Causes Of Lehman Brother's Bankruptcy And Auditors' Responsibilities

Using the reference materials available on the internet, research the topic and discuss the auditing issues surrounding the collapse of Lehman Brothers. Explain how this was not forewarned in the auditor’s report which gave an unqualified opinion before its collapse. 
Explain how the new auditing standard ISA 701 Communicating Key Audit Matters in the Independent Auditor’s Report may provide additional information about the impending collapse of Lehman Brothers, explaining clearly what these matters are. Also, state clearly what the auditor of Lehman Brothers would have disclosed in “Key Audit Matters” if ASA 701 was applicable then as well explain how this would be an improvement in auditing practice. 

Housing Market and Investment

Lehman Brothers once stood as one of the international financial service firms. Until September 2008, this firm stood up as the fourth largest firm of United States in the field of investment banking. Chapter 11 Bankruptcy was filed by the firm due to Lehman Brothers turning bankrupt in September 2008. Non-assessment was the main cause of the condition of the firm; also the negligence on the part of the auditors by not informing the management about their mistakes brought disastrous consequences. Positive and powerful control, as well as effective course of action, is the demand of the hour leading to strong procedure and regulations. The firm would have been saved if the auditors showed the concealed facts and figures of the financial statements (Tepalagul & Lin, 2015). However, the key factors and data were not revealed that led to a breach of the regulations and hence, it was difficult to know about the real happening.

Neglected and the absence of facts and the issues which has to be taken into concern while drafting the financial statements were:

The housing market was being run by a major boon between the year 2001 and 2008. Lehman brothers invested huge sums of money in the mortgage market by borrowing large sums, as they considered the investment as a vital and a large scale profit making the venture. Worsening of the situation was started by the decline of the sub-prime mortgage business in the housing financial field. Non-analysis and neglecting the consequences was followed by heavily investing in risky portfolios. At the same time, huge amounts of the firm's money were invested in Real Estate and private financing, the company also gave its own capital as loans (Black, 2010). Just like the other investment bankers the firm also borrowed billions of dollars to make such risky investments.

Wrong usage of the Repo 105 was the most disastrous and risky decision taken by the firm. The decision was basically taken to present a settled and bright picture of the firm in front of the public investors and the financial institutions, and secondly and most importantly to receive more lending. The losses or the trouble obligations of the firm were settled by the funds borrowed and keeping the securities as collateral (Roach, 2010). The Repo transactions were responsible for the decline of the firm by slowly decreasing the securities by imaging the transactions as the ones for inventory sale for securities. Auditors helped the management to hide the replication of securities in the balance sheet and also concealing that the firm was showing the securities as collateral by the third party as nothing in the financial statements (Roach, 2010). The entire loan taken by the firm was shown as Sales proceeds of investment securities and none of it was ever shown on the balance sheet. Less risky liabilities and to show easy and more liquid assets were the main target of undergoing such transactions.

Wrong Usage of Repo 105

Repo transactions and also Commercial Papers were the basis for taking short-term loans as the company mortgaged the assets and the long-term investment securities, but the company took huge loans on a daily basis in mid and late 2008. Borrowing of a large amount of money from different places led the firm to a huge risk. Lehman Brothers collapsed due to these major transactions and procedures (Wright & Charles, 2012). Lehman Brothers failed to meet the requirements and at the same time the institutions also stopped to accept the securities as collateral against the short-term borrowing, all caused due to the entry of obligation of debts in the system which put the company under a huge risk leading it to a disastrous collapse (Pilbeam, 2009).

Not a single matter about the conditions of the firm was disclosed in the financial statements. All the key matters were kept concealed by the auditors. It was possible to save the firm from such a collapse or to delay the time of the collapse if the auditors had forewarned the risks in the financial statements (Parker et. al, 2011). Ernest &Young LLP having its headquarters in New York was the auditor company of Lehman Brothers.

