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Auditing, Assurance & Services ACC707 Individual Assignment

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Question:

Discuss about the Auditing & Assurance ?
 
 

Answer:

Introduction

In the United States, Lehman Brothers were regarded as the fourth biggest investment-banking firm until 2008 when it became bankrupt. Prior to the year 2008, Lehman Brothers provided international financial services to its customers but after becoming bankrupt, it was forced to file for Chapter 11 bankruptcy. The reason behind such bankruptcy and failure of Lehman Brothers can be attributed to the non-assessment of risks by the management and negligence on the part of auditors to warn the management about such happening and its outcomes that would arise due to the management’s fault. Besides, various data relating to this situation were hidden from the financial statements by the auditors, which could have assisted the company in preventing disintegration (Zhang et. al, 2007). Therefore, this concludes the fact that effective regulations and strategies are vital in the present scenario as it can play a key role in leading towards an enhanced operation.

The major data that was hidden by the auditors from the financial statements are that Lehman Brothers started relying more on debts in order to invest all the proceeds in the mortgage market. This was because there a period of great prosperity betwixt the year 2001 and 2008, and the company assumed such period very profitable in nature. However, the sub-prime mortgage businesses related to housing finances had already become disastrous. Another vital vulnerability on the part of Lehman Brothers was in private financing, real estates, and leveraged lending from their own resources (Bhasin, 2008). In relation to this, the firm had already expended billions in risky portfolios and in order to expand such huge amounts, it had borrowed from various financiers, thereby generating a situation wherein the consequences came out to be immensely disastrous.

 

Instruments used

The riskiest step undertaken by Lehman Brothers was the utilization of Repo 105 transaction in an inappropriate way so that the image of the firm’s balance sheet can be made attractive in the eyes of the public and other financial institutions, thereby creating an effective opportunity to procure more borrowings from the institutions. Furthermore, the firm kept its investment securities as collateral and utilized the procured resources to pay off its other obligations. In order to show the collaterals as it is on the firm’s balance sheet, the auditors assisted in hiding the major details (Fazal, 2013). Furthermore, the transaction was depicted as the sale of inventory of securities, and eventually, such securities were minimized by Repo transactions. In addition, the borrowings or loans procured by the firm in opposition to such securities were not depicted in the balance sheet, as the firm made ways to treat such loans as ‘Sale proceeds of investment securities’. Nevertheless, the firm took all such steps in order to shed light on its liquid assets and less vulnerable liabilities.

Lehman Brothers also took steps to mortgage its long-term assets and investment securities for short-term borrowings in the form of commercial papers and repo transactions. Sooner, the firm was borrowing on a daily basis until the year 2008 when it became vulnerable to various kinds of risks due to such borrowings. Besides, providing entrance to debt obligations in the financial statements plays a key role in exaggerating the rate of interests, thereby generating a major risk over time (Parker et.al, 2011). Moreover, the financial institutions also stopped accepting long-term securities as collateral in opposition to short-term loans and therefore, Lehman Brothers became incapable of satisfying its debt obligations. On a whole, all these transactions played a key role in the disintegration of Lehman Brothers but the scenario was made disastrous because of concealment of relevant material information from the firm’s financial statements. If the auditors (Ernst and Young LLP) had performed their jobs in an effective way, then such disintegration might have been safeguarded or delayed to some extent.

ASA 707- Communication of relevant audit matters in the Independent Auditor’s Report

This auditing standard came into effect on or after December 15, 2016, in order to enhance the financial reporting standards. Moreover, the main goal of incorporating this standard into financial reporting is to evaluate the relevant audit matters and thereafter, communicating the same with an unbiased judgment on such matter to the management of the audit firm. Besides, communication of such relevant audit matter to the management can play a key role in enhancing the transparency of the audited financial statements that can, in turn, assist the user to observe the matters that can influence their decision-making as a whole (Guan et. al, 2008). Nevertheless, in relation to Lehman Brothers, if such auditing standard was implemented and followed, then the auditors could not have concealed such material information from the financial statements, thereby enhancing the user’s capability in interpreting the financials. Such key audit matters necessitate relevant and prior attention of an auditor while auditing the financial statements of a company (Wiggins et. al, 2014). Therefore, in order to evaluate the significance of such matter, the auditors must seek matters that pursue a bigger risk of material misstatement and the effects of such matters on the financial statements.

