A lot has been written in the blogosphere about Lehmans already. And a lot of it is blathering nonsense. So it's time to start rebutting some of the most flagrant idiocy out there.
We'll start with Michael Meacher MP, who is fuming.
It has just been reported that the Wall Street bank, Lehman Brothers, in its final days in September 2008 set up accounting ‘gimmicks’ which falsely gave the impression that its balance sheet was $50 billions stronger than it actually was. and that the auditors, the UK accountancy firm, Ernst and Young, when alerted to this by the Lehman vice-president, “took virtually no action to investigate”.
This is yet another example – almost daily – of the collapse of accountability in this country. Is Ernst & Youg guilty of negligence or malfeasance? If so, who is taking action to make them liable? $50bn isn’t pocket money.
This is not the first time that auditors have made appalling mistakes or shown extreme culpable negligence. Lehman Brothers had a leverage ratio of more than 30:1, i.e. for every £1 of hareholder funds, it borrowed £30. That means that a mere 3.3% drop in the value of assets wipes out the entire value of equity and makes the company insolvent. Auditors didn’t notice the problem, even though the warning signs were on the front pages of newpapers.
Auditors are supposed to be independent, but they are selected by directors and remunerated by companies. They act as consultants to companies and their directors, collecting huge fees in the process when in fact they’re auditing the transactions they themselves created. They also pick up a lot of insolvency and other work from their bank clients, but these details are kept quiet. Fee dependency encourages silence. The same audit firm can retain its position with a bank or company for years, creating a cosy, lucrative and corrosive relationship with the directors. There is no compulsory re-tendering for the job.
This is a huge public scandal. I intend to campaign via the OFT and other regulators to get this iniquity stopped.
Good grief, where to start?
Firstly, Lehman was not trying to give the impression that its balance sheet was $50 billions (sic) greater than it really was. Under the Repo 105 arrangement, it sold assets worth $52.5 billion and got cash back worth $50 billion. It made its books balance by recognising a derivative for the remaining $2.5 billion. Nowhere was it trying to improve its balance sheet by $50 billion. The benefit was subtler - in improved capital ratios that it could report to the markets.
Secondly, it's a bit rich for a member of the Labour Government, whose current leader pledged "no more boom and bust". If auditors can be criticised, then Gordon Brown must be seriously culpable as well. Unlike auditors, he was in a position to do something meaningful about it.
Auditors might be selected by directors, but their decision is voted on by owners annually. Authority from owners to set their remuneration is also typically sought annually. Auditors are restricted by ethical standards as to the range of services they can sell to companies. For a US-listed company like Lehmans, all services must be pre-approved by the audit committee. It's misleading to say that auditors are minting it in consulting fees. Many of the non-audit services offered, although classified as non-audit services, would be considered essential supplementary services to the audit.
And, to use political parlance, I do not accept that auditors gamble their firm's reputation by undertaking low-quality audits merely so they can rake in fees. That's just ridiculous. Rotation of key partners is helpful - and already required by ethical standards. Compulsory retendering isn't the answer. The Parmalat scandal is evidence enough of that. Further evidence is provided by a 2005 study, which concludes (p.52):
Based on the academic literature collected the present analysis supports the idea that the benefits of the rotation rule are largely doubtful. Moreover most of empirical papers present data contrary to the introduction of this rule. Furthermore an analysis of the empirical studies shows that the evidence doesn’t support the [rotation rule] with regard to [any] of the advocated possible advantages (increase in auditor independence, audit quality, audit market competition and financial market reaction).
Read my lips: auditor rotation doesn't work.
What do you think Meacher has in mind when he talks of "the daily... collapse of accountability in this country"? Uddin refusing to resign or pay back her ill-gotten expenses? Three of his party's MPs using parliamentary privilege to try to avoid having their expenses examined in court? Michael Martin's catalogue of failures as Speaker being rewarded with a peerage? Lord Mandelson's many starts?
Meacher, you are right on one count. We expect accountability. But what we're looking for starts rather closer to home than politicians might like.
Filed under: Academic research, Current issues, Politics with tags auditor rotation, ernst and young, gordon brown, idiots, labour, lehman, michael meacher, no more boom and bust, parmalat, repo 105, sleaze
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