This auditing standard was put to work for the financial reporting periods ending on or after 15^th December. The main target of this auditing standard is to keep a track of the vital audit matters and only after analysis, the key points should be reported to the managing department of the audit firm without any further delay. This auditing standard acts as a boon to the users of the financial statements to look into the conditions and important matters which In turn help them to prevent any kind of losses and also favors enhanced transparency (Hoi et. al, 2009). Financial statements would have been real and interpreted by the users if the concealed facts would have been disclosed by the auditor and this could only happen if in the case of Lehman Brothers the ASA 701 was applied.

It is the duty of the auditor to put significant attention towards key matters during the time of auditing process of financial statements and reports. It is an auditor’s responsibility to find out matters having a high risk of material misstatement, matters related to large-scale uncertainty and the effect of such transactions that have come up in the duration of audit (Manoharan, 2011).

Collapse of Lehman Brothers

ASA 701 would have disclosed the facts and figures of the firm if it existed at the time of the Lehman Brothers case. Its non-existence favored the auditors for hiding material facts and to follow non-disclosure and non-communication of the key facts about the firm. It can be said that absence of standard and major loopholes in the system at that time led to such a disastrous collapse (Wiggins et.al, 2014).

There was a materialistic decrease in the leverage ratio in the year 2008 as compared to the year 2007 for Lehman Brothers. Repo 105 transactions very cleverly framed the reduction as temporary and as false. The major impact on the leveraged ratio was due to the late payments of the debts of the Repo transactions which were made at the end of the fiscal quarters and thus reestablishing the securities in the balance sheet (Hoffelder, 2012). All this would result in decreasing the leveraged ratios to such a level which would bind the auditor to show it in the auditor’s report as well as the financial statements.

The vital matters which caused the collapse of Lehman Brothers are clearly depicted by the points which had to be reported to those charged with governance. The auditors of the firm would have been bound to follow strict rules and would have saved a lot of investors and most importantly the Lehman brothers from such a catastrophe if ASA-701 existed and would have been followed for the perusal of the Lehman Brothers firm (Wiggins et.al, 2014).

The firm was bound to obtain a true sales opinion so as to carry on with their transactions which fully agree with the legal platform for transfers. This was due to firm imaging the Repo 105 transactions as Sales under FAS 140. For this particular permit, the firm had to sign up a deal with the UK finances as they failed to get the permit in the US. The deal was that Lehman Brothers would trade and site their investment securities only within the UK. Fixed income securities were worth billions of dollars was made by the firm after entering such a number of transactions as per the deal (Wiggins et.al, 2014). But Lehman Brothers cleverly started to make transfers of American fixed income generating securities worth billions of dollars. All these transactions were known by the auditors but they never disclosed it in the financial statements of the firm (Guan et. l, 2008).

ASA 701 and Reporting Key Matters

The internal policy of Repo 105 and the Reverse Repo policy was made by Lehman Brothers after taking confirmation from the auditors. It was done to show the same in the balance sheet in the form of trading of investments (Hoffelder, 2012). It was the solely the duty of the auditors to inform the firm management about the consequences that would follow.

Above all, the firm also started showing equities as collateral in the place of fixed income securities so as to carry on with their Repo 108 transactions.

Non-disclosure of the effect caused by the Repo 105 transactions was the plan of the firm in association with the auditors as it would expose the disastrous conditions of huge loan liabilities and also the unchanged leverage ratio to the investors. The main role was played by the auditors in hiding all the impact caused due to such transactions by the Lehman Brothers, thus they decided not to reveal the fact (Cappelleto, 2010).

Short-term financing transactions were shown as the sales of the firm under the Repo transactions. The securities of the firm which were once shown as collateral were now removed and found no place in the balance sheet. The firm took another clever movement to reduce the liabilities to put up an image that the securities of the firm are being offered to the third party as compensation and there is a reduction in leverage. Also, the loans taken by the firm was supposed to be put up in the blanched sheet till repayment. But the transactions were treated as sales so the sold securities were deducted from the assets and there was no sign of any liabilities.

