Acc707 Auditing And Assurance : Assessment Answers

Auditor's Report 

Required 

Answer:

Introduction

One of the most devastating financial crisis which hit the globe took place in the year 2008 and even after seven years, the globe is reeling under the effects of the said crisis. The world almost came to a standstill when Lehman Brothers declared itself to be bankrupt and crashed. Everything tumbled down and shares across all the countries fell in double digit percentages. After the said collapse, the situation was analysed in detail and it was concluded that one of the most striking reason behind the collapse was the auditors report which failed to communicate important and crucial audit matters in its report due to which the investors were misguided. Thus it led to the introduction of a new auditing standard, ASA 701 (ISA 701), Communicating Key Audit Matters in the Independent Auditor’s Report. Key audit matters comprises of such issues which calls for adequate focus by the auditor while conducting his work of audit. KAM is selected from such issues which are corresponded with those charged with supremacy and are dogged by taking into consideration areas of greater risk, important judgements of the auditors and the impact on the audit of important events and transactions. The report discusses about how the collapse of Lehman Brothers led to the need of ASA 701 and what auditing issues should have been addressed in the audit report of Lehman Brothers so as to have tried to prevent the said collapse.

Auditing issues surrounding the collapse of lehman brothers

Lehman Brothers collapse taught the world its biggest lessons. However, it would be wrong to solely blame the directors and the executives and the owners of the firm as it was also the auditors who played a major role in the said collapse. Thus there was no single cause of failure. The auditor of the said firm was Ernst & Young and there acts raised in questions to the reputation of the accounting and auditing profession. The cash flows that Lehman was running were negative due to which they were unable to pay off their immediate obligations as well (Elliott & Treanor, 2013). The firm also failed to maintain the trust since a number of business situations had made the firm land up with a huge clogging of illiquid assets whose value was diminishing and it mainly comprised of residential and commercial properties. The executives of Lehman had purposely manipulated the accounts and hid the actual scenario from all (Lartey, 2012). Further to his, the auditors also had intentionally ignored to the manipulations as early as 2000. The auditors had a notion that Repo 105 was being used majorly by Lehman and they were unable to disclose it to the government, investors and its own board as well and the auditors were well aware of all. Even though Repo 105 was as per the American Accounting standards but its main motive was to cheat and Lehman used such ways and means to diminish its accounted influence to a great extent (Mawutor, 2014).

Without the aid of auditors, it would not have been possible for Lehman brothers to manipulate their accounts. The firm’s managers very easily ignored and breached the Sarbanes-Oxley Act which came into being after the Enron and Worldcom disasters in the year 2002. The said Act was introduced so as to improvise upon the external auditing practices and independence, ensure proper disclosure, regain the trust of the customers, improvise upon the internal control practice and strengthen the role of the directors. However all of these were contravened by Lehman while implementing Repo 105 and the auditors also ignored such a violation and went on publishing an unqualified audit report on an year on year basis (Inman, 2010). The confirmation of a detailed disclosure of all the financial frauds being undertaken by the firm by the external auditors would have ensured that the said catastrophe be avoided.

It has been contended by the courts in the U.S., that Ernst & Young had fully supported the firm while it was accounting gimmickry to camouflage its shaky condition from the world. The most surprising part of all was that Lehman was manipulating from seven long years and not a single year were the auditors able to get hold of the fraud being conducted. Ernst & Young failed to even understand the fact that Repo 105 was being misutilized by Lehman. It had never taken any steps to investigate into Repo 105 accusations and also did not take action to cross question about the non-disclosure by the firm of the usage of impermanent $50 billion, transactions which were off balance sheet in nature (Coenen, 2010). It clearly shows that the auditors were highly unprofessional in their conduct and it clearly states that accounting is no longer counting that counts and those who were responsible behind the same were not knowledgeable enough to put a check on the ploys of Lehman. There were accounting frauds, disclosure frauds and manipulations which led to the collapse and the auditors were responsible and the auditors were not competent enough to ring the warning bells so as to safeguard the shareholders and the investors (Murphy, 2008). Had the auditors ensured that the disclosures were made adequately without any manipulations, then the investors would not have only relied on the accounting ratios which portrayed a rosy picture. They lacked two most sought after characteristics of an auditor i.e. independence and objectivity. Supporting of improper disclosures and accounting also caters to auditing frauds as well. Thus it is clear that the auditors have been one of the major contributory to the failure (Azadinamin, 2012).

