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History Of Lehman Brother And Its Collapse

The study is prepared describing the Auditing Issues involved in Lehman Brother and the impact of these issues on the collapse of Lehman Brother along with the reasons for introduction and taking effect of ASA 701-Key matters in the audit report of the company. At the start of the study History of Lehman Brother has been discussed to understand the working and practices of the company with the causes behind the collapse has been discussed. Thereafter the basis of issuing clean report by auditor has been discussed in order to ascertain the impact of this clean report on the investor of the company. The third section of the study detailing about the auditing assurance standard 701-key audit matter and its impact on the auditor report after its introduction and inclusions to made in audit report. After this, matters to be included in audit report of Lehman Brother are discussed so to assess the impact of Key Audit Matter standard in terms as if this standard has been issued before the Lehman Brother Collapse. The study has been ended with most suitable recommendation so as to understand the improvements in auditing practice. The report has been prepared using the data from primary and secondary resources available on internet. 

Lehman Brother plays a role of providing major source of finance for new business ventures in USA for 150 years or more. The firm provides back bone as investment banker for modern companies and new business in United States. The founder of the firm Henry Lehman lays the foundation of the firm in 1844 by selling the dry good to the farmer’s dealing in cotton at Alabama. After some years in 1850, the other two brothers has also joined the firm and name of the firm then converted to Lehman Brothers. They have a policy which is applied till 1920 that only family members were the partners of firms.  After 1850, they made an agreement with King Cotton and open the cotton warehouse and move into merchandised industry. In 1858, they formed a New York Office from where they have started the business of the Merchandise and Financial Commodities. In 1870, after the period of civil war in England Lehman brothers is effected and they started new first future trading business of Cotton Exchange along with started the petroleum and coffee exchange. In 1867, the firm was appointed as fiscal agent of the Government. The firm after this started in joint venture and become financial advisor to railroad industry. They become financer and underwriters for some railroad projects like North West Railroad, Chicago railroad, Pennsylvania Railroad, Great Northern along with Union Pacific. 1887, the firm become the merchant bank from merchandise retailer and listed in New York Stock Exchange. In 1920, when the managing directors of Lehman Brother changed, he came up with new ideas of supporting new industry in term of finance. The firm supported airlines, pictures retail industry which led the firm to reach the new heights till 1969. In 1930, the firm underwrites some major IPO of motion pictures, television industry and radio industry also helped Radio Corporation of America. To mitigate the risk from there underwriting contract the firm introduced the concept of Private Placement for arranging funds. After the company move to oil industry and gas industry and 1980, the firm acts as advisor to US government for contract relating cross border transactions. As technology was growing that time the world is moving towards computers the firm financed the through capital markets in the companies like Intel. 2000 is year in which firm celebrates the 150th anniversary of success and become supreme power in the mortgage industry (HBS, 2014).

Reasons For Unqualified Opinion

After the success story, Lehman Brother filed an application in 2008 to Federal Court regarding their financial crisis. The reasons for financial collapse of firm are as follows:

  • No Business Combination Agreement – After entering into Subprime Mortgage Loan, the firm encountered with huge losses. The firm Goodwill is acquired by the any other person and this is the main reason of collapse of the company. If any company has acquired the firm like merger and acquisition agreement has been taken place then there may chances that the firm would have not filed the application of insolvency. (Chadha, 2016)
  • No Emergency Loan- The Federal Bank has major option to safe any firm in US from insolvency is by giving the Federal Reserve to the firm if no buyer is available to acquire that firm. The reason behind for not giving the loan is no collateral was available with firm which can be checked in firms Balance Sheet. The Federal Bank considered that they could have huge losses if they try to give emergency loan to firm which does not have collateral asset in their balance sheet. (Johnson, 2012)
  • Violation of ethical principles of accounting - The firm used the technique of window dressing in their financial statements to make it lucrative to investors and involves in the transactions of Repo 105. These transactions are ethically allowed as the accounting principles for bank to maintain the liquidity of cash in short term by engaged in repurchase agreement. But the firm has written off its liability of the 50 billion with cash received from repurchase agreement. The firm sells short term securities and shows it’s a sale for the firm and cash received from this is used to pay of the liabilities standing in Balance Sheet instead of treating as loans with ahs to be repaid by the firm with interest after the lock in period of two years. This practices was followed by the company from 8 eight years and actual liabilities of the company was not booked reducing the company’s assets. This unethical practice is major reason of collapse of the firm. (Maux and Morin, 2011).
  • Liquidity Problem- the Lehman Brother was having irregular liquidity problem in paying of its short term liabilities. For solving this problem the company uses its asset base to pay of these liabilities and thus it reduces the company’s base after sometime making its financial statements position negative. The customers and lenders confidence on firm reduces and they sold the shares of asset making the share price at lowest level of the firm (Farndale, 2008).
  • Complex Capital Structure of the firm- the firm was engaged with more than 3000 entities for doing business. These engagements making the firm capital structure very complex to understand and financial analyst considered it as reason for collapse. (Dutta, 2010).
  • Defaults under Subprime Contracts- the firm have given major loan to subprime customers who has very low credit rating to earn high interest in these transactions. As the property prices increase there are high chances of having gain. But as per 2007 crisis in US, the numbers of defaults were increased making the subprime contracts not profitable to the firm. The huge losses in these contracts making the reason for collapse of the company (Azadinamin, 2013)

