Lehman Brothers Collapse: Repo 105 and Auditor Ethics

Introduction

This report answers several case study questions related to the collapse of Lehman Brothers and the events that led up to it. The first question concerns Lehman Brothers' Repo 105 policy and what responsibility Ernst & Young, its external auditor, had to help develop the accounting policy and process, as well as to monitor Lehman's usage and compliance after the fact. The second question asks whether there can be agreement with the statement that "intent doesn't matter" as it applies to accounting rules. The third question asks whether auditors have a responsibility to determine if important client transactions are "accounting motivated," and requires a defended response. Finally, the paper analyzes Lehman's net leverage ratio in relation to the fact that the figure was not reported in the full financial statements but appeared only in a financial highlights table, and addresses whether auditors have a duty to insist on changes in such a situation.

Ernst & Young's Responsibility in the Repo 105 Policy

The first question asks whether Ernst & Young had a responsibility to intercede in the codification and execution of Lehman's Repo 105 policy and the ensuing transactions related to it. The answer is an unquestionable "yes." It is clear that this policy 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 had worked out well for Lehman (Ernst & Young, 2013).

Part of bringing in an external auditor is to ensure that the firm is crafting accounting policies and frameworks based on best practices and in a manner that is completely transparent to investors. Just because something is risky does not mean that Ernst & Young or any other external auditor should automatically intercede; rather, the obligation is to ensure that investors are exercising genuine informed consent and understand what they are getting into. However, if the crafting of a policy — or the degree to which it is followed — is clearly deficient or at odds with legal and ethical practices, the external auditor bears a responsibility to keep the firm honest. If the firm will not heed the external auditor's concerns, Ernst & Young has a responsibility to report what it knows and, if necessary, withdraw from the engagement. This is somewhat analogous to an attorney-client relationship, with one critical difference: if the client is acting improperly, the "attorney" — in this case, Ernst — has a responsibility not to contribute to those bad practices or to any resulting deception (Ernst & Young, 2013).

As the industry professionals, and because they are paid to provide the best and most honest advice, Ernst & Young must ensure it provides all relevant and important input during a Repo 105 policy construction process, or anything similar that touches on ethics, legal concerns, or ostensible impropriety, whether or not actual malfeasance is present. The external accounting firm should be honest and direct and should never compromise its values or the law simply because a client insists on doing something that is, or could appear to be, unseemly to the broader business or accounting industries. Failure to act in this way can often damage the external auditor more than the bad-acting firm, because one of the cornerstones of Ernst & Young's business is to act as a disinterested third party whose role is to assess whether a firm is acting appropriately. They therefore have a duty to respond when something improper is occurring, whether it involves actual law-breaking, ethics violations, or even just the appearance of either (Ernst & Young, 2013).

In short, Ernst & Young cannot issue commands to Lehman or any other audit client, but they have a duty not to compromise their values, the law, or their reputation. They must be willing to be a direct partner in crafting an accounting policy even when the client is resistant or openly hostile to the auditor's suggestions or requirements. Ernst was not hired to be a lapdog for Lehman — or for any client they have served or will serve — and they should not allow themselves to act as such, nor permit any perception that they are doing so (Ernst & Young, 2013).

Does Intent Matter in Accounting Rules?

The second question asks whether, so long as reporting is technically within the rules, reporting entities should be permitted to present their financial data in ways that embellish their actual financial state. The answer is multi-dimensional, but the core position is that intent does not make such embellishment acceptable. The complementary point is that financial data should not be positioned or reported in a way that obscures what is really going on, and firms should be transparent about why they present data as they do (Ernst & Young, 2013).

Some may see any embellishment as inherently malicious, but that view is overly binary. For example, a significant dip in profits can result from a one-time charge or some other non-recurring event. Rather than manipulate the numbers or conceal that charge and its effects, a firm should be open and honest about it, making clear that it is a one-time event unlikely to recur in the near term. Firms may fear how analysts and investors will react, but honesty will serve them far better in the long run than concealment — because being caught hiding a charge is immensely more damaging than disclosing it transparently in the first place (Ernst & Young, 2013).

The real reason the "intent doesn't matter" position resolves to "no" is that embellishment never reflects well on a firm, even when applicable accounting rules and regulations — such as GAAP or international frameworks — are technically followed. Analysts will fill in the blanks themselves, and they care little about what a firm says publicly; they will often assume the worst and report accordingly. In a post-Enron and post-Lehman environment, hiding losses is a particularly poor strategy because people will assume the worst when it comes to light — and it almost always does, if the amounts are large enough or the practice continues long enough. Analysts and investors are now far more diligent than they once were, sharpened by the massive scandals of the past decade and a half (Ernst & Young, 2013).

A private firm has more latitude to present its numbers as it sees fit, since it has no public investors and its reporting is generally not subject to SEC review. However, any company whose stock is available for purchase by the general public — which often includes the firm's own employees — has a duty to be open and honest. Following an accounting rule does not automatically make a reporting tactic a proper one (Ernst & Young, 2013).

Conclusion

Leaving the leverage data out of the full report constitutes a material sin of omission in the financial accounting sense. While the ratio did appear in the highlights section, it should have been in both places — and most importantly, it should have been in the full report. What Lehman did was almost certainly deliberate, and even if it was not, it would reasonably appear that way to any analyst or investor who expected to find the leverage ratio within the full report, where it could be assessed alongside all other financial data rather than tucked away in a summary elsewhere (Ernst & Young, 2013).

External auditors must ensure they are intimately involved in the policy execution and enforcement process. They are not meant to be friends of their clients, and they place themselves in serious jeopardy if that becomes the perception — as demonstrated by Arthur Andersen's cooperation with Enron in its financial misdeeds. Ernst & Young appears to have escaped that level of blame when Lehman collapsed, which reflects well on the firm in the sense that it was evidently not complicit in Lehman's misconduct. Even so, Ernst & Young and its counterparts — Deloitte, KPMG, and others — must remain ever-vigilant and maintain a clear, unambiguous line between their own auditing standards and the potential bad acts of their clients.