Ritchie strays into financial reporting and auditing, on the subject of Lehmans:

But let’s be clear – Ernst & Youngs’ defence – that their audit complied with US GAAP (Generally Accepted Accounting Principles - pronounced ’gap’) may be true. But that’s not the point. The point is US GAAP is crap and the Big 4 engineered that their audits do not need to report either truth  or fairness.

As the rules of the IAASB (International Auditing and Assurance Standards Board), which sets auditing standards says, an audit is:

The purpose of an audit is to enhance the degree of confidence of intended users in the financial statements. This is achieved by the expression of an opinion by the auditor on whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework. In the case of most general purpose frameworks, that opinion is on whether the financial statements are presented fairly, in all material respects, or give a true and fair view in accordance with the framework. An audit conducted in accordance with ISAs and relevant ethical requirements enables the auditor to form that opinion.

The wording is not a chance: the emphasis is on compliance with the financial reporting framework first; the consequence of being true and fair is assumed to follow, but is consequential, not the goal.

So, E & Y influence the International Accounting Standards Board that sets the framework.

And they influence the IAASB which limits the scope of the audit to the point it’s useless.

And although financial statements are meant to be produced for the benefit of the providers of capital to a business (in itself far too narrow a requirement) the auditors in the UK (by reason of the Caparo decision) and in the US under Delaware law basically can’t be sued by those providers of capital.

In other words the auditors charge a lot for doing a job badly for which they know they have almost no liability. It’s not surprising they don’t really care.

It’s not E & Y who have erred here – it’s all those who let this situation develop that have erred. The accounting structures we use are rotten to the core and so is auditing. Unless both are reformed we are heading for collapse after collapse after collapse as the prevailing mood of society to promote expedient short term greed will destroy entity after entity without any check or balance in place to stop it happening.

Ritchie should stick to tax advocacy. His knowledge of financial reporting and auditing, particularly in the US, looks pretty scant.

Financial reporting

The Lehmans examiner's report makes it very clear that technical compliance with a particular GAAP standard is insufficient in itself to comply with GAAP overall, if the resulting financial statements are misleading (Vol. 3, pp. 964-5):

Even if Lehman’s use of Repo 105 transactions technically complied with SFAS 140, financial statements may be materially misleading even when they do not violate GAAP. The Second Circuit has explained that “GAAP itself recognizes that technical compliance with particular GAAP rules may lead to misleading financial statements, and imposes an overall requirement that the statements as a whole accurately reflect the financial status of the company.”

Similarly, as noted in In re Global Crossing Ltd. Securities Litigation, even if a defendant established that its accounting practices “were in technical compliance with certain individual GAAP provisions . . . this would not necessarily insulate it from liability. This is because, unlike other regulatory systems, GAAP’s ultimate goals of fairness and accuracy in reporting require more than mere technical compliance.”

So Ritchie is plain wrong to suggest that technical compliance means the statements were compliant with US GAAP, or that US GAAP is, as he puts it rather crassly, 'crap'. The examiner's report explains that the courts expect more than slavish dedication to the letter of the law; they expect GAAP to be fair and accurate too.

This is underscored by the Sarbanes Oxley Act, Section 302, which requires management to sign a statement for each public report that asserts that:

• The report does not contain any material untrue statements or material omission or be considered misleading
• The financial statements and related information fairly present the financial condition and the results in all material respects

Again, this goes much further than Ritchie's narrow, flawed view of how US GAAP works.

Auditing

Ritchie is wrong to say that the IAASB sets auditing standards. Lehmans, as a US-listed company, is audited in accordance with auditing standards issued by the Public Company Accounting Oversight Board (PCAOB). On inception, the PCAOB adopted the former auditing standards as issued by the AICPA, and subsequently has been adding its own standards. These aren't the same as the IAASB's standards - most notably, PCAOB standards address the particular procedures a US auditor must follow to comply with Sarbanes Oxley Act Section 404, which does not apply to companies without a US listing.

I suspect it's bluster to suggest that Ernst & Young did influence either the IASB or IAASB, even if they could.

I'm not apologising for E&Y here. As I posted earlier, based on what is in the Lehmans examiner's report, E&Y have some very serious questions to answer about their audit work in the UK and/or the US. But it's imperative that any analysis of the situation is based on facts, instead of a inaccurate, sloppy diatribe that happens to fit in with Murphy's own intolerances.

Filed under: Accounting, Auditing, Current issues, Other blogs with tags ernst and young, fail, iaasb, iasb, idiots, lehman, pcaob, richard murphy, sarbanes oxley act, us gaap
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The report into Lehmans was published today. It's nine volumes and over 2,000 pages long.

Some of the papers have referred to how Lehmans used "accounting gimmickry" to massage its balance sheet so its main banking ratios would look better. At the heart of the matter is the enigmatically named Repo 105.

Repo 105

Repo 105, so named because it involves providing $105 of assets for each $100 of cash (not because it was preceded by 104 failed accounting gimmicks), was designed to switch illiquid assets for cash at key balance sheet dates. The basic idea is this: Lehmans sells some assets to someone else for cash, but signs a contract to buy them back later. The buyer makes a standard interest return on the cash.

Key to how this should be accounted for is how genuine the sale really was. Imagine a pawnbrokers. Is it a real sale followed by repurchase, or is it really just a standard loan that happens to be secured against something you value?

Accounting standards tend to assume that it's almost always the latter. Companies that sell things and buy them back probably wanted them all along. They were just using them to convince a third party to loan them money.

And, as the Lehmans report makes clear, Lehmans asked several US law firms to sign an opinion saying that Repo 105 was a genuine sale and buyback. They couldn't find a single one. In the end they got a UK firm, Linklaters, to sign an opinion saying that they believed Repo 105 was a valid sale under UK company law. Lehmans then used that opinion to justify wholesale window-dressing of their balance sheet, at one point by as much as $50 billion.

Where were the auditors?

Now, I used to be an auditor. I never audited banks, but I am familiar with the sorts of games companies can play to massage their balance sheets. My firm was keen to train us to be watchful to trickery. They showed us auditing horror stories, such as ZZZZ Best. I bought and read Terry Smith's Accounting for Growth. And, as it happens, I did see some shocking examples of bad accounting (a story for another day, perhaps). But I'm certain that my team would have expected - and would have been expected - to identify a case of window-dressing that was as egregious as the Lehmans report makes out.

What on earth were Ernst & Young thinking? Because the US law firms wouldn't touch Repo 105, Lehmans could only rely on the Linklaters UK opinion, which meant all Repo 105 transactions had to be routed through the UK. The UK auditors should, in my view, have picked up the transactions and reported it back to their parent company auditors in New York. They should have basically ignored the legal opinion. Had I been in their place, I would have told the client that the legal opinion is interesting but not binding on me. Linklaters are lawyers and accordingly are expert in law, not financial reporting.

Secondly, the parent company auditors should have picked them up too. The report is pretty damning about the conduct of the head office audit team, who were notified by a whistleblower of some serious concerns but appear to have failed to follow up on those concerns with the audit committee. This is despite being asked specifically by the audit committee to report on the whistleblower's concerns! The repos were referred to as one of the items.

Colorable claims

The Lehmans report uses the quaint term "colorable claim", which is legalese for "it's a claim that is pretty convincing". It concludes that there is a colorable claim that Ernst and Young were negligent in their audit of Lehmans. Based on what's in the report, I agree. There will be some very nervous risk partners at Ernst and Young tonight.

Filed under: Accounting, Current issues with tags ernst and young, fraud, lehman, linklaters, repo 105, terry smith, window dressing, zzzz best
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