So much for E&Y professionalism

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Accounting for the auditors Prem Sikka 

In the current financial turmoil, companies are falling like ninepins. 
Lehman Brothers is in administration. Northern Rock, Fannie Mae and 
Freddie Mac have been bailed out and the list of vulnerable banks is 
growing. Bear Stearns and Merrill Lynch have been sold at knockdown 
prices and HBOS has merged with Lloyds TSB. Governments are pouring vast 
amounts of money to bail out financial institutions. Amidst the mayhem, 
we need to ask questions about the role of auditors, who have been paid 
millions of pounds to give opinions on company financial statements. Yet 
companies are sinking within weeks of getting a clean bill of health. 

Ever since the 1998 collapse of Long Term Capital Management (LTCM) and 
its rescue by the US Federal Reserve, it has been acknowledged that 
derivatives are very difficult to value. In this case Nobel prize 
winners in economics could not work out the value of such financial 
instruments. Derivatives are central to the demise of Lehman. Its annual 
accounts mention derivatives contracts with a face value of $738bn and 
fair value of $36.8bn. 

Lehman Brothers, incorporated in the tax haven of Delaware, was audited 
by the New York office of Ernst & Young. On January 28 2008, the firm 
gave a clean bill of health to Lehman accounts for the year to November 
30 2007. The auditor’s report (page 75 of the accounts) says, “Our audit 
included obtaining an understanding of internal control over financial 
reporting, assessing the risk that a material weakness exists, testing 
and evaluating the design and operating effectiveness of internal 
control based on the assessed risk, and performing such other procedures 
as we considered necessary in the circumstances”. Lehman Brothers filed 
quarterly accounts with the SEC for the period of May 31 2008 and on 
July 10 2008 and these (see page 52) too received a clean bill of 
health. Despite the deepening financial crisis, auditors did not express 
any reservations about the value of the derivatives or any scenarios 
under which company may be unable to honour its obligations. Just two 
months later, Lehman collapsed. 

During 2007, Ernst & Young collected fees (see page 43) of $31,307,000 
from Lehman Brothers, compared to $29,451,000 for 2006. The fees for 
2005 and 2004 were $25,324,000 and $24,748,000 respectively. Over the 
last four years, Ernst & Young collected over $110m in fees, of which 
nearly $14m is for advice on tax and other consultancy services. 

The scale of fees raises questions about auditor independence. By 
providing other services auditors begin to perform quasi management 
functions and cannot objectively evaluate the outcome of the 
transactions they themselves have helped to create. The fee of $110m for 
the New York office of Ernst & Young is likely to be significant in 
influencing the financial rewards of local partners and managers. The 
fee dependency exerts pressure on auditors to acquiesce with management. 
Such concerns were raised during the demise of WorldCom, Maxwell, Enron 
and more recently in the insolvency examiner’s report on the collapse of 
New Century. 

Audit opinions are akin to financial mirages. In recent weeks, within a 
short period of receiving clean bills of health Bear Stearns, Carlyle 
Capital Corporation and Thornburg Mortgage hit the financial buffers, 
closely followed by Lehman Brothers. 

Time and time again it has been shown that the basic audit model is 
faulty. Private sector auditors cannot be independent of the companies 
that they audit. This fundamental faultline has not been addressed by 
the post Enron reforms. In addition, the ex-post financial audits are 
too late and cannot alert financial regulators of problems. The 
financial regulators have a wider remit and are also concerned with the 
financial health of the whole system. These shortcomings were recognised 
after the 1929 stock market crash. The draft legislation that created 
the SEC in the 1930s contained a provision making the SEC the auditor 
for public companies, but under pressure from corporate interests, 
legislation was diluted. 

It is time to go back to the future and ensure that audits of major 
companies, at least banks and financial institutions, are carried out 
directly by the regulators. These audits should be on a real-time basis. 
Audits by regulators have the advantage of independence and can address 
regulatory issues. Accounting firms and companies used to softer audits 
will no doubt fight tooth-and-nail to retain their privileges, but we 
can’t continue to indulge accounting firms and pay billions to rescue 
banks. guardian.co.uk ) Guardian News and Media Limited 2008