Further the said manipulations were also not cautioned in the auditor’s report which published an unqualified opinion before the collapse simply because the firm went on committing heinous accounting frauds and the auditor went on signing the same, giving a clean chit each year. Ernst & Young is said to have supported Lehman in such a conduct which involved furtive elimination of tens of billions of dollars of fixed income securities from Lehman’s balance sheet so as to cheat the readers of the financial statements about the actual liquidity position of Lehman. E&Y is said to have minted more than $150 million in the form of audit fees during the seven years tenure of its acting as the firm’s auditors (McCool, 2010). The auditors were simply watching the show and blind folded signing the audit reports while the firm was misutilising the provisions.

Although, Ernst & Young defended the case by saying that they had given a clean report basis the fact that the transactions were recorded as per GAAP and when the Repo 105 transactions took place, as per the accounting rules it was not a necessary to disclose the same. However, if the matter is dug further down, then it would be construed that the auditors had not even audited the Repo 105 transactions which is a big miss out. The auditors even failed to check whether the volume of Repo 105 transactions were material to the balance sheet of the company thus impacting its net leverage ratio (Rapoport 2010). The auditors job is not to just sign the audit report clean if the accounting treatment is right in the theoretical sense. They should check upon the ethical side of the transactions as well. The auditors did not possess adequate audit evidence to support the opinions stated by them which was also the reason behind the demise of Lehman (Sharp, 2010).

Asa 701 (isa 701)- communicating key audit matters in the independent auditor’s report

The new auditing standard was introduced in the year 2016 and is operative for the financial reporting period ending on or after 15 December 2016. The main purpose behind the introduction of the said standard was to increment the value of the communication made by the auditors in their report by ensuring better transparency with regards the audit work being performed. By communicating key audit matters, the auditors are asked to disclose such extra data to the expected and the prospective users of the financial statements, which would in turn help them in understanding those issues which in the auditor’s professional judgement were of most importance while the audit of the financial report of the period in question. The said standard enables the auditors to form an opinion with regards the financial statements of a concern in its entirety. However, it is very crucial to understand that the same is not a substitute for the disclosures which are to be made in the financial statements by the management of the concern, neither it is a substitute for the auditor giving an opinion which is not unqualified, neither it is a substitute for reporting instead of ASA 570 requirements and it is not to be considered as an opinion which is separate for certain specific matters. ASA 701, basically is applicable to the audit of the general purpose financial statements of listed entities and situation when the auditors else concludes to communicate key audit matters in the auditor’s report. Also there may be situations wherein the law would bind the auditors to report on the key audit matters.

The said standard came into existence due to the imminent crumple of Lehman Brothers which forced the institute to introduce the same so as to keep a check on the ethical stances of an auditor or the audit firm. The said collapse, made it compulsory to define the list of situations wherein reporting of key audit matters is a necessity. KAM is not introduced to change the scope of the audit, but simply to make it more transparent. KAM is related to such issues which the auditor tends to converse with those who are charged with supremacy while conducting the audit normally. Thus unlike that was missing during the conduct of Lehman Brothers, the said standard calls for corresponding the important finding during an audit to the authority which is charged with governance.

Secondly, KAM comprises of such issues which require prominent attention and focus by auditors and they decide upon such matters by considering certain situations such as the areas of advanced gauged jeopardy of substantive misstatement and then plan the audit accordingly, thus defining the areas which requires significant attention. The auditor also accounts and notifies such areas of important management decisions and therefore also the auditor judgement as well which takes into account such accounting estimates which are very significant and highly uncertain in nature too (Auditing and Assurance Standard Board, 2015). The auditor is also required to consider those accounting policies which are not in line with the industry to which an entity belongs, such as REPO 105 used by Lehman Brothers and Ernst & Young ignored it even though the said policy and practice was not in line with the industry practice. Also, if the auditor notices any unusual and significant related party transactions, even then the alarm bells should be considered.

