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ACC707 Analysis of Leman Brothers Case and Introduction of Auditing in Organization Assessment 2 Answer

King's Own Institute

ACC707 AUDITING AND ASSURANCE T119

Assessment 2

Assessment Type: Auditing case study – 2500 + 10% word report - individual assessment.

Purpose: To allow students to demonstrate their ability to research, critically analyse trends and issues in auditing and assurance services, identifying problems as would arise in a modern organisation. This assessment relates to learning outcomes a, b and c.

Value: 30%

Topic: Research, critically analyse and evaluate key audit matters in independent auditor’s report

Auditor’s report

The new auditing standard ASA 701 communicating key audit matters in the independent auditor’s report was developed in the wake of the global financial crisis (note: following the demise of Lehman Brothers shortly after it received an unqualified audit report, i.e. no prior warning of its demise). This development is in response to calls from shareholders to know more about the companies they invest in (students would need to explain what happened in Lehman Brothers which would evidently be a key audit matter if such an auditing standard had existed then). Further, investors have also requested earlier warnings of potential issues that may exist with respect to an entity’s ability to continue as a going concern which resulted in the revision of ASA 570 (ISA 570) going concern (to include a going concern uncertainty paragraph. Note: during the global financial crisis there was an increase in emphasis of matter paragraph mainly relating to going concern uncertainty now replaced by a “material uncertainty related to going

concern” paragraph).

Required: Students are required to research into the rationale for the new auditing standard ASA 701 and explain clearly what it is. Each student is to select an industry, eg. banking, mining, etc and analyse key audit matters in the independent auditor’s reports of all companies in that industry in ASX top 100 listed companies so as to evaluate the efficiency of reporting key audit matters in the independent auditor’sreport (i.e. does key audit matters disclosure provide more information to users). The report is to be fully referenced (including the annual reports of companies selected for your assignment) and up to 2,500 words (assignment in excess of 2,500 words will be penalised 10% of the marks). There should be a minimum of 8 academic references. The report should include title page, executive summary, table of contents, appropriate headings and sub headings, recommendations, reference list (Harvard- Anglia style), attachments if relevant, single spaced, font Times New Roman 12pt.

Answer

Auditing and assurance program

Executive summary 


The fall of Lehman Brothers was very huge and created a high impact on the whole economy including Lehman Brothers. The outcome of global financial crisis was worst, and every organisation was suffered due to the same. The main reason behind the demise of Lehman broth came in picture and the reason was the auditing issues. In this report, there is an overall analysis of Leman Brothers case and the main reason behind the introduction of the auditing standards for the organisations. It also includes clear understanding about key audit standards by doing the analysis of audit reports of some listed companies under ASX 100 list that comes under “Utilities Sector”. There is a discussion about the key audit matters provided by the auditors so that an analysis can be done on the informative value that is provided to the users of financial statements. This report is very useful as it can create a good understanding for readers about several auditing issues and information about the financial market.

Introduction

With the changes in the economic condition, various investors have faced loss in their invested capital due to the several corporate scandals. However, Lehman brother was the one of the biggest scandal of its time. Lehman Brothers was one of the largest banks in US in 2008 and as per financial year 2007, there was a recorded revenue of 19.3 billion and net income of $4.2 billion. But the information of bankruptcy has changed everything, and it was a nightmare for everyone. This incident was so unexpected, and investors and stakeholder did not have any idea about such situation. Even after such big revenue numbers, this was happened, and it was a shocking news for the public as well. The bank filed bankruptcy within 72 hours after declaration of the results of the year 2017 under chapter 11 (Holder, 2011). It resulted in the global financial crisis and it was discovered that the circumstances behind this bankruptcy was started in 2003-2004 in US when there was a housing boom running. Every investment banker was on the same pace that time and Lehman brothers did the same. The bank obtained five mortgage lenders and because of the boom, Lehman Brothers mortgaged to the clients at the same time (Petrovic, Manson & Coakley, 2016). But suddenly, economy got reverted. There is a deep discussion about the variance in the situation which can be happened at the time of this Incident if ASA 701 was already introduced at that time before this incident. There might be chances that the strong requirements of ASA 701 for auditors might prevented this collapse. The accountability level has been increased for the auditors by the introduction od ASA 701 that requires the explanation of the key audit matters in The Auditor’s report and it also fulfils the revision of ASA 570- going concern. Banking sector has also came with a new strategy that creates difficulties for the clients of investment banks to repay the granted mortgages (MIAO, 2018).

