Further Reading
  • Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, Third Edition
    Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, Third Edition
    by Howard Schilit, Jeremy Perler
  • Stolen Without A Gun: Confessions from inside history's biggest accounting fraud - the collapse of MCI Worldcom
    Stolen Without A Gun: Confessions from inside history's biggest accounting fraud - the collapse of MCI Worldcom
    by Walter Pavlo Jr., Neil Weinberg
  • Final Accounting: Ambition, Greed and the Fall of Arthur Andersen
    Final Accounting: Ambition, Greed and the Fall of Arthur Andersen
    by Barbara Ley Toffler, Jennifer Reingold
  • Power Failure: The Inside Story of the Collapse of Enron
    Power Failure: The Inside Story of the Collapse of Enron
    by Mimi Swartz, Sherron Watkins
  • WorldCom: The Accounting Scandal (Congressional Research Service)
    WorldCom: The Accounting Scandal (Congressional Research Service)
    by Bob Lyke Congressional Research Service, Mark Jickling Congressional Research Service
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« Study: Many Executives Escape Punishment for Accounting Fraud | Main | Ernst & Young's Many Past Legal Problems »
Friday
Jan142011

Will the Accounting Industry Ever be Reformed?

The history of accounting is filled with sorry stories of accountants helping to cover up frauds by corporations and banks. Long before Arthur Andersen famously collapsed in 2002 after being indicted on federal charges related to the Enron scandal, the accounting industry faced big ethical problems.

Accounting firms were implicated in some of the frauds that preceded the stock market's collapse in 1929 and helped facilitate some of the corporate frauds of the late 1960s and early 1970s. In fact, the ethics problems in accounting were seen as so serious that Congress undertook hearings on this issue in the mid-1970s and debated tougher oversight of the profession. A major report released by a key subcommittee chaired by Senator Lee Metcalf in 1976 stated:

Doubts as to the accuracy and reliability of information reported by corporations have resulted from continual revelations of corporate misconduct which was not found or not reported by independent auditors. Congress and the public have little assurance that corporate financial statements accurately portray the results of business activities because of flexible, alternative accounting standards. Public confidence in independent auditors, which is essential to the success of the federal securities, has been seriously eroded.

No new legislation was enacted at that time and major accounting firms went on to be deeply implicated in the Savings and Loan scandals of the 1980s. "Accountants didn't cause the S&L crisis," said Senator Ron Wyden in 1992. "But they could have saved taxpayers a lot of money if they did their jobs properly and set off enough warning alarms for regulators."

More hearings were held, but not much was done. Then came the frauds and earnings scandals at Enron, WorldCom, and many other companies. The combination of Arthur Andersen's collapse and the passage of Sarbanes-Oxley changed the calculus and put the accounting industry on notice that regulators would take a tougher approach.

Yet here we are just a few years later with the revelation that Ernst & Young may have covered up massive financial missreporting by Lehman Brothers. That missreporting helped ensure Lehman's rapid collapse and the financial crisis that followed.

The allegations were made in late December in suit filed against Ernst & Young by New York State Attorney General Andrew Cuomo. You can read the text of the suit below. A press release by Cuomo's office summarized their case this way:

The Attorney General’s lawsuit claims that for more than seven years leading up to Lehman’s bankruptcy filing in September 2008, Lehman had engaged in so-called “Repo 105” transactions, explicitly approved by E&Y. The transactions purpose was to temporarily park highly liquid, fixed-income securities with European banks for the sole purpose of reducing Lehman’s financial statement leverage, an important financial metric for investors, stock analysts, lenders, and others interested in Lehman.

“This practice was a house-of-cards business model designed to hide billions in liabilities in the years before Lehman collapsed,” said Attorney General Cuomo. “Just as troubling, a global accounting firm, tasked with auditing Lehman’s financial statements, helped hide this crucial information from the investing public. Our lawsuit seeks to recover the fees collected by Ernst & Young while it was supposed to be using accountable, honest measures to protect the public.”

The complaint, filed in New York Supreme Court, alleges that E&Y was fully aware of Lehman’s fraudulent Repo 105 transactions, specifically approved of Lehman’s use of them, and gave Lehman an unqualified audit opinion every year from 2001 to 2007, despite knowing that they concealed the Repo 105 transactions. Further, the lawsuit alleges that in 2007 and early 2008, when Lehman was facing demands to reduce its leverage, Lehman rapidly accelerated its use of Repo 105 transactions, removing up to $50 billion from its balance sheet on a quarterly basis without disclosing the use of the Repo 105 transactions.

The complaint also alleges that E&Y failed to object when Lehman misled analysts on its quarterly earnings calls regarding its leverage ratios, and that E&Y did not inform Lehman’s Audit Committee about a highly-placed whistleblower’s concerns about Lehman’s use of Repo 105 transactions.

The Attorney General seeks the return of the entirety of fees E&Y collected for work performed for Lehman between 2001 and 2008, exceeding $150 million, plus investor damages and equitable relief.

Boy, all that sounds familiar, doesn't it? Sounds a lot like the kind of stuff that Arthur Andersen did for Enron in helping it mask high levels of debt in various subsidiaries.

(Ernst & Young responded to Cuomo's charges by stating: There is no factual or legal basis for a claim to be brought in this context against an auditor where the accounting for the underlying transaction is in accordance with the Generally Accepted Accounting Principles (GAAP). Lehman’s audited financial statements clearly portrayed Lehman as a highly leveraged entity operating in a risky and volatile industry.)

If Ernst & Young did do something wrong, why does this kind of thing keep happening? Well the answer can be found in that last paragraph, about the huge fees that Ernst & Young collected during its work for Lehman. When a client like Lehman is worth millions and millions, there is a natural reflex to make them happy -- even if that is fundamentally unethical.

Accountants are in a famously tough spot: They were as supposed to serve as watchdogs of the financial system and ensure that companies are being honest about their finances. But they are also being paid to serve those same companies. The new regulations put in place after Enron were supposed to make it easier for accountants to do the right thing. Clearly those laws aren't tough enough.

Cuomo Lawsuit Against Ernst & Young

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