules would help. But something needs to be done in case another firm goes the way of Andersen.