The Sarbanes-Oxley Act was supposed to safeguard the US from another Enron-style accounting scandal. But the examiner’s report into Lehman Brothers’ failure has shed light on a new one. The parallels between the two bankruptcies are striking. First are the chief executives who claim ignorance of material measures. Second is the use of ugly, reality-cloaking off-balance sheet transactions. The resultant “repo 105/108” transactions, which in Lehman’s final three quarters increased by almost one-third to $50bn, massaged the bank’s period-end balance sheets and reduced its reported leverage.
But this type of financial window dressing is neither exclusive to Lehman nor, prima facie, illegal. It appears audit requirements were followed, and the technicalities of the dubious transactions rubberstamped by London law firm Linklaters before the accounts were signed off. So in spite of refusals by William Schlich, Ernst & Young’s lead audit partner for Lehman, to answer some of the examiner’s more pointed questions, the Big 4 audit group should make it through the scandal intact – albeit with a heavily dented reputation.
Investors, though, will be left shaking their heads once again. The spirit of the rules has been side-stepped and their confidence in the profession will be shaken. Although E&Y knew both the extent and consequences of Lehman’s addiction to repo transactions, accounting rules didn’t necessarily require it to disclose any concerns.
Fixing the problem requires wholesale change. Currently, auditors are paid by the company they inspect. This is like a home-buyer relying on an inspection report commissioned by the seller. A better system might be for auditors to be employed directly by the securities regulator who 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.
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