The author of this report is asked to answer to several case study questions related to the collapse of Lehman Brothers and what led up to it. The first question asks about Lehman Brothers' Repo 105 policy and what, if any, policy Ernst and Young (its auditor) had at that point to develop the accounting policy and process as well as monitor Lehman's usage and compliance of the same after the fact. The author is then asked to answer to whether there can be agreement with the comment "intent doesn't matter" as it applies to accounting rules. The third question asks whether the auditors have a responsibility to determine whether important transactions of a client are "accounting motivated" and the author is asked to defend any response given. Finally, the author is asked to analyze Lehman's net leverage ratio as related to the fact that the figure was not reported in the financial statements but was instead only featured in the financial highlights table only. The related question to that being the case is whether auditors have a duty to step in and insist on changes in such a situation.
As noted in the introduction, the first question for this case study asks whether Ernst and Young had a responsibility to intercede in the codification and execution of Lehman's Repo 105 policy and the ensuing transactions related to the same. The answer to this question is a unquestionable "yes" as it is clear that this was a major catalyst for Lehman's eventual collapse but the answer would still be "yes" even if that were not the case and everything worked out fine for Lehman (Ernst & Young, 2013).
Part of bringing in an external auditor of any sort, regardless of what the external firm does or does not do, is to make sure that the firm is crafting accounting policies and frameworks that are based on best practices and in a way that is completely transparent to the investors. Just because something is risky does not mean that Ernst and Young or any other external auditor should intercede but rather the burden is to make sure that the investors are practicing actual informed consent and know what they are getting into. However, if the crafting of a policy and/or how well it is followed after the fact is clearly deficient and/or clearly at odds with legal and ethical practices, the external auditor bears a responsibility to keep the firm honest and aware of their concerns and if the firm will not listen to the external auditor, then Ernst has a responsibility to report what they know and, if necessary, remove themselves from the situation. It is much like an attorney/client relationship where the client is not doing what is best for achieving innocence with the main difference in this analogy as compared to real-world practice is that if the client is guilty, the "attorney" (Ernst) has a responsibility to not contribute to the bad practices and/or any deception on the part of its client (Ernst & Young, 2013).
As the industry professionals, and because they are paid to give the best and most honest advice (supposedly), Ernst must make sure to give all relative and important input during a Repo 105 policy construction process or anything similar that is related to ethics, legal concerns or ostensibly impropriety, whether there is actual malfeasance or not. The external accounting firm should be honest and blunt and should never be compromising their values or the law and they should never bend to the client's will just because the insist on doing something that is or could appear to be unseemly to the broader business or accounting industries. Failure to do this can often damage the exernal auditor even more than the bad-acting firm because one of the cornerstones of Ernst and Young's business is to act as a disinterest third party that is simply there to say whether or not a firm is acting right and they thus have a duty to react if there indeed something improper occurring, whether it be related to actual law-breaking or ethics violations or even just the appearance of the same (Ernst & Young, 2013).
In short, Ernst cannot bark orders at Lehman or anyone else that they serve as an auditor for but they have a duty to not compromise their values, the law or their reputation and they must be willing and able to be a direct partner in the crafting of an accounting policy even if the firm they are serving is resistant or even openly hostile to the suggestions or requirements that the auditor stipulates. Ernst was not hired to be a lapdog for Lehman (or any other client they have, do or will serve) and they should not allow themselves to act as such or feed the perception that they are doing so in any way (Ernst & Young, 2013).
The next question that the author is to answer on this case study is to answer to the statement that "intent doesn't matter" as it relates to accounting rules. The restating of the question poses whether, so long as it's technically within the rules, reporting entities should be allowed to report their data in such a way that embellishes their current financial state. The answer to that is multi-dimensional but the answer is basically "no"…intent does not matter. The other side to that answer is the fact that financial data should not be positioned or reported in such a way that obfuscates what is really going on and firms should be clear about why (Ernst & Young, 2013).
Some may see such embellishment as always evil and always maleficent but the author of this reply does not see things in such a black or white fashion. For example, a huge dip in profits can easily be because of a one-time charge or some other ad hoc even that will probably not occur again, at least in the near-term. Rather than fiddle with the numbers or otherwise hide that charge or its effects, the firm should just be open and honest about it and be sure to note that it's a one-time event that will almost certainly not be a recurring problem. Indeed, firms may do this because they are worried about how analysts and investors will react but being honest will be a much better idea in the long run than hiding the charge or its effects because hiding it and being caught hiding it will be immensely more damaging than if the honesty is just offered in the first place (Ernst & Young, 2013).
The real reason the "intent doesn't' matter" answer is a "no" is because it never looks good when embellishment occurs and this is even true if the accounting rules and regulations that are applicable, such as GAAP or any of the international frameworks, are followed because the intent "blank" if filled in by the analysts and they care not at all what a firm might way in public about it as the analysts will often fear the worst and report the same. In a post-Enron and post-Lehman world, hiding losses is a very bad idea because people will assume the worst when it comes to light and it almost always does if it goes on long enough or is too high an amount. Analysts and investors often are much more diligent now than they have been in the past due to the recent massive scandals that occurred in just the last ten to fifteen years let alone what happened before then (Ernst & Young, 2013).
A private firm can skew its numbers however they like because they have no public investors to speak to, just private ones and that relationship and that is not subject to SEC or other legal review most of the time. However, any company whose stock is purchasable from the general public (which often includes the firm's own employees) has a duty to be open and honest and just because an accounting rule is being followed does not necessarily make the reporting tactics proper ones (Ernst & Young, 2013).
The third question to be answered, and also the third question in the case study, is whether or not auditing firms have a responsibility to police or otherwise try to intercede with transactions that seem to be or are clearly accounting-related in nature. In other words, if there is a transaction being undertaken that is clearly meant to improve the financial state (or at least the appearance) of a firm rather than serving a legitimate business need, the question is whether external auditors should get involved with that (Ernst & Young, 2013).
The author of this response would offer that the answer to that question is dependent on what exactly is going on and how deep the proverbial rabbit hole goes. An external auditor should have a clear and complete picture of what is…