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Communicating Key Audit Matters In Independent Audit Report

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Question:

How Communicating Key Audit Matters in Independent Audit Report?

 

Answer:

Introduction

ASA701” Communicating key Audit Matter’s in independent Audit report” it specifically deals with, the overall responsibility that an auditor has to convey key matters in the audit report. Communication of key matters provides a lot of transparency to the users of financial statements, they get an idea on which are the most important areas of audit in the auditor’s report. It also helps the users to understand the entity better and also the key areas that forms the basis of the auditor’s report in a better and a detailed manner. The main reason why this standard was proposed to give the overall transparency related to the method of audit and the financial statements of an entity and enhancement. It helps the management in preparing its books of accounts in a better way.

The key audit matters are those matters that are a significant part of auditing and are communicated to those charged with governance.

  1. Determination of Key Audit Matter(KAM)
 

The key audit matters are determine by the following factors-

  • The areas of material misstatement, where the chances of risks are higher.
  • The areas of significant judgment, that requires specific assertions by the auditor, like decisions regarding the management, very estimations of accounting and areas where there is an estimation of uncertainty.
  • The overall effect that occurs on the significant transactions and areas during the period.( Sirois, L.P., Bédard, J. and Bera, P., 2016)
  1. Need for ASA701

The need for ASA701, can be put in words like communication of key and important matters of auditing to the users of the audit report, to provide transparency and a detailed and more information to the users of the financial statements, and also that the users have an understanding of the entity they are putting a reliance on. The development of standard helps in bringing the important areas of audit into limelight and how they affect the entity, the end users and also helps in establishing the responsibility of the end users.

  1. c) Collapse of Lehman Brothers

The year 2008, witnessed the biggest collapse of that era, the fall down of the Lehman brothers that made the world aware about the severity of the financial crisis going on in the world, and how immediate action is required to fight the situation. The bankruptcy provided validation about the overall distress in the market; it also led to awareness among the investors. The reason behind the fall down was the , unpredictable government course of action amplified obscurity.

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

There were several reasons that led to the fall of the Layman Brothers, One of the primary reasons of the downfall was the liberation on the subprime mortgage. Seeing the Lehman Brothers, a large number of other banks in U.S started providing such enormous subprime mortgage advance in 2007.The main reasons why these submarine mortgages were forwarded was to give the customers with poor credit standing a stand, it would not be accepted if the customer had poor credit score. One of the main characteristics’ of the subprime mortgage advance was the changeable interest rate.  But these differential interest rates , later became a huge problem, because it held to trouble for the borrowers to pay back their credits, because these rates were ultimately higher than the normal rate , at which such credits were disbursed among the people in the society. Because of this, the prices of houses began to fall drastically, and the investors were not aware of the situation, because the company had given an assurance to the investors that such fall in prices will not affect the overall standing of the company and the investors. However due to high interest rates, there was a massive fall in the prices of the housed and that led to huge losses. (Frank, N. and Hessen, H., 2009)

The two faults that can be identified here, is the inability of the firm to correctly forecast the future and hence undertake counter actions to deal with the same. The second point would be the negligence on part of the top executives. They must have known the high rates effect on the prices of the housed and how eventually the investors will suffer from the same, but still they dint take any steps in that regard because they were busy, in making their own profit and making use of their dominant position. When we borrow too  much, it leads to high level of leverage and that is also one of the main reason for the fall in the bankruptcy of the Lehman Brothers. Another reason that was responsible for this fall was the perversion of the disclosure or revelation of repos transactions. The lack of component and operational risk management policies also led to the fall in the Lehman brothers. The company also entered into various mergers and other amalgamation s, but that eventually fizzled out and that was also one of the reasons. As the firm faced 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. Because of all these the investors lost confidence and thus there was a decline in the prices of the company’s stock.( Cordos, G.S. and Fülöpa, M.T., 2015)

 

Briefly if we put in the main reasons of the fall of the Lehman brothers was

  • The overall liquidity crunch
  • Huge losses
  • Subprime mortgages
  • Failed bailouts
  • Negligence of the executives
  • Manipulation of the financial disclosures
  • Failed mergers
  • Repo Transactions
  1. e) Effect of collapse of Lehman’s Brother.

The collapse of the Lehman brothers led an awakening in the world about the severity of the financial crisis and how that was affecting the other business companies in the U.S and the U.K. It led to depreciation in the prices of the property in U.S. It also led to writing of agricultural debt amounting to around nearly 47 million dollar that it owed to the Federal Agricultural Corporation. There was also sudden unemployment, as large number of people lost their jobs. The loss of jobs led to the demise of the Lehman brothers. The prices of the firm’s stock also fell, and it had an impact on the investors and the health of the company. This even had huge impact on the creditors and the investors. It had some major effect on the some of the big companies and firms outside Europe and the United Kingdom.(O Fernando, C.S., May, A.D. and Megginson, W.L., 2012)

  1. f) Auditing issues surrounding the collapse of Lehman’s Brother

There were several auditing issues that led to a fall the company. The main such issues were-

  • The failure on part of the external auditor to identify the occurrence of the repo rates and how the company was affected by the same.
  • The failure on part of the auditor to decipher how the company had broken the generally accepted accounting principles that is the responsibility to make sure that all the factors affecting the auditor externally was revealed properly.
  • There was no standard regulation on part of the company to be followed, and this absurd and ambiguous standard that was used to guide all the critical transactions contributed to the collapse on part of the Lehman brothers.
  • The failure on part of the auditors to identify the misconducts of the executives of the company
  • If the audit was conducted properly, the auditor would have been able to identify the main pointers of mistakes very easily.

