MARCH was a bad month for auditors, a case of Enron deja vu. In Australia, the Australian Securities and Investments Commission found that many audits conducted by Australia's biggest audit firms produced an opinion that the auditor couldn't verify. ASIC's findings go to the heart of what audit is about. It's supposed to be critical gatekeeper ensuring the market gets accurate information. ASIC found that not all auditors were up to scratch.
Meanwhile, in the United States there have been revelations that Ernst & Young failed to raise the alarm about the accounting trick, Repo 105, at Lehman Brothers that allowed the bank to manipulate its balance sheet in the run-up to its collapse in September 2008. Lehman was, in effect, temporarily swapping the assets - typically loans and bonds - for hard cash, creating the impression it had reduced its lending and reducing the amount of risk it was taking.
It removed $50 billion of assets in the blink of an eye from its balance sheet to create the illusion the company was in good shape. The loans were classified as sales, all with the help of its accountants.
As insolvency examiner Anton Valukas noted in his 2200-page report: ''The only purpose or motive for the transactions was reduction in balance sheet … there was no substance to the transactions.''
Repo 105 helped Lehman keep its crucial credit rating intact while creating a mountain of toxic assets, much as Enron had done. A repo is short for a repurchase agreement where collateral is exchanged for cash. The trade can be unwound overnight. Lehman could temporarily exchange assets in return for short-term loans and by doing so, temporarily park assets off the books to make those debt levels look better than they did.
The trouble was no American law firm would sign off on their classification as sales. Enter a British law firm Linklaters. Basing its brief on English law as opposed to American law, Linklaters told Lehman that so long as Repo 105 was conducted in London through the bank's European arm, Linklaters would sign off.
The big question: where was Ernst & Young? In response, E&Y put out a statement saying Valukas had made no findings that Lehman's assets or liabilities were ''improperly valued or accounted for incorrectly''.
There is no suggestion that Ernst & Young had in any way contributed to the Lehman Brothers collapse.
But questions have been raised about E&Y's failure to provide appropriate information to shareholders. Valukas says claims could be brought against E&Y for ''malpractice'' and ''negligence'' and ''failure to exercise professional care''.
He said there was ''sufficient evidence for a trier of fact to conclude that Ernst & Young knew or should have known that those statements were materially misleading and failed to provide necessary disclosures concerning Lehman's use of Repo 105 transactions''. Valukas was in effect putting up a big neon invitation for shareholders itching to take a class action against anyone they could blame. That hasn't happened yet, but for now, it has invited inevitable comparisons with Enron, Satyam or Parmalat.
The accounting giant Andersen went out of business because of its collusion with the accounting fraud at Enron. After Andersen was wiped off the slate, the accounting industry was supposed to have transformed itself. But the latest developments suggest we have learnt nothing from Enron. Or has the audit profession's corporate memory been wiped by the boom years?
The ASIC report into auditors is just as troubling. The report noted that firms needed to lift their game in such areas as risk assessments, impairment, fair value measurements, related party transaction and going-concern assessments, all issues that emerged during the economic crisis. The implication: a cycle of complacency in boom times that gets found out in a global financial crisis.
''There are instances where audit risk assessments have failed to identify key risks and where fundamental audit procedures have not been adopted,'' ASIC said.
''While there may be cases where the necessary audit evidence was obtained and proper consideration was given to significant judgment areas but not documented, there will also be cases where the necessary audit evidence and analysis to support the audit opinion was not obtained or performed. There may be no material misstatement in the audited financial report, but if evidence and analysis are not obtained or performed, the auditor does not have a basis for their opinion.''
Now, most auditors are scrupulously honest and would never engage in shenanigans. But when a handful turn a blind eye or collude to create a facade to appease their paymasters, it destroys trust, something no market or society could function without.
The ASIC report had its limitations. It was confined to only 19 audit firms. And unlike the Public Company Accounting Oversight Board in the United States, it protected the audit firms by refusing to name them. Perhaps if ASIC did what the oversight board does, naming and shaming, it would put more pressure on auditors.
The influential Lex column in the Financial Times comes up with the unusual but interesting solution for auditors to be employed directly by the securities regulator, which would then negotiate fees with the client. ''This would remove the pressure for auditors to side with a client when difficult issues arise. It would also remove any doubt over whether auditors are truly independent,'' the FT says.
If Lehman was a rerun of Enron, the big worry is what the rerun of Lehman will be. Sadly, that looks inevitable given the cycle of complacency, and auditors' inability to learn from Enron.
Lawyers and accountants need to be subjected to the same rigorous scrutiny now applied to banks and ratings agencies.
leon@leongettler.com
