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Analysis Of Lehman Brothers Collapse And Key Audit

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Question:

Discuss about the Analysis Of Lehman Brothers Collapse And Key Audit Matters As Per Asa 701.
 
 

Answer:

Introduction

In this report, the collapse of the Lehman Brothers has been detailed. The collapse faced by the company has led to the emergence and immediate application of the Auditing standard 701 on communicating the key audit matters in the independent audit report. At first the historical background of the company – Lehman Brothers has been given and for the last how many years the company is into banking business and how they have made profit. Thereafter the collapse occurred in the year of two thousand and eight will be detailed along with the reasons why the same has happened. Thereafter the reasons will be cited as to why the auditors have not given the qualified opinion in their audit report while authenticating the financial statements of the company. Then the auditing standard number 701 issued by the Auditing standard board in United States will be discussed and how the collapse had led to the emergence and application of this auditing standard.  It has also detailed the key audit matters that the auditor must have mentioned while auditing the books of accountings compiled in the form of financial statements of the company. At the last, the report has been ended up with the appropriate conclusion and the adequate recommendation.

The main aim of the report is to identify the key audit matters that would have been reported in Lehman Brothers audit report before happening of the historical event and what key matters are required to be mentioned as per the new and relevant auditing standard.  With this aim the report has been prepared and the date has been collected from the reliable sources.

Lehman Brothers

Historical Background

In the year of eighteen thousand and forty four, Mr Henry Lehman was settled in United States of America and he there opens a general store which is engaged in the business of selling the dry goods to the customers. Customers are mainly the cotton farmers. The name of the company was H Lehman. After the arrival of the brothers of Henry Lehman, the name of company was changed to Lehman Brothers. In the year of eighteen hundred and fifty, cotton has been considered as the most important crop in the United States of America and keeping this in view the three brothers have started to have raw cotton in lieu of the items purchased from their general store. Thus, in this way they have started the second business operation of trading in cotton. With the passage of time the company has engaged itself in the purchase and selling of commodities as the brokerage company and opened its first office in Liberty Street, United States where there is the home of factoring agents and commissioning agents. After the civil war that has happened in the year 1862, the company has merged with another company and has started financing for reconstruction of the affected parts of the country. Thereafter the company has converted its business operation from trading in commodities to the investment banking including the areas of underwriting the issue of shares and debentures and financing the big and huge projects of the different companies across the world. Almost twenty six thousands were employed by the company across the World. The company has financed many projects including the Chicago railroad project, the north western railroad project, Pennsylvania railroad project, etc. The company has been the way of having funds from various big companies like the company has financed the Paramount pictures and Century fox in year of 1930’s and has been the helping hand for developing the circuits for more than 700 theatres (HBS, 2014). The company’s profit since its inception has been ever growing and increasing at the increased rate.

 

Reasons for Collapse

With this background, certain conditions were there and circumstances have happened which have led to the collapse of company on the day of fifteen of year of two thousand and eight is of big concern. The reasons for the collapse are given below:

  • No Buyer – The major cause of the collapse of the Lehman Brothers is non availability of the buyer at the time before the company has filed for bankruptcy. If the company would have found the buyer then the situation of filing the bankruptcy protection would not have arisen. In the case of other companies like Merrill Lynch and Bear Sterns, etc who have faced the same financial crisis but have not applied for the bankruptcy protection as they have got the buyers at an early stage (Azadinamin, 2013).
  • Massive Accounting Fraud – The Company has used the accounting treatment which has led to the total transformation of financial statements. The company has used the technique which is named by Repo 105. The term repo is referred to as the Repurchase agreement. By this technique the company sells its short term securities in lieu of cash to the counterparty for short duration and via agreement the company will repurchase the securities so converted in cash after the completion of duration. In case the company fails to repurchase the same then the counterparty can get it exchanged from other the market. The company records the transaction so entered as sales and receives the amount in cash. Through the amount so received in cash, the company goes on paying its liabilities and thus managing their profitability and liquidity ratios and major balance sheet ratios (Johnson, 2012). The company has been engaged in this practice for the last eight years before the date of collapse and has been successful in writing off $50 billion liabilities out of the balance sheet (Maux and Morin, 2011). As per the American accounting standards, the securities so given shall be shown as the loan in the books of accounts and when the same is repurchased the amount shall be set off from the loan. But the company is showing the transaction as sales in the books of accounts which are the clear cut violation of American Accounting standard. Though Repo 105 is permissible by the American accounting standards but the way the company has followed is not permissible (Chadha, 2016). In this way, the company has created the blunder mistakes in the books of account and has done window dressing through violation of the standards.
  • Risk of Credit Default Swaps – Lehman brothers was actively involved in this market. The company has massively engaged in the business of granting loans for the sub prime property areas. Subprime areas are considered as the inferior area and banks usually charged higher rate of interest on the amount of loan sanctioned and granted. Due to increase in the demand for the property the probability and chances of having the defaults in payment of loans have become higher which in turn have led the wave of failure of companies and various securitization vehicles in the market (Dutta, 2010).
  • Government Restriction for Purchase by Barclay – Lehman Brothers would also have not filed the bankruptcy protection had the Government would have allowed the acquisition of Lehman Brothers by Barclays. Government has totally restricted the acquisition following which the company was forced to file the bankruptcy protection application (Farndale, 2008).  
 

Independent Auditor’s Report

Meaning and Why it is Issued

The audit report is the report issued by the auditor of the company which states that the financial statements so prepared by the company from the books of accounts are reliable and relevant and represents the true and fair view of the financial health of the organization. Financial health includes the financial position of the company as well as the financial performance of the company. The independent word has been used simultaneously with the Auditor’s report. It is because the auditor has to be impartial and free from any bias and his each and every opinion that he forms on the financial statements of the company after full and complete verification shall be objective and shall not be under any pressure or any form of self interest or any other factor. The opinion so formed may be qualified, adverse, disclaimer or unqualified.

The audit of books of accounts of the company is required by the corporation act of the respective country in which the company is operating. The independent auditor’s report is important and mandatory for all the companies and to be annexed with the financial statements of the company and shall form part of the annual report of the company. The independent auditor’s report helps the users of the financial statements including the stakeholders of the company to know the depths of the company in terms of its functioning, its performance and more importantly how much wealth the shareholder will earn by investing in the company. Without the independent auditor’s report no person can judge whether the company is operating within the limits of the applicable laws or not. For instance, in case of banking company whether the company is following the guidelines of Federal Reserve Bank and other similar regulatory authorities.         

Reasons for Unqualified Opinion

The auditors of the company – Ernst and Young have closed their eyes and signed the financial statements of the company in misbelieve that the Repo 105 that company is applying is accurate and in accordance with the American accounting standard. But in actual the auditors are very well aware of the fact that the company is in the technique of getting the books of accounts window dressed in such a manner that the liabilities of the companies are totally set off (Chatterjee, 2015, Mc 2010 and Inman, 2014).

It has also been detailed that the managers of the company, in their financial statements, have not mentioned about these type of transaction in their notes to the accounts and the same fact has not been qualified by the auditor in his auditor’s report and also not made the stakeholders of the company aware of the fact that the financial statements of the company does not represent the true and fair view (Coenen, 2010).

The major reason for issuing unqualified opinion is that the company has given $150 million as fees to the audit firm for auditing the books of accounts for the last eight years starting from the year 2000. The amount of fees is less than one percent of the revenue of the company earned globally (Goldstien, 2014). Therefore, the audit firm has the financial interest on the basis of which fraud has been committed.  

 

Meaning and Purpose

The new auditing standard is effective from the 1st of January 2016 and will apply for the financial reporting periods ending in or after 15th of December 2016. The Standard is concerned with defining the responsibilities of the auditor while issuing the audit report to their clients.