Discussion of the Lehman Brothers Limited

There is a discussion about the key audit matters provided by the auditors so that an analysis can be done on the informative value that is provided to the users of financial statements. The Incident of Lehman Brothers has created issues in the entire country. Such incident happened for the first time in US that felt such pressure of default. It collapsed the whole banking sector and economy. After the analysis, it was found that there was ineffective audit practise done by the Ernst & Young that was the auditor of the organization (Yongkui, 2013). All the stakeholders and investors had blind trust on the auditors and they believed that they are seeing a clear and fair picture of financial statements, but the auditors worked in a very ineffective way (Novák, 2018). While this incident happened, all the financial records related to subprime loans and housing prices got estimated and in future also, there was a survival of the boom in the market. Auditors were negligent, and they promoted the belief, and no one questioned them regarding future expectations. At the same time, Lehman brothers encouraged the usage if Repo-105 transactions. This basically prevented the disclosure of extra high leverage ratio to the public (Velte, 2018). At that time, the leverage ratio was 31:1 and the acceptable ratio for U.S. was less than 15:1. Because of this, there was a lot window dressing in the financial statements and no one has questions and even it was not disclosed by the auditors.

ASA 701, Communicating key audit matters in the independent auditor’s report: Rationale behind introduction

  With the increasing globalization, all the listed companies are disclosing their audit matter in their financial statements with a view to strengthen the financial viability in the long run. Because of this global crisis, there were different pronouncements made related to the auditing and accounting. The most important among all of them was the introduction of a new auditing standard that help in getting quality information from the auditors as well as improve the communication worth of the audit reports. Name of this auditing standard was Asa 701, Communicating Key Audit Matters in the Independent Auditor’s Report. A revision was also done in ASA 570- Going Concern. As per ASA 570, communication key audit matters in the independent auditor’s report, it is necessary for auditors to enter all the valuable information into it and they have to specify areas where they need more audit time and attention. Such areas are referring as Key audit matters. The decision related to the key audit matters are decided as per the communication charge as per the governance (Channuntapipat, Samsonova-Taddei & Turley, 2019). There is a different opinion that is offered to the auditors on such issues but still communication is made for the high importance matters related to the financial statements. It is all depend on the auditors to classify and categorise the key audit matters.


It can be clearly understandable that the main reason behind the demise of Lehman Brothers is the negligence of auditor’s as they have provided wrong and unfair financial information. There is a wide information provided in ASA 701 that clearly elaborated some audit matters that are introduced by this auditing standards and which were not focused while the demise of Lehman Brothers happened (Nguyen & Gong, 2014). There is an argument on this, if the same standard was introduced earlier, before the demise then the negligence shown by EY in audit function would have never happened. If ASA 701 was introduced that that time, then Lehman Brother would have known all the unfair and faulty practices in the organization. Financial information plays a very important role in business as decisions of investors totally dependent on the same and they prefer to take decisions in the transparent environment for future benefits. A good audit practice would have possessed a high leverage ratio and operation practices of Lehman Brothers that is full of risk ("The Joint China Accounting and Finance Review (CAFR) and Journal of Accounting, Auditing and Finance (JAAF) Conference", 2014). The actual state and picture of financial statements help the investor to let them understand the real scenario of operating environment of the organization. If there was an existence of key audit matters at that time then their audit report would have included all repo transactions, mortgage agreements, reverse repo transactions and high leverage ratios. The investors would not have trusted the information and facts and the market would not have crashed.

So, it can be concluded that there is a very strong relationship between the ASA 701 and the collapse of Lehman Brothers. The collapse was a very big reason for the introduction of ASA 701 by the Australian Accounting Standard Board (AASB) (Hasan, 2016).

Reasons for revision of ASA 570, Going Concern

The concept of going concern states that management of every business assumes the continuation of its business for an indefinite future period without any plans to discontinue the same. Every organization assumes its business to stay forever and never cease the operations. It is the responsibility of the auditors to conduct an analysis of going concern concept used by the management while preparing financial statements of the organization. The concept of going concern was also not audited in the correct manner by the auditors and EY was aware about the wrong expectation of going concern for Lehman Brothers and they never revealed the same to the management or to the members. If it was revealed earlier, then investors might consider this as a warning and would have changed the decisions about investing in Lehman Brothers (Feng & Pevzner, 2013).

After this incident, all the investor was expecting a measure that can help them in getting the clear picture of the financial condition as well as the potential signs that can create a doubt on the going concern of the organization. In order to resolve issues like this incident, AASB has revised ASA 570 that is related to going concern. Now it is mandatory for the auditors to report the signs if they notice for hampering going concern for the organization. It also assists investors to take decision in accordance with the fair and correct information. There is a separate paragraph for this information in the audit report with the name “material uncertainty related to going concern”.

