Trust, but Verify

Are audit committees digging deeply enough?  That’s one of the troubling questions raised by the Valukas report on the collapse of Lehman Brothers.

The Valukas report chastised Lehman’s auditor, Ernst & Young (“E&Y”), for failing to “question and challenge improper or inadequate disclosures.”  The report charges that E&Y (1) allowed Lehman to use an “accounting gimmick”, Repo 105, to disguise the reality of its liabilities, (2) permitted Lehman to use subjective, inconsistent methods to value its illiquid assets, and (3) failed to investigate and report a whistleblower’s claims about Lehman’s improper use of Repo 105.  Lehman was reportedly paying E&Y $31 million a year.

Bottom line: audit committees need to dig deeper.  Perfunctory questioning of the auditors is not acceptable.  As they do their job, audit committees need to ask the auditor specific questions to determine whether the financial statements and the accounting treatments that underlie them reflect economic reality.  For example, they need to ask about situations where there are alternative accounting treatments and the reasons that management chose, and the auditors concurred in whichever alternative was used.  Audit committees need to probe inconsistencies in accounting treatment or assumptions from previous reporting periods, and they must know which questions were referred to the firm’s national office for resolution.

The relationship with the auditors should not be adversarial, but auditors, like all of us, are subject to human frailties.  Maybe President Reagan had it right: “trust, but verify”.

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