Accounting for a Banking Collapse; City FOCUS

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Byline: Rob Davies

THE spotlight in the financial crisis blame game has fallen largely on champagnequaffing bankers, blinkered regulators and politicians obsessed by a 'light touch' approach to financial regulation.

Until last week, the less glamorous world of auditing had emerged from the fallout relatively unscathed.

But the publication of a 2,200-page report by US lawyer Anton Valukas into how Lehman Brothers hid its proximity to the abyss has placed its auditor, Ernst & Young, firmly in the firing line.

Valukas highlighted Lehman's repeated use of a practice called 'Repo 105', which saw it temporarily sell instruments in the lead-up to its quarterly results, allowing it to quickly generate cash to reduce apparent levels of leverage dramatically.

The bank then bought the assets straight back, a procedure it used to hide [pounds sterling]33bn in illiquid assets, which it channelled through its offices in London, where accounting standards make the practice easier. Despite concerns raised with E&Y by whistleblowers within the bank, the auditor signed off on the 2007 accounts and Lehman continued to use Repo transactions into 2008.

Despite Valukas's assertion that there is a 'colourable case' for E&Y to face legal action for malpractice and legislation, the firm protests that Lehman's accounts 'were fairly presented in accordance with Generally Accepted Accounting Principles'.

So if the accounts were 'fairly presented' - despite hiding serious problems at the heart of a systemically important bank - could it be global accounting standards and the audit process as a whole that need an overhaul? 'There's no doubt that the role of auditors has to evolve,' says Steve Priddy, director of technical and policy research at the Association of Chartered Certified Accountants.

'They have to think about the risks that organisations run, the assumptions behind underlying business models and the effectiveness of corporate governance.' For that process to begin, says Priddy, there needs to be a new set of international accounting standards with teeth, to abolish the regulatory arbitrage under which Lehman used UK jurisdiction to perform accounting magic tricks prohibited in the US.

Reform will no doubt be on the agenda when Sir David Tweedie, chair of the International Accounting Standards Board, meets European finance ministers this week. The IASB has plenty to chew over. E&Y was not alone in signing off the 2007 accounts of institutions that spectacularly fell from grace the following year. …