NY v. Ernst & Young: Who Cares Whether Lehman Brothers Followed GAAP?

NY v. Ernst & Young: Who Cares Whether Lehman Brothers Followed GAAP?

The Accounting Cycle
NY v. Ernst & Young: Who Cares Whether Lehman Brothers Followed GAAP?
Op/Ed
By: J. Edward Ketz



January 2011 — As stated in the previous essay, the Attorney General of New York filed a complaint against E&Y in the Lehman Brothers case. In particular, the plaintiff alleges that "E&Y substantially assisted Lehman Brothers ... to engage in a massive accounting fraud" and that E&Y helped the firm to "take advantage of a technical accounting rule, known as FAS 140, to treat these Repo 105 transactions, which in reality were short-term financings, as 'sales'".


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Late in the Complaint the Attorney General discussed the substance of the transactions and suggests that E&Y should have looked at the substance instead of the form of the Repo transactions (¶64). This perhaps is a more important paragraph than the former Attorney General comprehends, else he would have mentioned it earlier and more frequently. This is because the case for the plaintiff that depends on GAAP is by no means a slam dunk and perhaps is shaky. The case would be stronger if he said the accounting was improper, notwithstanding whatever the FASB said on the matter.

In particular, this case is eerily similar to the Continental Vending case from the 1960s, and that did not bode well for the accountants. It too turned first on the issue of leverage and second on rules versus economic substance.

The facts in the Continental Vending case (US v Simon 425 F.2d 796) are as follows. Harold Roth was president of Continental Vending Machine Corporation and owned about 25 percent of it and its affiliate, Valley Commercial Corporation. From time to time Continental would raise cash by giving Valley negotiable notes, and Valley would discount them at the bank and hand over the proceeds to Continental. On its books, Continental had a “Valley payable.” In addition Roth would borrow money from the parent corporation in an indirect manner. Continental would loan money to Valley, giving rise to a “Valley receivable,” and Valley in turn would lend the cash to Roth. Roth used the funds primarily to invest in the stock market.

Near the end of fiscal 1962 Valley could not pay off its debts, so Roth pledged his securities as collateral, and most of these securities were Continental stocks and bonds. When the financial statements were prepared, the firm netted a portion of the Valley receivable against the Valley payable, it did not disclose the fact that Roth had borrowed money from the firm, and it did not disclose the nature of the collateral of the loan. Shortly thereafter, Continental had a cash flow problem and the securities held as collateral lost value, and the firm declared bankruptcy.

Federal prosecutors charged three persons in Lybrand, Ross Brothers, and Montgomery with criminal fraud. While agreeing with the facts presented by the federal prosecutors, the defendants relied on a number of expert witnesses, all of whom stated that the deficiencies mentioned above were not part of generally accepted accounting principles. The trial judge issued directions to the jury that negated this perspective by maintaining that “the ‘critical test’ was whether the financial statements as a whole ‘fairly presented the financial position of Continental as of September 30, 1962, and whether it accurately reported the operations for fiscal 1962.” The jury found the defendants guilty. The auditors appealed, but the circuit court affirmed the decision. The auditors then appealed to the Supreme Court, but it denied certiorari.

The major result of this case is that the courts do not rely exclusively on whether the external auditors attest to an entity’s application of generally accepted accounting principles. Instead, the standard is fairness. This is the proper outcome, for managers cannot be allowed to loot corporations and cover it up with transactions that abide by generally accepted accounting rules (also known as cleverly rigged accounting ploys or CRAP).

A. A. Sommer, former commissioner at the SEC put this case into perspective as follows:


Judge Friendly … said in effect that the first law for accountants was not compliance with generally accepted accounting principles, but rather full and fair disclosure, fair presentation, and if the principles did not produce this brand of disclosure, accountants could not hide behind the principles but had to go beyond them and make whatever additional disclosures were necessary for full disclosure. In a word, “present fairly” was a concept separate from “generally accepted accounting principles,” and the latter did not necessarily result in the former.

While the FASB and the SEC and the accounting firms have shied away from the concept of “fairness,” the courts have embraced it. Interestingly, the courts ended up in a place quite similar to that in Statement of Financial Concepts No.1 The court said that corporate managers should report assets and liabilities and stockholders’ equity and revenues and expenses as fairly as possible and then to communicate these results fairly to the firm’s investors and potential investors.

Notice the similarities between the cases. Both Lehman Brothers and Continental Vending wanted to manage their financial leverage. They both accomplished this by reducing assets and liabilities by some number; while keeping the equity the same, the leverage ratios shrunk materially. Both Lehman Brothers and Continental Vending relied on GAAP to obtain the desired hiding of liabilities. And both Lehman Brothers and Continental Vending supplied deficient, uninformative disclosures on these transactions.

E&Y finds itself in a position similar to Lybrand, Ross Brothers, and Montgomery. It appears that E&Y will defend itself based on accounting rules, just as Lybrand, Ross Brothers, and Montgomery said it followed GAAP. The ultimate question is whether the judge of jury will find this sufficient. Is it a reasonable defense to follow the rules or is a professional auditor responsible for attesting that the financial statements as a whole fairly present the financial position and the results of operations?

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