 

Auditing issues that resulted in the collapse of Lehman Brothers

The following issues shed light on the auditing issues on the part of Lehman Brothers. If ASA 707 was there at that time, the collapse of the firm could have been avoided or delayed. Therefore, the role of auditors in hiding the material facts from the financial statements resulted in a grave scenario, thereby creating a downfall situation for the firm.

  • Non-disclosure of inappropriate treatment of the Repo transactions in the auditor’s report and Notes to financial statements

The audit firm and Lehman Brothers itself made attempts to not shed light on the influence of Repo 105 transactions on the firm’s balance sheet because it would not be attractive in the eyes of financers and other investors, as they would consider the firm to be too vulnerable for investment. Therefore, the auditors must have played a role in disclosing all the effects of the transaction together with the wrong treatment of such transaction that was done by Lehman Brothers (Roach, 2010).

  • Efficient approval by auditors to manipulate the Balance Sheet

Lehman Brothers had initiated an internal policy of Reverse Repo and Repo 105 transaction, together with their improper treatment by depicting them as’ sale and repurchase of investments’ in the balance sheet. Moreover, this policy was framed after getting a prior approval from the auditors (Gilbert et. al, 2005). Thus, it was the duty of the auditors to restrict Lehman Brothers from conducting such mistakes. In addition, they must have warned them about the outcomes that would follow because of such steps. Besides, Lehman also started Repo 108 transactions in the later periods wherein it utilized equities in the place of fixed income securities as collateral. Moreover, the auditors also approved the same that was a grave mistake on their part (Wiggins et. al, 2014).

  • Inappropriate classification of raised funds and utilization of the same through Repo transactions by adopting FAS 140

In relation to the Repo transactions initiated by Lehman Brothers, it treated its short-term financial transactions as sales in the financial statements. In addition, the offered securities as collateral were not shown on the balance sheet of the firm, and the liabilities was minimized in order to shed light on the fact that the firm had paid off its liabilities by selling its securities. Besides, this was done just to portray a wrong image of the firm (Lapsley, 2012). Nevertheless, the actual treatment of Repo transactions was to depict the offered securities in the balance sheet and nothing was to be depicted that such securities were given as collateral to the third parties in opposition to the revenues procured from them (Elder et. al, 2010). Besides, such procured loans from third parties were to be depicted in the balance sheet until they were paid off. On a whole, as the transaction was treated as sales through the means of FAS 140, the loans procured from third parties was not depicted anywhere and the sold securities were minimized from the asset side of the balance sheet of the firm. Besides, Lehman conducted all such deeds in lieu of their auditor’s affirmation because the FAS 140 did not offer anything about an independent disclosure obligation (Wiggins et. al, 2014). Therefore, Lehman and its auditors took leverage of the same.

  • Failure to disclose misstatement of leverage ratios

The leverage ratio of Lehman Brothers had deteriorated in the year 2008 in comparison to the year 2007. However, such deterioration was not permanent and it was falsely generated through the use of Repo 105 transactions. Lehman repaid the debts of such repo transactions after the termination of fiscal quarters so that the securities would again be highlighted in the firm’s balance sheet. Nevertheless, this would have influenced the firm’s leverage ratios on a significant level and it was necessary to depict the same in the financial statements of the firm by the auditors (Elder et. al, 2010).

  • Failure to disclose non-approval of true opinion of sale in the United States

In order to treat the Repo 105 transactions under sales through the means of FAS 140, Lehman Brothers were under a non-delegable obligation to procure a true sales opinion that could play a key role in certifying that the transactions are in lieu of the legal requirements. Such true sales opinion was not attained by the firm in the United States. Sooner, the firm made collaborations with the UK finances in order to enter into Repo transactions wherein true sales opinion was procured with a prior condition that the investment securities must not only be depicted in the UK but also must only be traded within the country itself (Pilbeam, 2009). Based on such opinion, Lehman Brothers entered into several transactions and through which they had collateralized securities of fixed-income amounting of huge amounts of dollars. Besides, Lehman also started transfers of billions of dollars of fixed income generating securities of America, and that too without the prior permission from the UK financers (Black, 2010). In relation to the above situation, the auditors had full knowledge of the same but they failed to disclose it in the financial statements.

