Ever since the fraud at U.S. energy trader Enron Corp brought down accounting firm Arthur Andersen eight years ago, global auditing firms have worried that a major misstep could be fatal.
Over the past few years, the firms have pushed for liability caps on litigation and settled dozens of cases, all amid concerns that each of the Big Four accounting firms faces potential litigation from undetected frauds at large public companies that could destroy them.
Ernst & Young became the latest auditor to come under fire this week after the court-appointed examiner in the Lehman Brothers Holdings Inc bankruptcy said the audit firm did not challenge accounting gimmicks that allowed Lehman to hide some $50 billion in assets in 2008, while claiming it had reduced its overall leverage levels.
As an auditor, you're always concerned when you're auditing a large company that ultimately fails, said Lynn Turner, a managing director in the forensic accounting practice at consulting firm LECG and former chief accountant of the Securities and Exchange Commission.
But a lot of those do occur where the auditors come out OK and the auditors aren't at risk -- obviously in this case the examiner thinks differently, Turner added.
At issue is a repurchase and sale program called Repo 105, which Lehman used without telling investors or regulators, and the examiner concluded was used for the sole purpose of manipulating Lehman's books.
In the examiner's report Lehman executives described the Repo 105 as everything from window dressing and an accounting gimmick to a drug.
According to the examiner's report, Ernst & Young's lead partner on the Lehman audit said the firm did not approve the Repo 105 accounting policies, but rather became comfortable with its use.
Lehman, which filed the largest U.S. bankruptcy case in history on September 15, 2008, is likely to use some of the examiner's claims to pursue lawsuits against those it believes are responsible for the investment bank's collapse.
This is like the horses getting out of the starting gate on the track -- the lawyers are going to sue the pants off anyone and everybody involved, said Anthony Sabino, a securities law professor at St. John's University's Tobin School of Business.
Bryan Marsal, chief executive of Lehman Brothers Holdings Inc and co-founder of restructuring firm Alvarez & Marsal, said through a representative that Lehman will carefully evaluate it in the coming weeks to assess how it might help us in our ongoing efforts to advance creditor interests.
Lehman's examiner, Anton Valukas, found the repo transactions to be partly responsible for Lehman's demise, and said Lehman may have colorable claims against Ernst & Young for failing to notice that the repos lacked a business purpose.
Auditors are supposed to look at the substance of such transactions in addition to seeing whether they have actually complied with U.S. accounting rules, Turner said, noting that he has not seen anything that would prove to him that the Repo 105 transactions complied with U.S. Generally Accepted Accounting Principles.
Ernst & Young said in a statement: Our last audit of the company was for the fiscal year ending November 30, 2007. Our opinion indicated that Lehman's financial statements for that year were fairly presented in accordance with Generally Accepted Accounting Principles (GAAP), and we remain of that view.
After an exhaustive investigation the examiner made no findings in his report that Lehman's assets or liabilities were improperly valued or accounted for incorrectly in Lehman's November 30, 2007, financial statements.
According to the examiner's report, Ernst & Young had just started planning for its year-end audit of Lehman, when the firm collapsed into bankruptcy.
They are going to say, hey, we got hoodwinked like everybody else, Sabino said.
They've got defenses. For the directors and the officers, they're in a much tougher spot.
But most troubling for the auditors could be allegations in the examiner's report that Ernst & Young did not inform the audit committee on Lehman's board about a whistleblower who had expressed concerns about the repos to them.
For Ernst & Young, the firm has previously faced similar allegations that it failed to notify a board of directors when it discovered potential problems in a tangle with U.S. securities regulators over its audits of health club operator Bally Total Fitness .
In December, the Big Four firm agreed to pay the U.S. Securities and Exchange Commission an $8.5 million fine, one of the highest settlements ever paid by an accounting firm.
Fines are not the only cost the firm might face, however.
If nothing else, it's perception -- this is going to cost them a whole lot in legal fees, and it's damaging to their reputation, Sabino said.
(Reporting by Emily Chasan; Editing by Gary Hill)