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Key Audit Matters

Question:

What Communicating Key Audit in Independent Audit Report?

ASA701” Communicating key Audit Matter’s in independent Audit report” deals with the Auditor’s responsibility to convey or to communicate the key Audit matters in the Audit report. Key audit matters communicated for more transparency about the performance of audit. It also provide more information to the proposed user of the financial statements so that they can understand the matters, which in the auditor’s professional judgement were the most significant in the audit of financial statements. Communicating key audit matters to the proposed users also helps them to understand the entity and the areas of significant management judgement in the financial statements, which has been audited by the auditor.

The reason for introduction of this standard is to provide greater transparency regarding entity and its management to the users of financial statements of the company Key audit matters are those matters that are significant and require full attention of the auditor in performing audit. Key audit matters communicated to those charged with governance. Determination of Key Audit Matter(KAM)

  • Areas of higher risk of material misstatements.
  • Significant judgement of auditor, which relates to areas of the financial statements, which have significant judgement regarding management, also includes accounting estimates, which are identified as estimation of uncertainty.
  • Effect, which occurs on the significant transaction and event during the period Need for ASA701

Requirement for need of ASA701 Communicating key audit matters in independent audit report is developed for better transparency and for providing more and detailed information to end users of the financial statements of the entity, so that users have the knowledge of the entity they are trusting in. This standard is required to develop auditing standard that have an apparent public interest centre of attention and are of the uppermost eminence.

  1. Collapse of Lehman Brothers

Collapse of Lehman brothers was the biggest financial collapse in the year 2008.This collapse brings huge recession in the economy. This bankruptcy was the vibrant indication to the investors of distress in the market, which was extreme from the reason of the crunch In case of Lehman one of the largest investment bank, unpredictable government course of action amplified obscurity.

  1. Reasons, which led to collapse of Lehman brothers.

There were numerous reasons that led to the collapse of Lehman Bros. The main cause for the collapse were the liberation on the subprime mortgage. Maximum of the U.S banks similar to Lehman Brothers grabbed benefit of the bang preceding to 2007 and stretched enormous subprime mortgage advance. Basically these subprime mortgage  loans are extended to the customers who does not have good credit score, which on the other hand would not be accepted if the customer have poor credit score. The main characteristic of this subprime mortgage advance was the changeable interest rate. Later on, these changeable interest rates became trouble for the borrowers as the ability to pay back their credits were confronted, because adjustable interest rates were comparatively higher than the interest rates they were formerly disbursing on their borrowings. Unfortunately, prices of houses began to fall drastically, the investors were unaware of the situation, as the assurances given by the executives that fall in house prices will not affect the company and its investors were in their minds. However, the higher interest rates give rise to immense default in addition to low prices of houses, the firm made vast losses globally. This resulted in loss of trust of investors in other investment banks (Siskos, 2017)

Reasons for Introduction of ASA701

Two mistakes can be pointed out here is that firm’s failure to sort correct forecasts for the future and execute counter approach when market circumstances altered. Second point should be the negligence of top executives. They might have known these future alterations regarding loan scheme, but were busy in making their own profit or in other words misusing their positions Too much borrowing causing high leverages is another reason for bankruptcy of Lehman Brothers.

Other reason for the Lehman Brothers collapse was the perversion of the disclosure or revelation of repos transactions. Absence of competent and operational risk management policies also led to the collapse of Lehman Brother.

Failed bail out and takeovers also led to the downfall of Lehman Brothers. The Firm faces huge Losses and this led to the disposal of some of their subsidiaries. Assets were disposed due to huge losses of around $3 billion in its second quarter. By September 2008, the Losses were around $4 billion, which make them to sell their shares. As investors’ lost confidence, stock prices lost its half of the value (Norbel, 2017).

Collapse of Lehman Brother headed to hard times in the action of numerous businesses in U.S and globally. Only in U.S Lehman’s failure results in depreciation in price of properties. Lehman’s collapse also results in writing off nearly $47 million debts owed to the Federal Agricultural Corporation. Losses of jobs in huge number were resulted from Lehman’s demise. Firm’s stock prices falls, which had impact on the investment of the investor. This event had huge impact on its creditors and investors.  

