New York Attorney General Andrew Cuomo has slapped Big Four audit firm Ernst & Young with civil fraud charges for its alleged role in the collapse of Lehman Brothers. The theory is simple: Lehman Brothers committed a massive accounting fraud, and E&Y went along with it when they signed clean audit opinions.

The press release from the Attorney General's office puts it nicely, saying that E&Y helped " . . . Lehman Brothers Holding, Inc. ('Lehman') engage in an accounting fraud involving the surreptitious removal of tens of billions of dollars of fixed income securities from Lehman's balance sheet in order to deceive the public about Lehman's true liquidity condition."

The clean audit opinions were a longstanding tradition, as E&Y audited Lehman brothers from 2001 until its bankruptcy filing in 2008. During that time, E&Y reportedly earned more than $150 million in fees from Lehman Brothers. The suit is asking for those fees to be returned, plus damages.

Too Big to Fail?

There is no shortage of opinions about the case. Those on the side of the attorney general say that E&Y should be held responsible, at least civilly, for not blowing the whistle on shady accounting practices at Lehman Brothers. It is alleged that E&Y helped cover up the ailing financial condition of the company by sitting by while Lehman used "Repo 105" transactions to improperly make its balance sheet look better.

And those on the side of Ernst & Young are suggesting that the audit firm shouldn't be held responsible for the bad actions of Lehman Brothers. Some people are even saying that E&Y should be considered "too big to fail," saying that if we lose one of the Big Four, all hell could break loose because there just won't be enough large audit firms. (Let me assure those who subscribe to this notion that indeed, there are plenty of audit firms willing and able to step up and take on new clients.)

E&Y's defense is straightforward. They say that the transactions in question were recorded in accordance with Generally Accepted Accounting Principles (GAAP), and the clean audit opinion was therefore justified. E&Y's attorneys will likely argue that when the Repo 105 transactions happened, the firm was not required under the accounting rules to disclose them. The auditors contend they did nothing wrong, and the collapse of Lehman was not their fault. They say the financial statements properly showed that Lehman Brothers was highly leveraged and operating in a very volatile and risky industry.

The truth behind the Repo 105 transactions might not be as simple as everyone wants to make it seem. Apparently, Lehman had to route Repo 105 transactions through a British affiliate because no law firm in the United States would offer a legal opinion on the accounting treatment Lehman wanted to use. A British law firm, however, approved Lehman's accounting treatment under English law.

Dig further, and you find that E&Y did not actually audit any of these Repo 105 transactions, according to the bankruptcy examiner's report. Even worse, E&Y told the examiner that it didn't even look at whether the volume of Repo 105 transactions was material to Lehman's balance sheet and net leverage ratio. E&Y personnel claimed that they only agreed to the accounting treatment applied to the transactions, but didn't actually look at the transactions themselves, their overall impact on the financial statements, and the real reason why they were used.

An "Accounting Gimmick"

According to the bankruptcy examiner, a strong argument can be made that the only reason Lehman Brothers used Repo 105 transactions was to manipulate the balance sheet. Internally, Lehman employees apparently referred to these transactions as an "accounting gimmick" and a way to manage the balance sheet. And that trick was apparently a house of cards that would inevitably fall.

Should the auditors be held responsible for the bad actions of Lehman Brothers? It's not an easy question to answer, but based on the above, my gut reaction is that E&Y didn't do enough.

Simply signing off on a theoretical accounting treatment, and not examining any of the transactions or their materiality to the financial statements doesn't seem to meet the professional standards to which auditors must adhere. Auditors must have sufficient, competent evidence to support their audit opinions, and that seems to be lacking in the Lehman Brothers case.

Audits offer a relatively low level of assurance on the financial statements. Put kindly, audit reports are of limited usefulness for a whole slew of reasons, and they're only useful in any respect when the audit is done right. The investing public really can't rely on auditors' reports to give them much comfort, and the case of Lehman Brothers is a prime example of why.

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The Enron collapse took Arthur Anderson with it. No reason to think that the remaining Big Four should be immune from liability. The complicity of auditing firms and ratings agencies and other "independent" monitors who were supposed to keep this sort of thing from happening is one of the root causes of the problem. Paying back the fees is not the right remedy. Being held liable for the damages of every person worldwide who relied, in part, on E&Y-verified "clean" balance sheets from Lehman would be more appropriate.

If E&Y can show that it reviewed the audits in good faith and was actively lied to or duped by Lehman, that would be a perfectly viable defense. But if E&Y turned a blind eye to the charade, or rubber-stamped the audits knowing that it was a "house of cards" built on gimmicks, then E&Y should be held responsible.