Firstly, it was nowhere disclosed that the Lehman Brothers has an obligation to buy back billions of dollars of securities from the third party as just temporarily transferred funds. The firm and the auditors were clever enough to show these transactions as small fluctuations in the balance sheet as per the management report.

A second obligation by the company highlighted that the repurchase of the securities was done at a lower cost and was shown and hidden under large-scale derivatives. The firm was clever enough to put these at the footnotes of the financial statements (Cappelleto, 2010). The whole thing was carried out only after the confirmation of the auditors who totally concealed the material misstatements.

It is solely the duty of the auditors to present the true picture of financial statements. Not just the company but the society as whole depends upon the auditors as they present a true image of the company in every manner, and to follow these auditors are required to comply with the auditing standards and to use them in the audit. In the case of the Lehman Brothers, the auditors can be held responsible for the losses suffered by the third parties who totally rely on the financial statements of the company made by the auditors during the audit. It is on the auditor’s part to show the mistakes of the management in the financial statements. The disastrous collapse of the Lehman Brothers clearly indicates the pitfall in the regulatory mechanism demanding a strict supervision. It is now vital for policy makers like IFRS, Accounting Standard Board, and Basel to make stricter norms.

Conclusion 

The collapse of the Lehman Brothers provides strict examples to all the organizations irrespective of the popularity to follow all the ethical standards with respect to corporate governance. It is the duty of the management and the auditors to strictly adhere to these rules and regulations. The organizations should think and understand that these rules are made for their own benefits, as these are made by keeping in view all the aspects of the financial matters required while drafting the financial statements. It is the demand of the situation that there should be a proper and wise imaging of the book of accounts in the financial statements. It is highly required that the organizations should prepare such reports as not to mislead the stakeholders about the financial transactions of the firm. In such case, the company should figure out a way for the adoption of regulatory accounts and auditing standards.

References

Black, W. K 2010, Epidemics of “Control Fraud” lead to Recurrent, Intensifying Bubbles and Crises, Working paper, University of Missouri-Kansas City.

Cappelleto, G. 2010, Challenges Facing Accounting Education in Australia, AFAANZ,

Guan, L, Kaminski, K. A & Wetzel, T. S 2008, ‘Can Investors Detect Fraud Using Financial Statements: An Exploratory Study’,  Advances in Public Interest Accounting vol. 13, pp. 17-34.

Hoffelder, K 2012, New Audit Standard Encourages More Talking, Harvard Press.

Hoi, C. K, Robin, A & Tessoni, D 2009, ‘Sarbanes-Oxley: are audit committees up to the task?, Managerial Auditing Journal vol. 22, no. 3, pp. 255-67.

Manoharan, T.N 2011, Financial Statement Fraud and Corporate Governance, The George Washington University.

Parker, L, Guthrie, J & Linacre, S 2011, The relationship between academic accounting research and professional practice, Accounting, Auditing & Accountability Journal, vol. 24, no. 1, pp. 5-14.

Pilbeam, K 2009, Finance and Financial Markets, Palgrave Macmillan

Roach, L 2010, Auditor Liability: Liability Limitation Agreements, Pearson.

Tepalagul, N. & Lin, L 2015 ‘Auditor Independence and Audit Quality A Literature Review’, Journal of Accounting, Auditing & Finance vol. 30, no. 1, pp. 101-121.

Wright, M.K. & Charles, J 2012, ‘Auditor independence and internal information systems audit quality’, Business Studies Journal vol. 4, no. 2, pp. 63-84

Wiggins, R.Z, Piontek, T & Metrick, A 2014, The Lehman Brothers Bankruptcy A., viewed 15 May 2107  https://som.yale.edu/sites/default/files/files/001-2014-3A-V1-LehmanBrothers-A-REVA.pdf