New at Forbes: My Comments On The Latest Sanctions Against Ernst & Young

As if Ernst & Young didn’t have enough to worry about:

To his credit, Judge Kaplan does leave one important allegation for Ernst & Young to defend:

Ernst & Young had reason to know that Lehman’s 2Q 2008 financial statements could be materially misstated because of the extensive use of Repo 105 transactions.

John McDermott of FT Alphaville does a good job explaining why:

Kaplan dismisses the majority of the specific allegations against the auditors but writes that one particular incident means that the case against them cannot be thrown out [when] he stops to ask another question on Repo 105:

In other words, have plaintiffs sufficiently alleged that E&Y knew enough about Lehman’s use of Repo 105s to “window-dress” its period-end balance sheets to permit a finding that E&Y had no reasonable basis for believing that those balance sheets fairly presented the financial condition of Lehman?

The answer: yes, in one case.

Plaintiffs rely for this purpose on precisely the same alleged red flags discussed previously in connection with E&Y’s GAAS opinion – the “true sale” opinion, the netting grid, and the Lee interview. The first two are no stronger in this context than in that. The Lee interview, however, is a different matter.

The “Lee interview” pertains to warnings allegedly made by Matthew Lee, Lehman’s SVP for Global Balance Sheet and Legal Entity Accounting, that Ernst & Young were told of a $50bn repo 105 move in June 2008 but did not pass on the full information to Lehman’s board. Thus, it failed to fulfill GAAP requirements as part of its Q2 2008 auditing.

I’ve been saying for a while that there’s too much deflective focus on the accounting for Repo 105 and not enough on the disclosure.

Now they’ve got a public airing of some dirty laundry by the PCAOB.

From Compliance Week:

The Public Company Accounting Oversight Board has barred the now-former E&Y partner, Peter O’Toole, from associating with a PCAOB-registered firm for three years and fined him $50,000. The board barred the now former senior manager, Darrin G. Estella, from associating with a PCAOB-registered firm for two years. Both auditors can petition the board for reinstatement at the end of their penalty periods. In December, the PCOAB issued an earlier action against Jacqueline Higgins, an E&Y manager, in connection with the same incident.

The PCAOB says the three auditors created, backdated, and added documentation to an audit file when they learned it would soon be inspected by the board. The disciplinary orders say O’Toole was the engagement partner for an audit of an unnamed public company with a Sept. 30, 2009, year-end. The firm gave the company a clean audit opinion on Nov. 23, 2009, then learned the audit would be inspected in April 2010, with inspectors planning to study “securities valuation.”

Ernst & Young spokesman Charlie Perkins tells The Financial Times, “no harm, no foul,” as far as the firm is concerned.

“Our firm’s policy explicitly prohibits persons from supplementing or changing audit workpapers in circumstances like those present here,” said Charles Perkins, a spokesman for Ernst & Young, in a statement.

“When we determined that firm policy had been violated, we subsequently separated the partner and senior manager from the firm. We have co-operated fully with the PCAOB throughout its investigation of this matter. The conduct described in the order had no impact on our audit conclusions or on the client’s financial statements.”

Unless there are sanctions, we won’t know if more of this kind of thing is happening at U.S. firms. That’s becasue that part of the PCAOB inspection report is private.

We do know it’s happening at Ernst & Young in the U.K. Repeatedly.

From my post at Forbes.com, “By Any Means Possible: Auditors Try To Meet Standards By Faking It”:

The latest inspection report for Ernst & Young in the U.K., the same global firm that the PCAOB recently disciplined, cited specific deficiencies: (The AIU inspected thirteen engagements of a total of 295 eligible.)

Signing and dating of audit reports:

On two audits the auditor’s report was signed prior to the completion or evidencing of all necessary review procedures.

Completion of audit disclosure checklists:

…On two of the files that we reviewed it was unclear from the audit file whether the team had re‐performed the completion of the financial statements disclosure checklist.

Audit finalisation:

We found weaknesses in connection with audit finalisation procedures on seven of the audits we reviewed. The majority of these weaknesses related to undetected clerical drafting errors in the accounts including, in one case, an error in the disclosed audit fee.