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New Auditing Standard Of Lehman Brothers Collapse And Applicability

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Question:

Discuss about the Lehman Brothers Collapse And Applicability Of New Auditing Standard 701
 
 

Answer:

Introduction

The title of the report is the Lehman Brothers collapse and the introduction of new auditing standard 701. The title suggest that the collapse is itself is the history and there has been some fault on the part of the company as well on the part of the auditors that’s why the new auditing standard has been developed and implemented immediately after the collapse of the great Lehman Brothers. The aim of the report is to identify the reasons as to why the Lehman brothers have been collapsed and the reasons of collision made by the auditors and what key matters should have been reported by the auditor which would have avoided the collapse of Lehman Brothers. In the first section the historical background of the company – Lehman Brothers will be discussed and reasons will be discussed as to why the company has been collapsed. In the second section the reasons will be mentioned and discussed in detail as to why the auditors have not mentioned the fact of accounting fraud on the part of the company in his annual report. Thereafter in the next section the introduction of the new auditing standard has been mentioned and its applicability has also been mentioned and listed the key audit matters that shall be reported by the auditors in his audit report. Then the key audit matters have listed which should have been reported by the auditor in his audit report which would have avoided the collapse. At the last the report has been ended up with the proper conclusion and recommendation. With these aims and the purpose, the report has been prepared in the defined sections and paragraphs.

 

Lehman Brothers – History And Collapse

The company Lehman Brothers was founded by Henry layman in the year of eighteen thousand and forty four and has opened its first office in Alabama. In the beginning years he keeps on selling the dry goods to the customers of that province. After the joining of his two brothers in the business and with the ever growing cotton market presence in that area, they have expanded their business into the field of the cotton and start selling the dry goods to customers in exchange of dry cotton rather than money.  Now they are into the cotton business. Soon during the period of English Civil war it has been recognized that the there was place where all the business men are engaged as the commission agents and they have decided to move to that place and have started the business of commissioning and start acting as an agent. With the English civil war, many roads, bridges and other transportations system requires the huge renovation and Government has started floating the tender for work and the applying contractors or the companies were found in the need of funds to get the tender and the work started. With this the business of funding has taken its pace and Lehman Brothers from that period has started the system of banking and starts providing the funds to various companies and contractors and with the passage of time it has become one of the leading investments banking company serving the customers across the United States of America and other parts of the World (HBS, 2014). On 15th September of 2008, the Lehman Brothers have filed the bankruptcy application for protection which have shocked all the banking companies across the world and has been declared as one of the reasons for emergence of the global financial crisis for the year 2009 (Azadinamin, 2013).

The Lehman Brothers have been collapsed not suddenly but has been facing the worst situation for the last eight years starting from the year of 2000. The reasons for the collapse of the Lehman Brothers are:

  • Accounting Flaws – The Company has been using the techniques of Repo 105 transactions. These transactions are permissible by the accounting standards and the corporations act 2001 if the nature and type of the transaction remains the same as mentioned in the accounting standard. But Lehman brothers have misused the provision. Repo 105 transactions state that the company may sell the securities to the prospective buyers in lieu of cash and then after the stipulated time will repurchase the security from them at premium (Chadha, 2016). The essence of the transaction is that the company has to sale first and repurchases the same within the specified period. But in actual the company has done the agreements for repurchase of the securities but the purpose has been defeated by just selling the securities and not treating the same as the loan and advance which has resulted in the manipulated figures of the financial statements and the actual has been hidden from the fact. This has been prevailing for the last eight years but no one has noticed this fact. Due to this fraud the company has been running into losses in actual but has been in profit and reporting the quarterly profits (Farndale, 2008)..   
  • Lack of Buyer – The Company immediately before the date of filing the bankruptcy protection was in the urge of having any buyer who could purchase or acquire the assets and liabilities of Lehman Brothers. The company has been able to find the buyer – Barclays Bank but the same acquisition has been restricted by the Government regulations. Due to which the acquisition could not be done. Other banks that have faced the financial crisis have been able to find the buyers like Merrill Lynch and etc (Johnson, 2012).
  • Lack of Rehabilitation Loan – The federal reserve bank of India has backed from giving the loan to the company for its rehabilitation and revival as the company’s daily expenses are being incurred from the daily loans that the company keeps on taking from the banks (Maux and Morin, 2011). The down turn has secondly because of deep investment in the real estate sector and at that time it was at its peak and simultaneously the company was not able to receive the payment from the borrowers and the loan given has become the bad debts.

Thus, these factors apart from the liquidity problem and the heavy cost of employee majorly have led to the collapse of Lehman Brothers (Dutta, 2010).

