USA: Lehman Brothers, the Valukas Report and the auditor's role

Anton R. Valukas, chairman of law firm Jenner and Block, published his Chapter 11 Proceedings Examiner's Report for Lehman Brothers Holdings Inc. last week: see here. To quote from the report (vol 1, p. 3):

Lehman’s financial plight, and the consequences to Lehman’s creditors and shareholders, was exacerbated by Lehman executives, whose conduct ranged from serious but non‐culpable errors of business judgment to actionable balance sheet manipulation; by the investment bank business model, which rewarded excessive risk taking and leverage; and by Government agencies, who by their own admission might better have anticipated or mitigated the outcome"

Much attention has focused on the devices through which the balance sheet manipulation was achieved and the role of the firm's auditors in this regard, discussed in volume 3 of the report: see here (pdf). To quote from the report (pp. 732-)

Lehman employed off‐balance sheet devices, known within Lehman as 'Repo 105' and 'Repo 108' transactions, to temporarily remove securities inventory from its balance sheet, usually for a period of seven to ten days, and to create a materially misleading picture of the firm’s financial condition in late 2007 and 2008 .. 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 ... Lehman never publicly disclosed its use of Repo 105 transactions, its accounting treatment for these transactions, the considerable escalation of its total Repo 105 usage in late 2007 and into 2008, or the material impact these transactions had on the firm’s publicly reported net leverage ratio ... Repo 105 transactions were not used for a business purpose, but instead for an accounting purpose: to reduce Lehman’s publicly reported net leverage and net balance sheet ...

... The Examiner concludes that sufficient evidence exists to support colorable claims against Ernst & Young LLP (“Ernst & Young”) for professional malpractice arising from Ernst & Young’s failure to follow professional standards of care with respect to communications with Lehman’s Audit Committee, investigation of a whistleblower claim, and audits and reviews of Lehman’s public filings".

So, once more, the value of the external audit is under the spotlight in the USA and beyond. The UK's Financial Reporting Council has requested information from Ernst & Young as part of an enquiry into how the 'Repo' transactions were accounted for and audited in the UK. With regard to the auditor's function, an editorial in today's Financial Times newspaper offers some interesting suggestions, including:

A more manageable change might be a shift from the binary convention that accounts are either fine or qualified. One way to beef up the due diligence value of the audit would be for the auditor to pass judgment on the quality of the information provided – perhaps on some scale with reasons given. This would give the investor a clearer appraisal of the value of the financial information. It would also force the auditor to remember who its customer actually is".