Audit report analysis of listed companies of ASX 100 under “Utilities” industry

There is a description related to all key audit matters that needs to be reported in the audit reports of the organization that operates under “Utilities” sector. There are many benefits of this report in understanding the main issue and information regarding finance (Ye, Gao & Zheng, 2018). All the key audit matters have been assessed in context of the different companies which are found to be the top 100 ASX listed companies working the utilities sector. Nonetheless, all the applicable AASB are considered as a key audit matter as it is necessary to inform the investors about the size as well as the complexities of derivative portfolios. The portfolios in operating in an environment that is full of risk.

Key audit matterCorporation in which the matter is identified and discussion
Property, plant & equipment and intangible asset’s valuationDeloitte is responsible for undertaking the audit of APA group and Deloitte. There is a description in key audit matters Paragraph to make then investors know about the significance. Allocation of the cash generating units is disclosed. Information regarding Contract renewals, assumption regarding inflation and discount rates has been provided to the investors.
  • Hedge accounting
It is also considered as a key audit matter by the auditors for APA group. Hedge accounting is applied in the business using Derivative transactions as well as balances. It is defined as a key audit matter to the investors as there is an exposure about the foreign currency in which organization is involved and the same has hedged the same.
  • unbilled Revenues and the unbilled distribution costs
Deloitte is also responsible for the audit of AGL Energy Limited and the first key audit matter is given in the key audit matter paragraph which is related to the unbilled revenues. Auditors had given warnings to the investors so that they cab use the information provided by the management according to the estimate of consumption of electricity and gas. The estimate is related to the reporting period date and the last invoice date. It is an important matter that must be informed to the investors so that they can get the knowledge about the unbilled distribution cost (Kaupelyte, Seilius & Zinkeviiiitt, 2014).
  • Financial instruments
This is also considered as a key audit matter as it involves high assumptions regarding valuation, market prices and future rates. All the estimations are done as per the judgement of management. Investors are required to consider such financial figures as it is totally depending upon the market expectation.

  • Recoverable amount of investments using the equity method
Spark Infrastructure trust has appointed Deloitte as its auditor. Recoverable amount of investments is the key audit matter disclosed by the auditor. Recoverable amount is related to the SA power networks, TransGrid and Victoria Power network. The information has been provided to the investors about the valuation of $2,326 investments that is calculated by using the equity method.
  • Revenue Recognition
  KPMG is appointed as the auditor of Ausnet Services. It has a very complicated framework related to the revenue recognition and billing related to the distribution of gas and electricity (Asbahr & Ruhnke, 2019).
  • Valuation of non-current assets
Information related to the regulatory framework has been provided to the investors in Victoria so that valuation of assets can be considered as a key audit matter for Ausnet Services.
  • Valuation and Accounting for derivatives
This is considered as a key audit matter as it is necessary to inform the investors about the size as well as the complexities of derivative portfolios. The portfolios ae operating in an environment that is full of risk.


With the help of above analysis, it can be clearly understood that effective communication in key audit matters play a very important role and revision of ASA 570 assumes the accuracy of the going concern. Nonetheless, the going concern in the given companies is strengthen by setting up harmonization in its reporting frameworks and proper implication of the IAS 137 in its accounting compliance.  These key audit matters are the imperative to determine the disclosure and transparency of the recorded assets in the books of account. It helps in assessment of the all the top listed companies and their key audit matters which have been recorded in the financial statement. It is also used by the investors to assess the financial viability of the company in long run (Yongkui,  2013). After assessing the case of the, Lehman brothers, it is found that this case encouraged the usage if Repo-105 transactions which is used to make the misstatement in the books of account.  This basically prevented the disclosure of extra high leverage ratio to the public (Velte, 2018). 

Conclusion

It has been concluded that is very important for every organization to maintain transparency and a proper framework as it helps in determining the leverage and audit risk attached to the company. Because of the absence of transparency in the books of accounts of Lehman Brothers, the incident was happened. It is necessary to maintain transparency to the stakeholders and investors to sustain in the market. Auditors are responsible to comply with all auditing standards in a proper way and report everything related to the risky transactions and events. ASA 701 and revised ASA 570 help in fulfilling the requirement and avoid future uncertainties. It is analysed that AASB has revised ASA 570 that is related to going concern and all the listed companies were asked to comply with the applicable standards to strengthen the reporting frameworks and set up proper harmonization in their domestic and international reporting frameworks. Now it is mandatory for the auditors to report the signs if they notice for hampering going concern for the organization. It also assists investors to take decision in accordance with the fair and correct information. Nonetheless, there is a separate paragraph for this information in the audit report with the name “material uncertainty related to going concern in the listed companies. 

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