  • Collapse of Lehman Brother was surrounded many audit issues such as external auditors fails to identify the occurrence of the timing of the repos transactions.
  • Failure of external auditors to realise that Lehman’s had broken generally accepted accounting principles i.e. obligation to make sure that all-important events that are probable to a firm’s financial statements should be revealed.
  • In absence of acceptable and unambiguous standard to guide all these transactions critically contributed to Collapse of Lehman Brother.
  • Failure of auditors by not identifying the financial misconducts by executives of Lehman (Fox, 2017).
  • The auditors in the financial statements could easily identify the main pointers of deception.

Downfall of Lehman Brother not only affected U.S economy but also resulted in financial crisis worldwide. Reasons which led to the Downfall has been discussed earlier also the auditing issues related to such downfall.

In order to enhance the report quality, increment of transparency, and to increase the accountability to the users of the financial statements of the entity they are investing or dealing in resulted in the introduction of ASA701 communicating key audit matters in the independent audit report (Azadinamin, 2017)

Lack of disclosure of consistent accounting policies, lack of communication of the material misstatements to  those charged with governance, lack of unambiguous standard to guide all the transactions in Lehman’s case, breach of generally accepted accounting standards calls for the introduction new accounting standard.

Year 2008 was the phase of global financial crisis, which involves the perplexing situation for the companies and their auditors. Economic state of affairs were deteriorating markets were illiquid. There were complications in sustaining liquidity and retrieving funds through financial institutions, shares and asset sale.

During this period there were problems for the auditors to obtain sufficient audit evidence. Auditors are likely to counter the rise in risk by increment in their professional suspicion.

  1. Give resignation to the clients having higher risks.
  2. Increment in the susceptibility to issue modified audit report
  3. To increase the effort in auditing.

Resigning from the risky clients were not so easy step. Hence, two approaches changes

in the susceptibility to issue going concern modification and to increase the audit effort        

These situations burdened auditors with additional pressure because if auditors do not

Lehman Brothers Collapse

Point the key auditing matters to clients before they fail because this may become the

Cause of penalties for auditors.

Where there is a substantial uncertainty that their clients will stay as a going concern both 

ASA570 and ASA701 necessitate auditors to amend their audit judgement.

Hence above mentioned circumstances resulted in introduction of new auditing standard

ASA701 communicating key audit matters in the independent audit report.

This standard ASA701 communicating key audit matters in independent audit report 

provides greater transparency, more information to the shareholders and investors.

  • Users of financial statements shows more interest in the matters in which auditors has the vigorous communication with those charged with governance, as stated in SSA260.
  • Necessitates auditors to communicate the key audit matters with those charged with governance, which not only is the reason for increased communication between auditors and with those charged with governance.
  • Increased communication with those charged with governance will bring to the notice of management of the entity to revelations in the financial statements, which are referred in audit report.
  • SSA 320 materiality in planning and performing the audit, clarifies that it is sound to the auditor to adopt that the users of financial statements :
  • Having knowledge of the entity and economic activities of the entity and accounting of the entity and have the inclination to study the facts in financial statements with sound attentiveness.
  • Apprehend that financial statements are equipped and audited considering materiality.
  • Realisation of uncertainties involved in future estimations judgements and events.
  • Making sound decisions based on the financial information of the financial statements (Audit reporting, 2017)
  • Requirement of disclosure of key audit matters in case ASA701 is applicable to Lehman Brothers during that time:
  • There should be transparency in the internal controls performed for the safekeeping of assets under prime brokerage. Lehman Brothers lacks transparency in their internal controls performance. Investor looks for assurance that the custodians of these assets perform proper internal controls related to assets under mortgage.
  • There was lack of management, extent of monitoring liquidity risk.
  • Lack of understanding of counterparty default risk, credit risk involved in the transactions.
  • Non-disclosure of significant events and transactions in the financial statements of the firm, which lead to the breach of generally, accepted principles of accounting.
  • Financial misconduct by executives of Lehman is the key audit matter.
  • Identification of timing of 105 repos transaction could be communicated to those charged with governance.
  • Extreme losses need to be communicated and disclosed in the audit report.
  • Lack of correct forecast to be gathered with counter approach to the changed market condition.
  • Risk involved in prime mortgage loan.

These Key audit matters are required to be disclosed in independent audit report. Each key audit matter should be separately disclosed.

Key audit matter should be separately disclosed under subheading in the audit report.

This will be an improvement in auditing practises as it enhances the transparency in internal controls, communication between auditor and management and provide additional information, which helps the investors and shareholders to have knowledge about the entity.

