A BRITISH regulator has demanded that Ernst & Young hand over vital documents detailing its role in the collapse of Lehman Brothers after the firm was accused of professional negligence in its audit of the US bank.
The Financial Reporting Council, which oversees British corporate reporting rules, said it wanted the audit firm to provide information covering trades that allegedly enabled the bank to disguise risky debt structures built up in the two years before the credit crunch.
The move will heap more pain on Ernst & Young, which expects to face a series of class action suits alleging it was partly responsible for the bank filing for bankruptcy in September 2008.
Critics of the accounting profession said the firm's behaviour highlighted deep-rooted flaws in the audit profession and the need for reform of the way auditors check the financial statements of banks.
A report on the Lehmans collapse published in the US last week said the bank used controversial accounting techniques known as ''repos'' to disguise billion-dollar holes in its balance sheet.
The council said: ''Following the publication of the recent report on Lehman Brothers, the FRC is ascertaining the facts on how the repo transactions were accounted for and audited in the UK in order to determine any implications. To that end, we have asked Ernst & Young to provide further information in relation to what happened in the UK.''
A review by the council of the quality of auditing by British firms had been due next month but will be delayed. A spokesman said the delay was due to internal matters and not the decision to investigate details of Ernst & Young's audit of Lehmans.
Last week's 2200-page report for the US bankruptcy courts by a court-appointed examiner, Anton Valukas, found that repos, which are artificial sale and buy-back deals, were sanctioned by Ernst & Young and enabled the bank to offload $US50 billion of debts into off-balance-sheet vehicles. The deals, described as ''window dressing'' by bank staff, masked the precarious state of the company's finances while it was under scrutiny from regulators and investors.
The British law firm Linklaters was also described as aiding the transfer of funds after it gave opinions that the transactions were legal under English law. Linklaters and Ernst & Young have issued statements arguing that a thorough internal review of their practices showed they did nothing wrong. They also said Mr Valukas failed to explicitly criticise them, focusing his fire on the Lehman boss, Dick Fuld, and the bank's senior management.
A spokesman for Ernst & Young said: ''Lehman's bankruptcy was the result of a series of unprecedented adverse events in the financial markets. Our opinion indicated that Lehman's financial statements for that year were fairly presented in accordance with generally accepted accounting principles (GAAP), and we remain of that view.''
However, Mr Valukas said the part played by Ernst & Young had been crucial to Lehmans hiding the fund transfers, and amounted to ''professional negligence''. He said at least one Lehman's staff member warned Ernst & Young that financial statements by the bank were misleading.
Prem Sikka, professor of accounting at Essex University and a longstanding critic of the audit profession, said the council needed to take a root-and-branch approach to reform. He warned that piecemeal recommendations for greater transparency and closer co-operation between investors, auditors and directors would fail to tackle problems.
''There needs to be fundamental reform, but none of the reviews of the financial sector have looked at this question. Not the Turner review for the Financial Services Authority, not the Walker report into bank governance nor the Bischoff report into governance in the City. Investors need enforceable rights and regulators should be able to shine a light on what is going on. At the moment it is a cosy club that abuses the trust given to it every time.
''Last year E&Y was criticised for its role in Anglo Irish Bank's hidden loans controversy, when it was accused by politicians and the bank's shareholders of failing to detect large loans to Sean FitzPatrick, its chairman, during its audits.''
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