Never Mind the PCAOB, Here Comes the Martin Act train

News of New York State Attorney General Andrew Cuomo’s decision to file a civil lawsuit against Ernst and Young LLP for its role as auditor to Lehman Brothers is just the latest crack to develop in the foundation of global capital markets. As we noted a few weeks ago, the Public Company Accounting Oversight Board (PCAOB) recently issued a “report card” (PDF) on audit risk areas related to the financial crisis, with ample criticism but very little demonstrable action on the audit quality revealed by inspection programs. Leave it to the state of New York and its securities fraud statute, the venerable Martin Act, to take aim at such transgressions.

Meanwhile, in Europe, the European Commission (EC) issued a green paper consultation on lessons we can draw from the global financial crisis with regard to audit policy — including some very high level questions about what investors should expect from auditors. In response (PDF), CFA Institute commended the EC’s discussion of “professional skepticism” as a necessary attribute of the relationship between auditors and issuer companies, where management assertions are challenged from a user perspective. Audit policies and procedures make this easier in theory, but a change in tone in the relationship between auditors and companies also is required — something less cozy and more demanding.

Auditors also need to do a better job describing their methods and assumptions so that investors have an enhanced perspective on what has been verified and what judgments have been made. The Lehman Brothers lawsuit will probably have auditors huddling with their lawyers to find protective language or otherwise limit the amount of additional discussion and disclosures in the audit report. However, we think it’s high-time for a more useful and enlightened auditors communication that is more than a pass/fail report card.