Due to Lehman Brothers collapse, KAM has acquired a significant place for itself in the auditor’s report under the heading “key audit matters” and using desired sub headings for every KAM. The additional information being demanded by the said standard would have led to more transparent reporting of Lehman Brothers financial position as each KAM necessitates description of matters such as the reason behind considering it to be a KAM, any reference to the disclosures being made by the management which would in turn help to increment the understanding of the users with regards addressing of the matter by the management and how was the KAM addressed in the audit (Reinties, 2015).

Another very significant question which the collapse of Lehman Brothers had pointed out towards the auditors was that of ‘going concern.’ Thus here the same has been replaced by ‘going concern basis of accounting’ and the same is applicable until and unless the management is of the opinion that the company would go into liquidation or stop operating anymore. Thus while conducting the audit, if the auditor finds that the going concern basis of accounting is not being used then he should report the same under KAM. The event of Lehman Brothers has also led to introduction of a new need when such events have been found out that may cast a prominent doubt on the entity’s ability to persist as a going concern, however there is no such existence of a material uncertainty (Pratt, 2014).

The disclosure by auditor as per asa 701 of lehman brothers

Had the said standard been introduced before the collapse of Lehman Brothers, then it might have saved the lives of many and also not led to such a disaster in the financial history of the world. The auditors would not have been able to ignore the uncontrolled usage of REPO 105 which was very uncommon to the usual industry practice. It was communicated to the auditors about the usage of REPO 105 and how the accounts were being manipulated so as to hide the unprecedented transactions. They should have drilled further at the time, as per ASA 701 and had the said standard been applicable at that moment, then E & Y would have been bound to report about the such abnormal applicability (Adu-Gyamfi, 2016). These transactions were occurring while the auditor was conducting his work and hence should have warned the executives and reported as well as per ASA 701. As per the standard, the going concern basis of accounting would have been checked by the auditors and they would have found the accounting fraud thus reporting in the KAM section of the report. When the auditor saw that a large number of assets were recorded off balance sheet, then they should have tried to gather significant audit evidence and report the same as a part of the KAM as this showed a material misstatement was undergoing since it is quite out of the normal course to have a huge number of assets off the records thus showing a rosy picture (Moran, 2010). The applicability of the said standard would have forced the auditor to question about the use of REPO 105 as it is a key audit matter which requires adequate disclosure and communication. The then applicability of ASA 701 would have also alleviated the responsibilities of the auditors which would have included and forced E&Y to exercise intimate professional judgement, indentify and assess the risk associated with so much of off balance sheet funding which was clearly showing the risk and the volatile nature of the company, check onto the present internal control systems in vogue within Lehman Brothers, evaluate the accounting policies and thus blow the whistle over the incorrect and fraudulent usage of the accounting practices and finally the compliance with the independence requirements (Akbarli, 2011). Therefore had ASA 701, become applicable during that time, then the auditors would have been bound to report under the section “key audit matters” without any lame excuses.

Conclusion

Thus it is understood, that the collapse of Lehman brothers led to the emergence of the most prominent and sought after auditing standard which would ensure communication of the key audit matters as a separate section even if the auditor does not give a qualified opinion. This would enable the users of the financial statements; take an informed decision with regards their investment as well as the risk being undertaken by entities. Holding Ernst and Young solely responsible would be unacceptable, but disclosure of such unusual transactions or at least an intimation of the same would have saved at least the money of many investors and also led to avoidance of such a huge collapse. The economy got impacted majorly and of which the auditors, the most trusted profession by all also was a contributor. Thus ASA would definitely bring in some relief and safeguards, thus strengthening the reporting requirements of the auditors and allowing no room for escape or such unethical conducts.