The auditor opinion which shows that the financial statements of entity is prepared according to all generally accepted accounting principles does not involved any material misstatements in the financial statements. The auditor gives its opinion that the financial statements show the true and fair view of financial and non financial affairs of the company. In case of unqualified opinion the auditor issue Independent Auditor report stating that he opinion is free from bias and the companies affairs the as per applicable rules and regulations.

The following are main reasons for issuing unqualified opinion stating the affairs of the company are free from frauds and errors by auditor in case of Lehman Brothers:

Being Ernst and Young the auditor of Lehman Brothers have issued unqualified report in relation to Repo 105 transaction in which the company has repurchase the short term securities for cash and treated it as sales and pay of its liabilities standing in the balance sheet. The repurchase agreement was not disclosed by the auditor involving $ 50 billion finance transactions with purview that the firm was applying correct policy in relation Repo 105. Repo 105 policy was clear and Lehman manipulated that in such a way that auditor believe the policy followed by firm was appropriate and as per American Accounting Principles. (Chatterjee, 2015, Mc 2010 and Inman, 2014).

  • Misbelieve of Auditor about the previous audit report- Auditor was under the impression that last audit which was done for period ending on November 30, 2007 stating that the financial statements are free from errors and frauds.  The auditor was remaining in that impression only as the bankruptcy was reported in 2008 after the auditor opinion.
  • Financial Intimidation on auditor by Lehman Brother where the firm had paid $ 150 billion audit fees to the auditor for issuing the Unqualified opinion by the auditor on the affairs of the company and for ignoring the Repo 105 transaction for which auditor was not sure. (Goldstien, 2014).
  • Not followed the detailed audit procedures by auditor resulting non disclosure of the material misstatements in the financial data of the firm. The auditor has not gathered all the audit evidence before making his opinion (Coenen, 2010).

The unqualified opinion by auditor misleads the stakeholders of Lehman Brother resulting in huge losses to investor after declaring bankruptcy and crash the financial market.

Auditing Assurance Standard 701 is the recently introduced standard in the field of the auditing to enhance the quality of reporting which cannot mislead the investors or stakeholders before making any decision about an entity on the basis of reporting. This standard is applicable from December 2016 and describes the responsibilities of the auditor in detailed before giving opinion on the affairs of an entity. The auditor is requiring mentioning the Key Matters of the company which can impact the decision of the investors in their audit report (AASB, 2015).

After the introduction ASA 701, the auditor has to apply his professional competence and due care and identified the matters which require the attention of stakeholders of an entity.  The following are require to be reported as Key Audit Matters in the report of the auditor:

  • Matters relating to considerable risks areas identified as per ISA 315 by applying the professional opinion by auditor
  • Matters in relation to areas where it is difficult to obtain the appropriate substantial audit evidence after applying the audit procedures in detail.
  • Matters identified by auditor which make auditor helpless in change of its audit procedures like internal control weakness identified during audit make the auditor to change the audit plan and work in detail for checking the impact of such weakness.

These matters are identified as per professional verdict of the auditor and important in the financial statement audit. They can be identified by those charges with Governance and opinions on these matters are not qualified and auditor thinks he is not in position to issue full clean opinion.

The Auditing standard 701 if introduced in the year 2000 or thereafter before the bankruptcy of the Lehman Brother, the auditor would be liable according to the responsibilities laid on him by standard and would have report the key matter in the auditor report which could help the stakeholder in decision making about the firm. This could also help in reducing the chances of collapse of firm and US crisis in financial industry may not happen. The following are Key Audit Matters which have to be reported by auditor in Auditor Report:

  • The Repo 105 transaction has been identified by the Vice President of the company. The auditor should followed the detailed audit procedures to test the validity of the transactions and the auditor should report about the Repo 105 repurchase agreement transactions where the firm was selling short term securities for cash and considered it as business operating income rather than booking the same as borrowings to the company. The auditor should report that this transaction can have impact in future on the solvency positing of the firm and can impact the going concern assumption of the firm.
  • The auditor should mention in report of decreasing capital gearing ratio of the firm to 0.9 in 2008.  The firm asset base has been reduced to $ 50 billion as firm is selling the assets on frequent basis in past. This can have high impact on the investment of investors.
  • The firm’s cash and cash equivalents were reduced by $ 167 million showing that the liquidity position of the firm can be hampered in future and there is liquidity crunch situation can be occurred in future.
  • The auditor should report the major involved of the firm in subprime contracts which were very volatile and contains high chances loss from those transactions involving low credit rating customers.
  • The firm is increasing the borrowings to meet its financial obligations like dividend payments to shareholders and paying of the liabilities. These solved the liquidity crunch at point of time but were dangerous for future solvency position (Masytoh, 2010).  

