Ernst & Young charges highlight grey area in leverage accounting – Complinet

By Guest Contributor
December 23, 2010

By Emmanuel Olaoye, Complinet

Civil fraud charges against Ernst & Young LLP have raised the question of whether accounting standards have become so specific that institutions view them as obstacles to maneuver around rather than guidelines for accurate reporting. Legal and accounting experts said that the suit filed by Andrew Cuomo, New York attorney general, was likely to mean the end for transactions such as the “Repo 105″ device at the center of the controversy, particularly if it led to a settlement. It could break new ground in the liability of accounting firms, they added.

The lawsuit has accused E&Y with improperly allowing Lehman Brothers to use a complex accounting transaction known as “Repo 105″ to reduce the apparent debt level of the failed investment bank, giving investors the impression that it had a lower level of debt than it actually did. The lawsuit has claimed that E&Y knew Lehman was treating the transfer of billions of dollars of securities in “Repo 105″ transactions as asset sales rather than loans. “Repo 105″ is the name of the accounting transactions that Lehman used to classify its short-term borrowings as sales. Lehman collapsed in September 2008, at the height of the global financial crisis.

“If there is a settlement this type of transaction would not be used again. The ‘Repo 105′ is radioactive. I don’t think accounting firms will be allowing their clients to use them again,” said Howard Schilit, founder and chief executive of the Financial Shenanigans Detection Group LLC.

Schilit told Complinet that the accounting standards for repurchase agreements such as ‘Repo 105′ were written clumsily and Lehman was easily able to find loopholes. “This is a case to show that if rules were written as they should have been then nobody would have attempted to misinterpret them,” Schilit said.

The Cuomo lawsuit was notable because it focused on the role of the accounting firm and not the role of Lehman executives, said Peter Henning, professor of law at Wayne State University. It raised questions about whether accountants were liable if a financial institution failed to disclose accurately an accounting transaction to investor, he said. “The fact that Cuomo is going after accountants first raises questions. What is the responsibility of the accountant in this? Accountants will always say we are not responsible for financial statements,” Henning told Complinet.

Cuomo said that Lehman engaged in “Repo 105″ transactions approved by E&Y for more than seven years prior to its bankruptcy. The lawsuit is seeking the return of more than $150m in fees that E&Y charged for auditing work and is one of the biggest government cases involving an accounting firm since Arthur Andersen was criminally indicted in 2002 over the Enron scandal. That indictment led to Andersen’s collapse and the introduction of new laws to govern financial reporting and auditing standards.

Schilit said that he did not expect the Cuomo case to have as dramatic an impact on the role of auditors today as the Andersen case because it would likely be resolved in a financial settlement, rather than go to trial. He said, however, that auditors would be forced to stop their clients from using repurchase agreements such as “Repo 105″.

MUDDY WATERS

Billy M Atkinson, a past chairman of the National Association of State Boards of Accountants and a sponsoring member of the Blue Ribbon panel on private companies accounting standards, said that the lawsuit demonstrated how the accounting standards had become so complex that it sometimes made it difficult to identify the intent of the rule. “If I’m the chair of FASB (Financial Accounting Standards Board), I would want to know if the application of the accounting standards is assisting inappropriate behavior from financial institutions or not. I would ask myself what I had to do to change the accounting process.”

Atkinson contrasted the rules-based approach of the Financial Accounting Standards Board with the principles-based approach of the International Financial Reporting Standards. He said that the IFRS standards required financial institutions to give more thorough disclosures about alternative treatments of off-balance sheet transactions. He declined to comment directly on the E&Y case but said generally that auditors’ hands would be tied as long as financial institutions could say that their actions were in accordance with general accepted accounting principles.

“Complex accounting standards result in complex transactions that may sometimes avoid the rules,” Atkinson told Complinet. “The lawsuit is an opportunity to revisit the accounting standards to see whether the rules are supporting inappropriate behavior or not.”

Ronald Huefner, a professor of accounting at State University of New York at Buffalo, said that the Cuomo case highlighted the grey area between what was “permissible and aggressive” and what was “impermissible and fraud”. He said that accounting firms had always used repurchase agreements as legitimate measures to raise cash but the collapse of an institution the size of Lehman highlighted the use of complex accounting techniques.

“No one gives care to these transactions unless something big happens,” Huefner said, adding that Cuomo’s suit would ultimately boil down to the issue of disclosure — whether E&Y allowed Lehman to use “Repo 105″ to deceive its investors.

“If Ernst & Young inappropriately agreed to these measures to keep a client happy it will be liable.”

Emmanuel Olaoye (Emmanuel.Olaoye@ThomsonReuters.com) is a correspondent for Complinet. Complinet, part of ThomsonReuters, is a leading provider of connected risk and compliance information and on-line solutions to the global financial services community. Established in 1997, Complinet serves over 100,000 industry professionals in 80+ countries. Its connected approach provides one single place to get all the relevant regulatory news, analysis, rules and developments from the region to support firms in highly regulated industries.

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