References:

Adu-Gyamfi, M., (2016), The Bankruptcy of Lehman Brothers : Causes, Effects and Lessons Learnt, Journal of Insurance and Financial Management, vol.1, no.4, pp. 132-149

Azadinamin,A., (2012), The Bankruptcy of Lehman Brothers : Causes of Failure & Recommendations Going Forward, Available at file:///C:/Users/E-ZONE/Downloads/SSRN-id2016892.pdf (Accessed 18th May 2017)

Auditing and Assurance Standard Board, (2015), Auditing Standard ASA 701 Communicating Key Audit Matters in the Independent Auditor’s Report, Available at https://www.auasb.gov.au/admin/file/content102/c3/ASA_701_2015.pdf (Accessed 18th May 2017)

Akbarli,R., (2011), Causes of Collapse of Lehman Brothers and accounting fraud- Repo 105, Available at https://www.academia.edu/9278011/Collapse_of_Lehman_Brothers?auto=download (Accessed 18^th May 2017)

Coenen,T., (2010), Fraud Files: Is Ernst & Young to Blame in Lehman Bros. Fraud? Available at https://www.aol.com/article/2010/12/23/fraud-files-is-ernst-and-young-to-blame-in-lehman-bros-fraud/19774486/ (Accessed 18^th May 2017)

Collings,S., (2010), Auditors called on the carpet over Lehman collapse, Available at https://www.accountingweb.com/practice/practice-excellence/auditors-called-on-the-carpet-over-lehman-collapse (Accessed 18th May 2017)

Elliott,L., & Treanor, J., (2013), Lehman Brothers Collapse, Five years on: ‘We had almost no control’, Available at https://www.theguardian.com/business/2013/sep/13/lehman-brothers-collapse-five-years-later-shiver-spine (Accessed 18th May 2017)

Inman,P., (2010), Auditor’s role in Lehmans collapse unites opposition in calls for reform, Available at https://www.theguardian.com/business/2010/mar/15/auditors-role-lehman-collapse-critics (Accessed 18th May 2017)

McCool, G., (2010), Ernst & Young accused of hiding Lehman troubles, Available at https://www.reuters.com/article/us-ernstandyoung-lehman-lawsuit-idUSTRE6BJ1FP20101221 (Accessed 18th May 2017)

Murphy,A., (2008), An Analysis of the Financial Crisis of 2008: Causes and Solutions, Available at SSRN: https://ssrn.com/abstract=1295344 (Accessed 18^th May 2017)

Lartey,R., (2012), What caused the collapse of Lehman Brothers? Available at https://www.jteall.com/Lehman%20Brothers%2001.pdf (Accessed 18^th May 2017)

Mawutor, J.K.M., (2014), The Failure of Lehman Brothers: Causes, Preventive Measures and Recommendations, Research Journal of Finance and Accounting, vol.5, no.4, pp. 85-91, Available at https://www.iiste.org/Journals/index.php/RJFA/article/viewFile/11290/11598 (Accessed 18th May 2017)

Moran,S., (2010), Ernst & Young: Could the Auditors have saved Lehman Brothers? Available at https://businessdonerightpress.sheilamoran.net/2010/12/20/ernst-young-could-the-auditors-have-saved-lehman-brothers/ (Accessed 18^th May 2017)

Pratt.H., (2014), New Auditor reporting requirements are imminent, Available at file:///C:/Users/E-ZONE/Downloads/Dec14%20-%20AuditorReporting%20(2).pdf (Accessed 18^th May 2017)

Reinties,C., (2015), Analysis: Focus on Key Audit Matters, Available at https://www.accountancysa.org.za/wordpress/analysis-focus-on-key-audit-matters/ (Accessed 18^th May 2017)

Rapoport,M., (2010), Role of Auditors in Crisis Gets Look, Available at https://www.wsj.com/articles/SB10001424052748703814804576036094165907626 (Accessed 18th May 2017)

Sharp,A., (2010), Lehman Brothers’ ‘Repo 105’ Accounting Scandal, Available at https://www.wealthdaily.com/articles/lehman-brothers-enron-accounting-gimmicks/2375 (Accessed 18th May 2017)