As per the new standard the auditor has to disclose the key audit matters in its audit report. In the standard it is mentioned as what will be the key audit matters and what key audit matters the auditor will report in his auditor report (AASB, 2015).

The main purpose of the standard is to provide the users of the financial statements with sufficient and appropriate information through which they will be able to make corrective action with proper decision.

Key Audit Matters Specified in the Auditing Standard

As per the new auditing standard, key audit matters are those matters which are considered to be most important and significant to be mentioned in the audit report. The key audit matters are selected from the matters with those charged with governance. In identifying the key audit matters the auditor needs to apply his professional knowledge and judgment. The standards has specified that the auditor shall take into account the following while determining whether the matters observed during the audit are required to be disclosed as key audit matters:

  • Areas which are defined as high risky areas or areas having the significant risks. These are to be determined in accordance with the Auditing Standard 315 on risks control systems.
  • Areas where it is probable that the management of the company might have used unethical practices like wrong estimation of useful lives of an asset or impairment of an asset or booking of advance revenue or deferment of revenue, etc.
  • The effect that the matters will have on the financial statements of the company if reported and how the users of the financial statements will deal with such disclosures.    

Thus, the responsibility of the auditor has been increased with the introduction of the new accounting standard and he has to apply his professional judgment with due care.

 

Key Audit Matters that Auditor would have Disclosed

As per the new auditing standard, the auditor shall disclose the key audit matters that he has observed while performing the audit of the company. Had this new accounting standard made applicable from the year of 2000 or in between anytime ranging from the year 2000 to 2008, the collapse of Lehman Brothers would not have occurred and the history in the banking industry of United States would not have created. If the auditing standard would have made applicable in those earlier then the auditor shall have disclosed the following key audit matters:

  • The company’s cash flow position has been deteriorating from the last three years resulting in total decrease of cash and cash equivalents amounting to $167 million. If this fact would have been disclosed then the collapse would not have occurred.
  • The company cash flow also depicts that the company is paying dividend to its shareholders every year and the payment is mainly from the long term funds which the company keeps on borrowing on daily basis.
  • Thirdly, being aware of the fact that the company is in the process of window dressing of the financial statements by wrongly applying the Repo 105 process, the auditor would have disclosed that the transactions will result the bad position in the future as the same or even worst position will happen when they will go for repurchasing the securities. Thus, as per auditing standard 570, the effect on going concern assumption for the preparation of financial statements shall also be mentioned (Masytoh, 2010).

Conclusion And Recommendation

Lehman Brothers, renowned company has collapse suddenly due to the accounting fraud that the company has been doing for the last eight years. The management of the company along with the auditors of the company has tried to cheat the users of the financial statements of the company along with the different stakeholders. The company has ended up with the filing of bankruptcy protection application.

It is recommended for the auditors and companies to follow the very nature and purpose of auditing and accounting standard and shall not violate their terms and conditions in any manner.

 

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 on 16/05/2017.

Azadinamin A, (2013), “The bankruptcy of Lehman Brothers: Causes of Failure and Recommendations Going Forward” available on https://www.researchgate.net/publication/230687440_The_Bankruptcy_of_Lehman_Brothers_Causes_of_Failure_Recommendations_Going_Forward   accessed on 15/05/2017.

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

Chadha P, (2016), “What caused the failure of Lehman Brothers”, available on 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 on 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 on 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 on 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 on 15/05/2017.

HBS, (2014), “History of Lehman Brothers”, available on https://www.library.hbs.edu/hc/lehman/history.html accessed on 15/05/2017.

Inman P, (2010), “Auditor’s Role in Lehman Collapse Unites Opposition in calls for reform”, available on https://www.theguardian.com/business/2010/mar/15/auditors-role-lehman-collapse-critics  accessed on 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 on https://www.reuters.com/article/us-ernstandyoung-lehman-lawsuit-idUSTRE6BJ1FP20101221   accessed on 15/05/2017.

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