Having sidestepped major legal fallout after Lehman, E&Y now stands accused; corporates should take note (and cry a little).
th the spectacular collapse of Lehman Brothers in 2008 and a scathing bankruptcy examiner’s report in March 2010, Ernst & Young likely knew it would be the target of legal action sooner or later. Today is later. A little more than two years after the Lehman debacle, the largest bankruptcy in US history, New York Attorney General Andrew Cuomo filed suit against the auditor, claiming it allowed and encouraged fraudulent accounting practices.
The claims against E&Y are that it blessed regular use of cosmetic accounting gimmicks at the end of each quarter to make its finances appear less shaky than they really were. “Colorable claims exist that Ernst &Young did not meet professional standards,” wrote the bankruptcy examiner in its report. Specifically, Lehman used a type of repurchase agreement – called Repo 105 – that temporarily removed securities from the company’s balance sheet. This, wrote the examiner, created “a materially misleading picture of the firm’s financial condition in late 2007 and 2008.” But Cuomo claims these practices were going on since at least 2001.
However this plays out going forward, it could pose a problem for corporates, many of whom lament the lack of world-class accounting firms left in the world. Not to mention the turmoil such cases cause clients, investors and the business community in general, as was witnessed after Arthur Andersen’s downfall in the wake of the Enron bankruptcy. The reason for the dearth of world-class accounting firms is because most of the top shops have consulting practices, too, and consulting brings in way more income and is far less risky than accounting. Therefore, firms peddle their consulting work more aggressively and they can’t both consult and audit for the same client. This narrows the playing field.
So far E&Y is staying mum, as it likely sorts out the impact of the suit. Unfortunately, like the old saying about cockroaches, i.e., when you see one, there are another 20 you don’t see, the NY action could open up a breach through which a steady stream of lawsuits will flow. If this were to happen it could be a significant blow to the auditing giant, both in terms of business and reputation.
At a March meeting of The NeuGroup’s Internal Auditors’ Peer Group, members said they saw the chances of a complete E&Y meltdown as low; that opinion could change now after the NY AG action. And even back then, in informal discussions at the meeting, members suggested that they were more likely to give business to “second-tier” firms, such as BDO Seidman, Grant Thornton and their ilk, to support these firms and ensure they are up to speed and can step in, if necessary, to pick up the slack if the worst-case scenario for E&Y plays out. But even picking up the slack could be a challenge to the smaller players, much to the frustration of MNCs.
There is no shortage of complaints against the major auditors at NeuGroup peer group meetings – they’re wrong, naïve, opaque, too strict, etc. – but in the end, they serve as a necessary evil.