Attempting to understand the sequence of events that led to the downfall of Lehman Brothers is normally a mind numbing process, but occasionally an obvious outrage is discovered such as Lehman’s use of “Repo 105” transactions.  While we have not perused the 2,200 page bankruptcy examiner’s report, enough information has been reported to draw some conclusions.  While Lehman’s top management deserves much criticism and blame, the firm’s auditors were derelict in their responsibilities as well.  Whether Ernst & Young is legally culpable is an open question.  However, it is obvious that the firm acted as an “enabler” to Lehman’s management when it came to the use of Repo 105.

“Lehman Complied with GAAP”

The Wall Street Journal provides the following quote from an unnamed source at Ernst & Young who commented on the use of Repo 105 transactions at Lehman:

The firm’s auditor, Ernst & Young LLP, on Friday said it reviewed the accounting for Lehman repo deals under scrutiny by the examiner “on a number of occasions. Our view was, and continues to be, that Lehman’s accounting policy for these repo transactions complied with generally accepted accounting principles. The examiner has not concluded otherwise.”

Let us carefully consider what this statement implies.  Based on the bankruptcy examiner’s report and quotes found in multiple sources such as the Wall Street Journal and The Financial Times, top managers at Lehman specifically state that they were relying on Repo 105 at the end of reporting periods in order to move tens of billions of dollars off Lehman’s balance sheet in an attempt to create the illusion of lower leverage.  The firms auditor, Ernst & Young is now stating that they reviewed the repo transactions on a number of occasions and they complied with GAAP.  However, can anyone believe that the auditors did not understand the nature of the transactions or the illusion it was intended to create?  That is highly doubtful.

Principle vs. Rule Based Accounting

Generally Accepted Accounting Principles, or GAAP, present general principles and rules under which companies are supposed to report their business activity to investors and other interested parties.  At its very basic level, GAAP is supposed to ensure that management is accurately matching costs with revenue, recognizing revenue at the appropriate time, using consistent standards across accounting periods, and can substantiate financial statements based on evidence.  GAAP is considered a “rule based” accounting standard.  In contrast, International Financial Reporting Standards (IFRS) is “principle based”. The United States is moving toward convergence with IFRS. (It should be noted that we are not aware of whether Repo 105 would have passed scrutiny under IFRS.)

While GAAP is considered to be “rule based”, it does not follow that auditors should turn a blind eye toward obvious manipulation of accounting by management which is intended to mislead users of financial statements.  Perhaps there was no explicit rule in GAAP that prohibited the Repo 105 transactions or required disclosure of the transactions.  However, this fact alone does not mean that auditors should sign off on financial statements when such material misstatements have taken place.

Every public company files audited financial statements in which the audit firm makes a statement similar to the following:

“In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of [Company Name] and subsidiaries as of December 31, 2009 and 2008, and the results of their operations and cash flows for each of the three-year period ended December 31, 2009, in conformity with U.S. generally accepted accounting principles.”

The last point in italics is the key problem.  If we examine the quote from the Ernst & Young official provided earlier, we can see that he or she did not claim that the Repo 105 transactions were not designed to mislead financial statement users or that they fairly represented Lehman’s financial condition.  The statement is qualified by a reference to GAAP.

A Modest Proposal

A modest proposal for audit reform would add the following statement to the auditor’s report immediately following the statement above:

“Furthermore, we are not aware of any material transactions or off balance sheet entities, even if in compliance with GAAP, that in our judgment have been designed to mislead users of the company’s financial statements.”

Would the auditors like to see such language added?  Obviously not because it would add an element of professional and perhaps legal liability that does not exist today.  Should auditors accept this additional responsibility?  It would seem that if your business is to examine the accuracy of financial statements and provide your seal of approval to the public, such responsibility goes with the territory, even if your motto is not “Quality in Everything We Do”.

Intelligent investors should always approach financial statements with a healthy level of skepticism, but at the very least is it too much to ask to be alerted when the firm’s auditor knows of material attempts to distort reality, whether or not the deception runs afoul of GAAP or not?