Role of Auditors in Crisis Gets Look

Role of Auditors in Crisis Gets Look
By MICHAEL RAPOPORT

Until this week when civil-fraud charges were brought against Ernst & Young LLP for its role in the collapse of Lehman Brothers Holdings Inc., auditors had largely side-stepped blame for the financial crisis.

Yet auditors had to pass judgment on some of the practices that caused the big losses that led to government bailouts. The case against Ernst highlights the roles accounting firms played and raises questions about whether reforms enacted after the last financial crisis went far enough.

Auditors weren't involved in a lot of the primary causes of the crisis: bad lending and investing decisions; a lack of understanding of risk; and flaws in the credit-rating system. Auditing isn't meant to stop companies from making dumb business moves—just to make sure those moves are properly disclosed.

Accounting firms were at the center of the last financial crisis, when companies such as Enron Corp. and WorldCom Inc. collapsed amid scandals. New accounting rules focused on the abuses of the time, but touched on some of the issues in the Ernst case, including the relationship between companies and their auditors, the processes companies have in place to prevent fraud or errors in their financial statements, and the way companies value their assets.

Ernst has denied the allegations in the civil-fraud suit filed against it Tuesday by New York Attorney General Andrew Cuomo. The firm declined to comment further beyond its statement Tuesday in which is said there was "no legal or factual basis" to bring a claim against it.

Every big auditing firm had clients that blew up or required huge government bailouts or engaged in questionable practices leading up to the crisis. PricewaterhouseCoopers LLP is the auditor for American International Group Inc. and Goldman Sachs Group Inc., for example. KPMG LLP audits Citigroup Inc. Deloitte & Touche LLP was the auditor for Bear Stearns Cos. and audits Fannie Mae.

Several investigations are currently underway into some of these companies and their auditors, though none are expected to yield charges in the immediate future.

"We have to take this as a very serious red flag that there really may be something that has changed in the audit industry," said Lynn Stout, a professor of corporate and securities law at the University of California, Los Angeles.

That's particularly the case with the valuation methods for companies' assets, she said. "Companies rely on auditors to bless their valuation methods and there's so much subjectivity," Ms. Stout said. "There's a real problem if we can't rely on the valuations."

Lynn Turner, a former Securities and Exchange Commission chief accountant, said auditors did perform better after the Sarbanes-Oxley Act, which took effect in 2002. But around 2006, faced with a slowing economy, they "stepped back from that, reversing course, heading back down the same old road they've been on before the corporate scandals."

In addition, a series of court rulings in recent years have made it tougher to hold auditors accountable when their work is flawed. In 2008, for instance, the U.S. Supreme Court restricted the ability of shareholders defrauded by a company to sue third parties such as the company's accountants.

Others believe auditors have performed well recently. Michael Young, a lawyer at Willkie Farr & Gallagher specializing in cases involving accounting irregularities, said auditors have actually been pretty tough during the crisis in forcing companies to justify their valuation methods, a move which has resulted in many banks having to write down the value of their assets.

"By and large, the accountants rose to the occasion," Mr. Young said.

Michael J. Gallagher, head of PricewaterhouseCoopers' U.S. national office, said, "This was fundamentally an economic crisis, but all parties in the financial reporting chain should use the lessons learned to continue improving financial reporting going forward to better serve investors and the capital markets."

A spokesman for KPMG declined to comment. A spokesman for Deloitte couldn't be reached for comment.

Some see parallels in the role played by the credit-ratings firms in the current crisis and the one played by the auditors. In both cases, the firms are paid by the companies they are supposed to evaluate independently. "When the people being watched get to choose their watchdog, they're not going to choose the toughest animal around," Ms. Stout said. Lehman paid Ernst $185 million in fees in the decade before the investment bank collapsed.

Asset valuation is one area in which investors and regulators might question accountants. Banks still carry huge amounts of potentially questionable assets like mortgage-backed securities and collateralized debt obligations on their balance sheets, often valued using nothing but the bank's own estimates. As of Sept. 30, the four biggest U.S. commercial banks alone had a total of $332 billion in "Level 3" securities—those valued using the bank's models instead of market prices.

Valuing assets became particularly tough during the crisis when many markets froze and more firms had to rely on their own models to price their holdings. Even then, though, there were questions about accountants' role. For a time during the crisis, AIG and Goldman were on either end of credit-default-swap transactions that produced big losses for the insurer. Each was valuing the swap differently, even though they were both audited by PricewaterhouseCoopers. The auditing firm did find a material weakness in AIG's internal controls in 2008 related to asset valuation, and under accounting rules, there can be a range of proper valuations for some assets.

Auditors' responsibility for overseeing a company's internal controls —the processes it has in place to prevent misstatements or fraud—might also draw inquiries, especially in light of the recent foreclosure scandal and the securitization of mortgages.

Recent court cases have shown that in at least some securitizations, banks didn't properly transfer mortgages being sold to investors, possibly because of a lack of controls. If auditors didn't make sure companies had sufficient internal controls related to those sales, that might mean they improperly signed off on sales transferring hundreds of billions of dollars of mortgages from banks to investors.

Auditors, however, note that what they're supposed to vet are companies' internal controls over financial reporting, —making sure a company has working procedures to insure that what goes on the financial statements is accurate—and not necessarily the controls related to business transactions like securitizations.

Another potential trouble area, companies holding assets and debt off their balance sheets, was addressed earlier this year when new accounting rules forced banks and other companies to bring more of their holdings back onto the books.

Write to Michael Rapoport at Michael.Rapoport@dowjones.com