December 27 2010 at 3:08 PM Report abuse +1 rate up rate down Reply

i watch the inside on this... E & Y not guilty, I know for the fact

December 27 2010 at 1:12 AM Report abuse rate up rate down Reply
Everett Bassie

What happened to the Public Company Accounting Oversight Board (PCAOB)? This government entity was setup after the Enron scandal to prevent such a fraud from ever happening again. The PCAOB is required by law to inspect the audits of large accounting firms (100 or more public clients)every year. The PCAOB is a joke. The PCAOB only go after small auditing firms. The PCAOB should have sued.

December 26 2010 at 9:10 PM Report abuse +2 rate up rate down Reply

I don't see any difference between this and Arthur Andersen and the Enron scandal.

December 26 2010 at 8:08 PM Report abuse +3 rate up rate down Reply

Too bad the SEC is paid off by Ernst & Young or other Wall St. bigwigs. Its really the Fed. Govt. SEC that should have brought this case vs. Ernst and Young and Lehman Management for the Accounting Frauds. I thought Obama was going to clean up the Corruption and not do "old boy network business as usual" Washington taking big campaign contributions from Wall St. Where's Obama's Justice Dept. or SEC on this? Luckily NY Attny. Genl. and Gov. Elect CUOMO is standing up for the Law and what's right, even if Obama's ignoring these Wall St. fraudsters and making deals increasing size of the deficit (by extending tax cuts in exchange for more welfare-unemployment) with certain Republicans.

December 26 2010 at 1:36 PM Report abuse +1 rate up rate down Reply

New York Attorney General Andrew Cuomo sure moving ahead at slow speed. Standard accounting practices better check all their clients and the TBTF entities like Goldman Sachs and Bank of America no mark to fantasy there just look at the year end bonus train coming down the line.

December 25 2010 at 1:15 PM Report abuse +1 rate up rate down Reply
Barack Obama

What is the big deal? These people at Lehman were, in reality, just bouncing money back and forth. They produce nothing and add nothing to the economy. The only way to really make any money doing what they do is to steal it. That is what they did, so quit picking on them. Now, if you want to make some money, open a factory in China and sell stuff to Americans. You can make real money doing that.

December 25 2010 at 11:12 AM Report abuse rate up rate down Reply

Don't worry, it's our White House.
Here’s a Christmas story that goes like this; we seized all the Federal Reserve bankers’ money, machinery, and their personal assets.
Don't worry.
They’re just a Fox in a private company. Just sit there… Just sit there…
Don't worry.
Use the Unemployed, Police, Army, Navy, and Marines and pay them to keep the Federal bankers under arrest for treason, national security risk, plot to disrupt, fraud the government system from the beginning.
Don't worry.
Others are involved in deception too; need to be clear as possible and short, it’s not too late.
Don't come across as a nut. Or the fox will make up stories to make them look like they’re not part of the story.
Don't worry.
Give hope; Inspire others to make things right; Make this nice, it could get scary, off with the blinders.
Don't worry.
ET has been here and we have proof, but be wary. God is still here; with a glimmer of hope and prayer with a blink of his eye; all things are back in the heavenly skies. Just don’t forget what his son stood for…Ho Ho Ho.
Don't worry.
All the King's roosters and all the King's hens tried to keep the fox out of the White House.
Don't worry.
The Fox keeps whispering to all the roosters; don’t worry, the hens are safe! Just keep telling them you make the laws. Just change it slowly; make it long and fussy, don’t forget to give them a treat… Ho Ho Ho.
Don't worry.
I won't eat you today said the fat fox. I'm too full; I'll just put you and the others in their new house of bars.
Don't worry.
Did you have a say in your city and state,fed laws? Just sit there, Ho Ho Ho can’t make all this petty.
Don’t worry.
It’s just business.
Don't worry.
Why did the chicken cross the road? Because the chicken was doing the work of the fox just like the SS…
Don't worry.
Stay in your house. The Fox makes the money.
Don't worry.
It will be all right tomorrow even if we will go hungry.
Don't worry.
Christmas is here to spread the word of hope and a good cheer, God is still here.
Don’t worry.
The Fox will see you next year.
Don't worry, it’s our White House.
Don't worry.
Written by your local blacksmith, copyright 2010 Max Kammerer

December 24 2010 at 9:16 PM Report abuse +1 rate up rate down Reply

Is this the new name for Dewey, Cheatum & Howe?

December 24 2010 at 12:03 PM Report abuse +1 rate up rate down Reply

Take the head of Ernst and Young and put him in with Geo Ryan.

December 24 2010 at 11:50 AM Report abuse +1 rate up rate down Reply