 

Reasons For Collision Of The Auditors In Fraud

The auditor has to mention all the matters that he thinks to be disclosed according to the materiality in his auditor report on the financial statements of the company. He along with the relevant disclosure has to give the opinion as to whether the financial statements of the company represent the true and fair view of the affairs of the company.  The major reasons as to why the auditor has not disclosed the material facts in the auditor report are explained below:

  • The auditor of the company has received the high remuneration for the audit of the last eight years on consecutive basis amounting to $150 million and may be because of that the audit firm is under pressure to issue the unqualified audit report (Chatterjee, 2015, Mc 2010 and Inman, 2014).
  • The auditor of the company was having the view that the company has been operating and entering the transaction of Repo 105 within the provision of the relevant accounting standard (Goldstien, 2014).
  • .
  • With this misbelieve the auditor has not applied the relevant and additional audit procedures through which the fraud could have been easily defined.
  • The auditor has not verified the cash flow statements of the company and has blindly signed the cash flow statement which otherwise was showing the negative change in cash or cash equivalents for the last eight years (Coenen, 2010).  
 

Introduction Of New Auditing Standard 701

January 2015 is the history making period in the field of the audit and the most important standard in auditing practices has been introduced by International Auditing Assurance Standard Board that ISA 701- Communicating the Key Audit Matter (KAM) in the reporting of the auditor where the auditor has issued the Clean Opinion as a part of Independent Audit Report. This standard is further notified in 2016 by American Auditing Assurance Standard Board and applies on all American companies listed in New York Stock Exchange. The intention of this standard is that the auditor should:

  • Find out the matters which can be considered as Key Audit Matters, and
  • Mention these identified matters in the Independent Auditor Report

The matters which are considered as Key Audit Matters are opt by auditor from the information given by those charged with governance and have been assessed by auditor from his professional finding (AASB, 2015).

The auditor will determine the KAM after doing discussions with those charged with governance and then among these discussed matters auditor will identify the significant areas which require his attention and detailed audit procedures. The following key areas help the auditor in verifying the KAM:

  • Areas recognize as per ASA 315 in relation to identifying and assessing the material misstatements in the organization and its internal and external environment containing high risks.
  • Areas where the management has taken accounting estimates for recording the uncertainty in the transactions.
  • Areas where the audit procedures have made impact on transactions and its validity.

The auditor will assess the important matters from above areas and called them as Key Audit Matters.

After determining the Key Audit Matters, the auditor has to communicate these matters in the audit report. Each matters so identified by the auditor should disclosed properly in the audit report by containing the following:

  • What are reasons for considering the particular matter as Key Audit Matters
  • What are the methods employed by the auditors for assessment of key audit matters and their implications and if any corrective actions is required to be performed whether they have been performed and if so what are the implications of these actions and any other important point which needs investors attention on the matter.
 

Key Matters Disclosures – No Collapse

The fallback of Lehman Brothers cannot be happened on such a high scale if Australian Auditing Standard 701 was introduced in the earlier period before 2007 instead of 2016 when it was introduced by Auditing Standard Board.  The auditor in the collapse will be escaped on the fact that he issued unqualified opinion because there was no option to issue key audit matter and the opinion is not came under the category of qualified opinion. Even the stakeholders can save themselves if the key audit matters were reported in the auditor report and auditor has done substantial details audit procedures to check the key audit matters. The following reporting matters were considered as Key Audit Matters in case of Lehman Brother to stay away from fallback:

  • The complex nature of business of Lehman Brother should report as Key Audit Matter in the auditor report. As the firm was operating in more than 40 countries with 7000 or more offices across the world, there is high significant risk of having the disputes and difference of opinion among management personnel which was actually the major reason of the collapse.
  • The repurchase short term securities agreement known as Repo 105 transactions in the banking sector. The auditor should report the policy which was adopted by the firm in relation to these agreements. The firm shows these agreements as their operating sales and generates operating revenue which was used to pay of the liabilities lying in the balance sheet instead of recording them as borrowings which needs to repay with interest after lock in period of two years.
  • The auditor should report the decreasing level of liquid assets in the company. The cash and cash equivalents were impacted and decreased by $ 167 million in 2008 as compared to 2007 as result of payment of borrowings which has been generated from short term repurchase agreements.
  • The auditor should report about the subprime contracts entered into by the firm which the customers having bad credit rating for housing loans. The defaults were increased in these contracts creating a significant risk matter which can have material impact on the financial statements of the firm and lead to the reason for collapse and required the those charged with governance attention (Masytoh, 2010).

Conclusions And Recommendations

The report has been concluded with aim of finding the impact of fall back on the auditor report in case of Lehman Brother which created a history of manipulation of accounts from its accounting practices. The significance of the professional competence and due care by the auditor has been analyzed and discussed in relation to New Auditing standard 701- Communication of Key Audit Matter where the responsibilities of the auditor against the stakeholders has been increased in the matters having high risk and can impact the financial and liquidation position of the firm.

It is highly recommended from the study that the auditor should maintain the professional behavior with integrity and objectivity to find out the different risk factors which can have impact on the decision making of different users of the audit report.

 

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 at 16/05/2017).

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

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

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

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

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

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