Ernst & Young, PwC under fire

MANILA, Philippines – Two top international accounting firms are now under fire for their role in the financial meltdown that is up to now causing untold difficulties to economies and people everywhere. The last time a large accounting firm got into similar trouble was when Enron fell apart and Arthur Andersen, its accounting firm, subsequently collapsed under the weight of its legal problems. Andersen’s local affiliate at that time was SGV.

Ernst & Young, whose local practice had recently been incorporated with SGV, was accused by New York prosecutors of helping Lehman Brothers engage in a “massive accounting fraud.” PricewaterhouseCoopers (PwC), on the other hand, was alleged to have missed numerous warning signs about the state of Iceland’s banks whose subsequent failure caused an economic and political crisis in that country.

According to a Financial Times report, the civil lawsuit in New York alleges that Ernst & Young “substantially” helped Lehman mislead investors from 2001 until it went bankrupt in 2008 by signing off on an accounting sleight of hand. The FT further reports that “the strongly worded lawsuit goes further than accusing Ernst & Young of misconduct. It alleges Lehman engaged in a ‘massive accounting fraud’ by using the accounting treatment known as Repo 105.”

The suit alleges that Ernst & Young could be liable for malpractice by approving the treatment which allows Lehman to remove some securities from its financial statement giving the impression that it had lowered its debt. The practice, according to the FT, gave a “false” impression to investors of Lehman’s financial health. Ernst & Young made $150 million in fees between 2001 and 2008. The New York Attorney General is seeking the return of all these fees plus damages.

Ernst & Young claims the practice is legal. But the FT notes, “the issue is where to draw the line between allowable window-dressing and deliberate concealment. Thus the extent of the repo transactions allowed by Ernst & Young and not the legality of the transactions themselves will be under the spotlight.” That may also be more of an ethical question but the suit now gives it legal implications.

In the PwC case, investigators found out that the banks “grossly overstated” their financial strength, hidden large risk exposure and failed to disclose the full extent of lending to the banks’ owners and other related parties. It is claimed, the FT reports, that PwC showed “negligence” in failing to spot financial misstatements that should have led to the banks losing their operating licenses.

The reports argue that losses from the eventual crash would have been reduced had PwC not given its endorsement to the faulty accounts at the end of 2007. “The audit work was below acceptable standards in important areas,” the FT quotes the investigators’ report. PwC, according to the FT, said it stood by its audit, which means nothing in the light of the bank failures.

The two cases have important local implications if only because both international firms are operating here. The case of Ernst and Young is of particular interest because it would seem from the New York case that it is willing to bend over backwards for a client, something we already saw with Arthur Andersen in the Enron case. It would seem that the bean counters have not learned the lessons from the Andersen case.

I, for one, least expected Ernst and Young to be so malleable to a client’s wishes. It will be recalled that this is the same audit firm that refused to sign off on the financial reports of a large Philippine conglomerate on the eve of its bond offering. The audit firm claimed the conglomerate’s books were not reflective of its true state… something that had to do with alleged inventory fixing. Now it seems, if the Lehman case is to be believed, the audit firm could have been persuaded with the right fees… Or it might have been inclined to see things the conglomerate’s way if it was American, rather than Filipino.

Many years after Enron and Andersen, government regulators must once more review its rules to make sure the bean counters are not tempted enough to put ethical considerations aside. Then again, it would seem that no regulation can really assure the integrity of a bean counter’s work. In the end, only a strong commitment to ethical standards can assure an honest audit.

We still don’t know if the case filed by the New York Attorney General against Ernst & Young is lethal enough to make it follow the fate of Andersen. But we do know now with these two cases that the shadow of doubt had been cast on the integrity of their work.

That is a worrying thought because we are now being told that if the bean counters did a better job, the tragedies of collapsing financial institutions may have been arrested in time. Next time we see financial statements with their signatures, market analysts and regulators should view them with skepticism.

At the very least, we should shed our colonial mentality… the thing that makes us accept without question anything that is associated with a big American institution. Maybe some all-Filipino firms could do a whole lot better. –Boo Chanco (The Philippine Star)