Should Auditors Shoulder Blame for the Financial Crisis?

A lawsuit against Ernst & Young over Lehman raises questions about the role of accounting in the Great Recession

This article is from the archive of our partner .

Earlier this week, New York Attorney General Andrew Cuomo filed civil-fraud charges against the country's second-largest accounting firm, Ernst & Young, in the first major legal action arising from the collapse of Lehman Brothers two years ago. The lawsuit accuses Ernst & Young of approving Lehman's use of an accounting trick known as Repo 105, which enabled the investment bank to move assets off its balance sheet temporarily and thereby conceal its financial distress from investors.

Until this week, auditors like Ernst & Young had largely escaped scrutiny in the ongoing investigation of the economic meltdown's root causes. Yet, as The Wall Street Journal points out, the other three major accounting firms--PricewaterhouseCoopers, KPMG, and Deloitte & Touche--all had clients that failed, sought government assistance, or behaved questionably during the financial crisis:

Do accounting firms bear some of the responsibility for the Great Recession, and does the Ernst & Young case herald more sweeping allegations against the industry?

  • It's Complicated, states Michael Rapoport at The Wall Street Journal. On the one hand, "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." On the other hand, "auditors had to pass judgment on some of the practices that caused the big losses that led to government bailouts." The Ernst suit, Rapoport explains, uncovers concerns about the efficacy of accounting rules implemented during the last financial crisis, in the wake of the Enron and WorldCom scandals.
  • And There's Legal Ambiguity, adds Colin Barr at Fortune. Ernst & Young will argue that it "was just a gatekeeper hired to vouch for Lehman's books, something it will claim it did well within the confines of the law," he notes.
  • Audit Firms May Be Poised to Fall, claims Matt Taibbi at Rolling Stone: "My guess is that this suit is the beginning of the end for Ernst and Young and, who knows, may be the beginning of a series of investigations that ultimately take down the auditors and ratings agencies that made the financial crisis possible. Without accountants and raters signing off on all the bogus derivative math and bad bookkeeping, a lot of this mess would never have happened."
  • No, They Won't Be Allowed to FallĀ  Regulators will pursue fines and penalties, argues Allan Sloan at Fortune, but they are not going to indict Ernst & Young or any of the "Big Four" accounting outfits,. Why? Because, like the nation's banks, he says, 're too big to fail. An Ernst & Young collapse would exacerbate an already unhealthy concentration among the country's audit firms:

In the accounting world, being indicted puts you out of business as customers and partners flee, and you lose some of your licenses that allow you to do business. And I don't think any sentient regulator wants to run the risk of E&Y going out of business.

Call it the Arthur Andersen effect. Andersen, you may recall, was indicted and convicted in 2002 for its role in the collapse of Enron. Just being indicted destroyed the firm, because partners and clients fled. By the time Andersen won on appeal, it was a husk of its former self, and what had been the Big Five accounting firms had become the Final Four.

  • That's True, But It's Depressing, responds Jonathan Weil at Bloomberg: Fear of another Arthur Andersen-like collapse permits accounting firms "to plod along, fending off one regulator after another, knowing they will be allowed to carry on no matter how much they offend the public's sense of decency."
This article is from the archive of our partner The Wire.