From the above study, it has found that the collapse of Lehman Brothers was mainly due to hiding of fact by both management and auditor from its stakeholders. The firm was involved in unethical practices from long period of eight years from 2000 to 2008 in relation to the repurchase agreement and maintenance of liquidity. The auditor was not able assess the risk in non disclosures of off the balance sheet financial transactions and thus misleading the investors in their decision making. The auditor become bias in reporting and issued the unqualified opinion for 8 eight years and not done substantial audit testing for checking volatility of the transactions happening in the firm.

It is therefore recommended from the report that the auditor should performed all the audit procedures as laid down in auditing standards before making any opinion and issuing report about the true and fair view of affairs an entity. The auditor should followed the terms specified in engagement letter along with terms specified in professional standard before framing an opinion.

References

AASB, (2015), “ASA 701, Communicating Key Audit Matters in the Independents Auditors report”, available on https://www.auasb.gov.au/admin/file/content102/c3/ASA_701_2015.pdf  (accessed at 16/05/2017). 

Azadinamin A, (2013), “The bankruptcy of Lehman Brothers: Causes of Failure and Recommendations Going Forward” available through

https://www.researchgate.net/publication/230687440_The_Bankruptcy_of_Lehman_Brothers_Causes_of_Failure_Recommendations_Going_Forward   (accessed at 15/05/2017). 

Chatterjee P, (2015), “Ernst and Young pays $10 million to settle Lehman Brothers Audit failure Lawsuit”, available through https://www.corpwatch.org/article.php?id=16019 (accessed at 15/05/2017).

Chadha P, (2016), “What caused the failure of Lehman Brothers”, available through https://www.omicsonline.com/open-access/what-caused-the-failure-of-lehman-brothers-could-it-have-beenprevented-how-recommendations-for-going-forward-2472-114X-S1-002.php?aid=77283 (accessed at 15/05/2017).

Coenen T, (2010), “Is Ernst and Young to blame in Lehman Brothers Fraud?” available on https://www.aol.com/article/2010/12/23/fraud-files-is-ernst-and-young-to-blame-in-lehman-bros-fraud/19774486/   (accessed at 15/05/2017). 

Dutta, (2010), “Lehman Shell Game”, Strategic Finance, Vol 92(2), pp 21-29 

Farndale N, (2008), “Lehman Brothers Collapse : How the worst economic crisis in living memory began” available on https://www.telegraph.co.uk/finance/recession/3917584/Lehman-Brothers-collapse-How-the-worst-economic-crisis-in-living-memory-began.html   (accessed at 15/05/2017).

Goldstien M, (2014), “Arbitrators Ease Blame on Ernst and Young for Audits of Lehman Brothers”, available on

https://dealbook.nytimes.com/2014/08/11/arbitrators-ease-blame-on-auditors-of-lehman/?_r=0  (accessed at 15/05/2017). 

HBS, (2014), “History of Lehman Brothers”, available on

https://www.library.hbs.edu/hc/lehman/history.html (accessed at 15/05/2017). 

Inman P, (2010), “Auditor’s Role in Lehman Collapse Unites Opposition in calls for reform”, available through

https://www.theguardian.com/business/2010/mar/15/auditors-role-lehman-collapse-critics  (accessed at 15/05/2017). 

Johnson M, (2012), “The failure of Lehman Brothers and its impact on other Financial Institutions”, Applied Financial Economics, Vol 22(5), pp 377-383 

Masytoh O, (2010), “The analysis of determinants of Going Concern Audit Report”, Journal of Modern Accounting and Auditing, Vol 6(4), pp 27-36. 

Maux J and Morin D,(2011), “ Black and White Red All over : Lehman Brother’s inevitable bankruptcy splashed across its financial statements” , International Journal of Business and Social Science, Vol 2(20), pp 42-61 

Mc G, (2010), “Ernst and Young accused of hiding Lehman Troubles” available through https://www.reuters.com/article/us-ernstandyoung-lehman-lawsuit-idUSTRE6BJ1FP20101221  (accessed at 15/05/2017).

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