The importance of the key audit matter in regard to the audit of financial statement may be recognized by association between key audit matter and other essentials of audit report.

Collapse of Lehman Brothers was not forewarned in the auditor’s report which gave and unqualified report before its collapse because auditors were failed to identify the timing of repos transaction, they failed to identify the credit risk involved and materiality of the transactions, they failed to identify the financial misconduct mad by the executives of the Lehman. After introduction ASA701 communication of key audit matters in independent audit report not only increase the quality of audit work as well as enhance the auditors effort to determine the significant audit matter and to make disclosure of those in audit report as well as communication with those charged with governance.

Conclusion:-

From the collapse of Lehman brothers following points of failures have been highlighted:

Poor political actions, 105repos transactions, failed bailouts, poor management, poor financial practises, liquidity crunch, non-disclosures of significant transactions and events in financial statements and failed auditing practises.

This downfall was one of the biggest downfall in the history of U.S economy which also have a huge impact on global economy as well, which necessitates the introduction of ASA701 communicating key audit matters in independent audit report.

Auditor should communicate the key audit matter, which was disclosed in the report with those charged with governance. Downfall of Lehman not only applies to financial service industry but it also provides the lessons about corporate governance that relate to all companies. Recommendation would be to be practical and pursue reasonable business approach. Enforcement of strict regulatory measures that is the investment banks should act in accordance with their factual financial capability in place of deceiving anyone in order to acquire financial support. Investment banks should have controllable leverage ratios.

To retain the investor confidence is a big deal, this can be achieved through strict lawful and authoritarian framework.

Lehman acted immorally by breaching reliability  of standards in its use and violating accounting requisite by manipulating financial statements. Apart from the above Lehman were lacking risk management practises and flexible capital structure. The new audit standard ASA701 was developed in the wake of the global financial crisis in particular of Lehman brothers.

References

Norbel , M(2017).Lehman brothers. [online] Available at: https://www.heritage.org/report/lehman-brothers-bankruptcy-and-the-financial-crisis-lessons-learnedhtml [Accessed  9th April. 2017].[1]

Siskos, D(2017).Lehman brothers case. [online] Available at: https://www.thinkingfinance.info/uploads/1/7/7/1/17713111/dimitrios_siskos.pdf [Accessed  9th April. 2017].[2]

Auditing ans Assurance standards board [online]ASA 701 Available at: https://www.legislation.gov.au/Details/F2006L01403 [Accessed  9th April. 2017].[3]

Siskos, D(2017).Lehman brothers case. [online] Available at: https://www.thinkingfinance.info/uploads/1/7/7/1/17713111/dimitrios_siskos.pdf [Accessed  9th April. 2017].[4]

Lehman brother bankruptcy(2017).Lehman brothers. [online] Available at: https://www.pwc.com/jg/en/events/lessons-learned-for-the-survivors.pdf [Accessed  9th April. 2017].[5]

Fox, J(2017).Three lessons of the Lehman brothers collapse . [online] Available at: https://content.time.com/time/business/article/0,8599,1923197,00.html [Accessed  9th April. 2017].[6]

Audit Reporting(2017).ASA 701 [online] Available at: https://www.ifac.org/system/files/meetings/files/20140311-IAASBCAG-Agenda_Item_C1-Auditor_Reporting-Key_Audit_Matters-final.pdf [Accessed  9th April. 2017].[7]

Fox, J(2017).Three lessons of the Lehman brothers collapse . [online] Available at: https://content.time.com/time/business/article/0,8599,1923197,00.html [Accessed  9th April. 2017].[8]

Azadinamin, A(2017).The bakruptcy of lehman and brothers. [online] Available at: https://www.researchgate.net/publication/230687440_The_Bankruptcy_of_Lehman_Brothers_Causes_of_Failure_Recommendations_Going_Forward [Accessed  9th April. 2017].[9]

Mewtour , M(2017). Failure of Lehman brothers. [online] Available at: https://www.iiste.org/Journals/index.php/RJFA/article/viewFile/11290/11598 [Accessed  9th April. 2017].[10]

Audit Reporting(2017).ASA 701 [online] Available at: https://www.ifac.org/system/files/meetings/files/20140311-IAASBCAG-Agenda_Item_C1-Auditor_Reporting-Key_Audit_Matters-final.pdf [Accessed  9th April. 2017].[11]

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