Issues led to the introduction of ASA701 communicating key audit matters in the independent audit report:

The downfall of the company not only affected the U.S economy, but also led to wide spread crisis worldwide. The main reasons that led to this fall was have been discussed earlier. In order to increase the overall transparency and to improve the quality of auditing, the ASA701 was introduced, for communicating key audit matters in the areas of the independent auditors. The overall lack of the accounting policies, the lack of communication between the various parties that led to the overall material misstatement and the use of ambiguous and substandard method for reporting on key matters, all this led to a need to introduce this standard of auditing.( Hofmann, C., 2011)

In year 2008, the world witnessed huge financial crisis, and this led to a serious situation for the other companies also. The overall economic state was also detoriating, there was a lot of complications in maintain liquidity in the market and ascertaining flow of income through the financial institutions, shares and asset sale. The auditors also faced a huge amount of problem in conducting the audit, there were issues in collection of data and the overall documentation. The auditor was not able to counter fulfil their suspicions that aroused during audit. There are three ways by which the auditor can conduct their audit work effectively. There were three approaches open for the auditors to accomplish audit risk :

 

If the clients are having risks, the auditors can give their resignation.

If there is a continued suspicion, then the auditors can change their audit report and modify their opinion

The auditors must follow the code of ethics and give their best in conducting the audit. It was not easy to resign from the risky clients, hence the auditors, can resort for the other two options of modifying their report and also increase their efforts for the same. The auditors are in risky situation, if they fail to identify the hidden risks and comment for the same they will be liable because they are auditing the financial statements, so they have to answer the clients, thus it burdens the auditor with additional pressure. 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 the above situation led to a introduction of anew standards of auditing known as the ASA701 communicating key audit matters in the independent audit report. It provides great transparency to the investors , and the end users of the financial statements. (Gentler, M., Kiyotaki, N. and Quorate, A., 2012). 

Requirements of ASA701

The main requirements are communication of key audit matters to those charged with governance, to determine the key audit matters, and proper documentation.

Scope of ASA701

Users of financial statements show more attention in the matters in which auditors has the vital communication with those charged with governance, as stated in SSA260

Necessitates auditors to converse the key audit matters with those charged with governance, which not only is the cause for increased communication between auditors and with those charged with governance

Increased communication with those charged with governance will carry to the note of management of the entity to revelation in the financial statements, which are stated 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 :

That covers that auditors must have a detailed about the entity and the management; pre field audit must be done. The auditor should ascertain that the financial statements are properly equipped and properly audited. The auditor should have  a realisation about the uncertainties of the future, and should make sound decisions based on the financial information of the company.

 
  1. l) Requirement of disclosure of key audit matters in case ASA701 is applicable to Lehman Brothers during that time

There should be proper transparency in the internal control performed by the auditor in the areas of book keeping. In case of Lehman Brothers it lacked transparency in case of its internal records and its management. There was also lack of management to monitor liquidity; there was lack of understanding of counter party risks, the large amount of risks involved in prime mortgage loan was also not mentioned. The overall losses are needed to be communicated to the company. (Sánchez-Medina, A.J., Blázquez-Santana, F. and Alonso, J.B)

The key audit matters are to be described in the auditor’s report, each matter must be described separately and proper judgement must be passed on the same. It will lead to an improvement in the overall method of auditing, as the quality of audit increases and also helps in recognising the relationship between the key audit matters and the independent auditor’s responsibility. (Wiggins, R.Z., Bennett, R.L. and Metrick, A., 2014.) Collapse of Lehman Brothers was not forewarn in the auditor’s report which gave and unqualified report previous to its collapse because auditors were failed to recognize the time of repos transaction, they fail to identify the credit risk occupied and materiality of the transactions, they failed to identify the financial misconduct mad by the executives of the Lehman. (Azim, M.I., 2013.)

  1. l) Recommendations and Conclusion:-

From the detailed analysis of the collapse of the Lehman brothers it is very how important it is to audit the finical statements to the best of one ability to showcase the true position of the financial statements and the advent of the new standards of recognition helps in making the work easier and more effective. It was wrong on part of Lehman to not give importance to overall standards and policies of accounting ,and therefore it faced the consequences.( Presley, T.J. and Jones, B., 2014.)

 

References

Financial spillovers to emerging markets during the global financial crisis (No. 9-104). International Monetary Fund

Central bank collateral and the Lehman collapse. Capital Markets Law Journal, 6(4), pp.456-469.

. The value of investment banking relationships: evidence from the collapse of Lehman Brothers. The Journal of Finance, 67(1), pp.235-270.

Financial crises, bank risk exposure and government financial policy. Journal of Monetary Economics,59, pp.S17-S34.

Independent Auditors Report: Australian Trends From 1996 to 2010. Journal of Modern Accounting and Auditing, 9(3), p.356.

Do Auditors Reflect the True Image of the Company Contrary to the Clients’ Interests? An Artificial Intelligence Approach. Journal of Business Ethics, pp.1-17

. The Informational Value of Key Audit Matters in the Auditor’s Report: Evidence from an Eye-tracking Study.

 Understanding audit reporting changes: introduction of Key Audit Matters. Accounting and Management Information Systems, 14(1), p.128.

The Lehman Brothers Bankruptcy D: The Role of Ernst & Young.

Lehman Brothers: The Case Against Self-Regulation. Journal of Leadership, Accountability and Ethics, 11(2), p.11

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