 
  • Approval of financial statements that hidden such Repo 105 transactions

It was the duty of Lehman Brothers to buy back the billion dollar securities being transferred to the third parties. However, they did not disclose the same in their financial statements. Besides, all these kinds of transactions were depicted as mere balance sheet fluctuations in their management reports. In addition, the responsibility to repurchase such securities at a minimal rate was shown as derivatives on the balance sheet (Manoharan, 2011). Besides, these derivatives were concealed in a huge number of derivatives that were highlighted in the footnotes section in the financials (Hoi et. al, 2009). In relation to this case, all the affairs of Lehman Brothers were approved by the auditors that shed light onto their concealment of facts.

 Hence, the previously mentioned issues clearly depict the deficiency on the part of the auditors of Lehman Brothers. Moreover, if there were an ASA 707 standard, the auditors might not have stepped back from their obligation in following an ethical audit process. Besides, this could have safeguarded Lehman Brothers from being collapsed and the investors as well from infinite losses.

Recommendation

It is the duty of auditors to follow an ethical procedure while conducting an audit process. Furthermore, in the case of misstatements or errors, the auditors must make steps to initiate corrective actions and report to the management regarding the same. Besides, adherence to auditing standards is a compulsion while conducting an audit process. Further, such auditors are not bloodhounds, and instead, they are watchdogs who must be capable in interpreting the affairs of the company in an effective manner. This is the reason why auditors cannot be responsible for losses to third parties who materially relied on the financial statements that were examined by the auditors. Unlike the case of Lehman Brothers, auditors must not make way for incorrect reporting on the deeds done by the management. On a whole, the downfall of Lehman Brothers summarizes the fact that there was a major loophole betwixt the statutory rules and their real implementation. This also sheds light on the loopholes in the statutory mechanisms and therefore, necessitates effective and strict auditing standards.

 

Conclusion

The incident of Lehman Brother is an eye opener to every organization as its projects the needs of corporate governance and strong ethical standards. Further, the organizations must follow the principles of corporate governance and ensure the ethical standard is being followed as it will lay a strong foundation. This will ward off any financial collapse. It is imperative for the company to adopt the accounting policies that best meets the requirement and helps in steering the company. Moreover, a strong accounting policy helps to face the situation with ease and hence recommended that companies must ensure a strong accounting policy.

 

References

Bhasin, M. L 2008, ‘Corporate Governance and Role of the Forensic Accountant’, The Chartered Secretary Journal, vol. 38, no. 10, pp. 1361-1368.

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,

Elder, J. R, Beasley S. M.& Arens A. A 2010,  Auditing and Assurance Services, Person Education, New Jersey: USA

Fazal, H 2013, What is Intimidation threat in auditing, viewed 8 May 2017, https://pakaccountants.com/what-is-intimidation-threat-in-auditing/.

Gilbert, W. Joseph J & Terry J. E 2005, The Use of Control Self-Assessment by Independent Auditors, The CPA Journal, vol.3, pp. 66-92

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.

Lapsley, I. 2012, Commentary: Financial Accountability & Management, Qualitative Research in Accounting & Management, vol. 9, no. 3, pp. 291-292.

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.

Wiggins, R.Z., Piontek, T & Metrick, A 2014, The Lehman Brothers Bankruptcy A., viewed 8 May 2107  https://som.yale.edu/sites/default/files/files/001-2014-3A-V1-LehmanBrothers-A-REVA.pdf

Zhang, Y,  Zhou, J & Zhou, N 2007, ‘Audit committee quality, auditor independence, and internal control weakness’, Journal of Accounting and Public Policy vol. 26, pp. 300-327.

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