Peeling away financial reporting issues one layer at a time

Could Lehman’s Audit Committee Have Done Better?

I am, and have always been, a very reluctant user of pen and paper. Even on the rare occasion where I am sufficiently moved to take handwritten notes, they frequently end up to be little more than random doodling. Soon thereafter, I transfer them to the recycling bin.

But a few months ago, as I was culling about a tree's worth of papers from the piles I absolutely did not want to transfer to my newly renovated office, I unearthed a rare anomaly—a useful page of notes. The precious artifact was my scribbles during the annual meeting of the Association of Audit Committee Members Inc. (AACMI.org), which I attended as a speaker. My presentation from two or three years ago was on the changing accounting standards for business combinations, and especially what audit committee members should be asking management about them. Not exactly scintillating I know, but such has become my lot—to play the geek at meetings of big picture guys. As usual for such a meeting, the agenda for the afternoon had been set in descending order of turgidity, which clearly made me and my topic the last thing standing between everyone else and the cocktail hour.

But, at least I was on the undercard for a luminary. The first speaker of the afternoon was the one and only Harvey Pitt, securities lawyer extraordinaire and former SEC chair. I don't remember the formal title of his talk, but the gist of it was 15 suggestions for audit committees. Memorializing them in a blog post had been my intention as a follow-up to my previous post on Koss. There, I noted that the effectiveness of Koss's audit committee appeared dubious, to say the least—if not moribund and incompetent. I had thought that Pitt's words of advice were so self-evident (once he made them evident) that they could help any smaller company set up, or perform a pretty thorough evaluation of their own audit committee.

But, this past Thursday, another potential use of "Pitt's Tips" came to mind. The bankruptcy examiner for Lehman Brothers issued his 2200-page report. So far, I have read only a few pages of that report, but many sources already strongly suggest that Lehman's auditor, Ernst & Young, and its management may have some explaining to do. As regards the involvement of Lehman's audit committee, the report apparently finds that the directors of Lehman did not breach any of their duties, but that doesn't really address whether the board, and the audit committee in particular, could have done more to prevent the bankruptcy.

So, I am presenting my notes from Harvey Pitt's talk with these two cases as reference points—and one important caveat. The caveat is that I do not claim that anything in my notes were Harvey Pitt's exact words. The 15-item list I am presenting is nothing more or less than a transcription of my notes with some minor rewrites for clarity, based on my memory of a cogent and engaging presentation.

Pitt's Tips

 

  1. Audit committee member should limit themselves to two or three boards.
  2. The committee should strive to maintain the appropriate "tone at the top."
  3. A culture of compliance should continually be taught.
  4. Continually evaluate how best to meet one's duties.
  5. The corporation should have a compliance committee.
  6. Stay current with legal and financial reporting requirements affecting the company.
  7. Strive for collegiality and "play nice" together.
  8. Develop a formal policy for financial statement disclosure.
  9. Access to both internal and external experts should be easy.
  10. Develop effective relationships with management
  11. Keep communications paths open and objective. The audit committee should have separate meetings with the internal and external auditors.
  12. Keep in mind that the IRS looks at public company disclosures.
  13. Consult an outside expert for tax issues
  14. Ask tough questions – make sure all of the questions raised are answered by the auditor to your satisfaction.
  15. Be able to prove what you did; make sure that the minutes of your meetings reflect your actual diligence.

A 16th Tip from Yours Truly

I'm willing to bet that Lehman's audit committee might say that they complied with each one of Pitt's guidelines.  So what, if anything is missing from his list? Maybe nothing, depending on how one reads them, but I might put things a little more bluntly than I recall Harvey Pitt having done.

My own Tip 16 is a variation on a theme that pops up in many of my posts: audit the auditor. Yes, the PCAOB inspects audit firms and may select audits to review; and there are new PCAOB audit standards for concuring partner review of the work of the audit team, but this is clearly not enough.

Tip 16 is, "The auditor should be concerned that the audit committee might, at any moment directly examine some of its work." Just as management's assertions should be subject to verification by the auditors, the assertions made to the audit committee by the auditors should be subject to verification. If the audit committee tells the auditor to do something, verify it was done. If the auditor stakes out a position on a sensitive issue, and if you are not an expert yourself on that issue, hire an expert to verify that the auditor's conclusion is the correct one.

In Lehman's case, it appears that the audit committee was aware of the whistleblower's letter, but it did not even read it! Instead, they instructed E&Y, in no uncertain terms they thought, to investigate and report on each of the allegations. Yet, the bankruptcy administrator concludes that E&Y omitted mention of certain critical allegations, pertaining to the accounting for a series of repurchase agreements ("repos") in its communications with the audit committee. The repo transactions may have lacked any valid business purpose other than to make Lehman's capitalization ratios look better to the naked eye; and, as the whistleblower pointed out, the accounting treatment itself may have been questionable.

A straightforward application of Tip 16 would require that the audit committee should have at least considered hiring an outside expert to provide assurance to the committee that each one of the whistleblower's allegations had been thoroughly investigated. If the audit committee would not even read the allegations for themselves, then hiring an investigator should have been a no brainer at a company the size of Lehman, especially given the perilous situation they were in.  Even if they had read the whistleblower's letter and did not consider themselves sufficiently qualified to evaluate the auditor's conclusions regarding the accounting treatment for the repo transactions, then maybe that was another reason to hire an expert.

Maybe Lehman's audit committee did enough to satisfy its legal obligtions, but I am sure that each member inidvidually holds themselves to standards of integrity that far exceed the minimum established by law.  If there are lessons to be learned from Lehman, one of them could come from asking whether audit committees, as presently constructed, are as effecive as they should be.  Would simple changes on the order of Tip 16 result in fewer audit failures?  It seems to me that the answer is clearly 'yes.'

1 Comment

  1. Reply Tessa Carroll March 16, 2010

    The process of checks and balances associated with financial reporting is everyone’s responsibility. Sure, the minimum letter of the law may have been met by Lehman’s audit committee, but shouldn’t some level of diligence and responsibility be expected? In short, yes Lehman’s audit committee did their job, but certainly not to the best of their ability.
    Tessa Carroll
    http://www.blogs.vbpoutsourcing.com

Leave a Comment