Britain's accountancy regulator will today launch an investigation into Ernst & Young's role as auditor of the European arm of Lehman Brothers.
The investigation follows an allegation in March by a US court-appointed examiner that E&Y – one of the world's "big four" accountancy firms – approved accountancy tactics that allowed the failed investment bank to hide $50bn (£33.7bn) of debt off its books.
"The accountancy and actuarial discipline board (AADB) has begun an investigation under its accountancy scheme into the conduct of E&Y as auditors to Lehman Brothers International Europe," said the Financial Reporting Council (FRC).
One industry expert described the inquiry as the "tip of the iceberg" and said it opened up the prospect of a flood of legal claims against the firm.
The report by US court examiner Anton Valukas found that a sales programme known as "Repo 105", which involved the artificial sale and buy-back of deals, was used to make it look as though the company had not borrowed as much money as it had. Valukas described the trick as "window dressing", an "accounting gimmick" and a "drug".
Valukas also said Lehman could have a plausible claim against E&Y for missing the danger of such a programme, which misled investors. In addition, E&Y did not inform the audit committee on Lehman's board about a whistleblower who had raised concerns, he said.
E&Y said it planned to fully co-operate with the investigation, and reiterated that it was guilty of no wrong-doing.
"E&Y's audit opinion stated that Lehman's financial statements for that year were fairly presented in accordance with the relevant accounting standards, and we remain of that view," the accountancy firm said in a statement.
The UK regulator has now decided to start a more detailed investigation. Following the US examiner's report, the FRC has asked E&Y to provide further details and documents about the controversial repo agreements.If negligence is found, it could trigger a wave of lawsuits against E&Y.
UK law firm Linklaters was also described as aiding the transfer of funds because it had said that the transactions were legal under English law. It denied any wrong-doing.
The audit profession has been widely criticised for its model, where companies pay to receive an opinion. As with credit rating agencies, a bad opinion may lead the client to move to a competitor.
Essex University professor Prem Sikka has long advocated fundamental reform, arguing that guidelines demanding more transparency would not be enough.
"The E&Y fiasco is just the tip of the iceberg, of [problems caused by] the close relationship between the audit firm and its clients," Sikka said. "E&Y were aware of 'repo 105' – and auditors are more powerful than the police – they can examine anything, interview anybody without a court order; they already have the statutory right."
Accountancy firms, however, "are reliant on clients because of the fees; that influences what they are willing to do and say publicly, and all too often, bad news is buried," Sikka said.
The involvement of audit firms in big accounting scandals such as WorldCom and Enron, which put Arthur Andersen out of business, shows that "audit firms, simply can't deliver".
Because banks have a key role in the economy, they should be audited on a daily basis by the central bank or an official regulator, he said.