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Auditing and Assurance Program: Chaotic Case of Lehman Brothers Assessment Answer

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's report (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

Module Number-

Executive summary 

The fall faced by Lehman Brothers had not affected the organisation alone. The entire economy suffered because of the corporate collapse. The global financial crisis overweighed the entire economy and the performance of every organisation faced a downfall. Evaluation of the demise of Lehman Brothers unveiled the presence of several auditing issues that promoted this collapse.  The current report is prepared to analyse the chaotic case of Lehman Brothers and discuss the rationale behind the introduction of this auditing standard in the corporate world. To make the understanding about key audit matters in a better way, the audit reports of listed entities falling under ASX 100 list in “Utilities Sector” are analysed. The key audit matters reported by the auditors of these organisations are discussed to analyse their informative value to the readers. The usefulness of this report revolves around the raised understanding for readers about the auditing issues and detailed information about world of finance.

Introduction

Lehman Brothers was the fourth largest investment bank of U.S. in the year 2008. The company had announced revenues of $19.3 billion and $4.2 billion of net income for financial year 2007 then. But the news of bankruptcy filing came as a nightmare. Neither the investors, not the other stakeholders expected this demise. Being the fourth largest investment bank, the bankruptcy of Lehman Brothers was a total shock. But, the reality cannot be escaped. The entity filed bankruptcy within 72 hours of declaration of blooming results of financial year 2017 under Chapter 11 bankruptcy on September 15, 2008. This demise initiated the Global Financial Crisis. The conditions behind the bankruptcy started at the time of housing boom in US in the year 2003-2004. In the boom period, Lehman Brothers like other investment bankers obtained five mortgage lenders. Owing to the boom in housing sector, the organisation mortgaged immensely to its clients.  But, economy took a U-turn (Ball, 2016). A concrete discussion is presented about the difference in situation which would have persisted at the time of Lehman Brothers if ASA 701 had been introduced before the collapse. Maybe, the solid requirements for the auditors laid by this standard might have even prevented the collapse (Sirois, Bédard, & Bera, 2018). Undoubtedly, the level of accountability of the auditors has been raised by the announcement of ASA 701 Communicating Key Audit Matters in the Independent Auditor’s Report and revision of ASA 570, Going Concern. Banking sector introduced a new reform, which made it difficult for the clients of the investment banker to repay for the mortgages granted to them (Auditing and Assurance Standards Board., 2013).

Discussion of the Lehman Brothers Limited

 The rates of default rose for the entire country. Lehman Brothers had been the first US investment banker which felt the pressure of this default. The bank collapsed and the entire banking sector faced the implications along with economy. Analysis of the demise of Lehman Brothers brings in light the ineffective audit practices undertaken by auditors Ernst & Young. Investors and other stakeholders placed deep trust over the audited financial statements assuming them to be effectively audited. However, in reality, the auditors worked unprofessionally (McDonald, 2016). 

At the time of demise of Lehman Brothers, the financials and recording in them in relation to subprime loans was with an estimation of surge in housing prices in near future and continued survival of market boom. This belief was promoted by the auditors as they never questioned the future expectation and were negligent. Also, Lehman Brothers encouraged the use of Repo-105 transactions. This led to preventing of excessively high leverage ratio from being disclosed to the public. The leverage ratio was as high as 31:1, while for U.S. the acceptable ratio that time had been less than 15:1. There was a continued window dressing of the financial statements, which again was not cross questioned and neither disclosed by EY. Neither of the malpractices nor the inefficient operations were indicated by the audit reports (McKinley, 2018). 

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

In response to this global crisis multi – fold pronouncements were made in the field of auditing and accounting. The most prominent among them had been the introduction of an entirely new auditing standard, which raised the quality of information provided by the auditors in their audit report and eventually aimed at raising the communicative value of audit reports. This standard was named ASA 701, Communicating Key Audit Matters in the Independent Auditor’s Report. Also a revision was brought in the ASA 570, Going Concern. The ASA 701, communicating key audit matters in the independent auditor’s report, mandates the auditors to inform in their audit report the areas which has required significant audit time and attention from auditors (Cordoş, & Fülöp, 2015). These areas are referred to as key audit matter. The auditors decide the key audit matters on the basis of the communication they conclude with those charged with governance. Although no separate opinion is offered by the auditors on these matters, yet a communication is made in regard to their high significance in comparison to the rest of financial statements.  The auditors are responsible to decide whether or not a certain matter can be categorised as key audit matter (Carson, Fargher, & Zhang, 2016)

From the discussion presented for the demise of Lehman Brothers, it is easy to understand that auditor’s negligence had a major role to purport the spread of erroneous financial information to the users. Study of ASA 701, provides insight into several audit matters which have been introduced only by this auditing standard and which never prevailed at the time of demise of Lehman Brothers (Köhler, Ratzinger-Sakel, & Theis, 2016). It has been argued several times that if such standard was in operation at the time of Lehman Brothers’ existence, the kind of negligence shown by EY in audit function would have never been observed. If ASA 701 had been there, the members of Lehman Brothers would have known the faulty practices employed in business by the management (Auditing and Assurance Standards Board., 2015).

An efficient audit practice would have declared the high leverage ratio as well as the risky operating practices of Lehman Brothers. The investors upon the knowledge of these important aspects about business would have made investment decisions in a transparent environment. The understanding about the actual state of financial statements would have proved to be more relevant for the investors and have let them understand the actual operating environment (Brasel, Doxey, Grenier, & Reffett, 2016). If the key audit matters were existed at that time, the repo transactions, revenue transactions from mortgage agreements, and the high leverage ratios would have been stated in the audit report. A clear indication of extremely risky areas would have proved better to give warning to investors about the high risk profile of organisation. The investors would have not relied upon the financials if they were aware of these facts, and ultimately the market would not have crashed (Sánchez-Medina, Blázquez-Santana, & Alonso, 2019).

Hence, a strong relationship exists behind the introduction of ASA 701 and the collapse of Lehman Brothers. The collapse was the actual reason for which Australian Accounting Standard Board (AASB) found it relevant to introduce the ASA 701, Communicating Key Audit Matters in the Independent Auditor’s Report. 

Reasons for revision of ASA 570, Going Concern

Going concern assumption is laid by the management of any listed organisation where the entity’s ability to continue business in indefinite future is affirmed. Any organisation continues business with an assumption of not ceasing operations in foreseeable future. The auditors are responsible to analyse the use of Going Concern assumption used by the management in preparation of the financial statements. When Lehman Brothers demised, the use of Going Concern was not audited accurately by the auditors. Even when EY knew about the wrong expectation of going concern implied in the business of Lehman Brothers, it never bothered to communicate the same either to management or to the members. Had the investors got early warning about the wrong use of going concern assumption in business, they would have made strategic decision about making investment in Lehman Brothers. The shock that went to the investors on collapse of the organisation would have been avoided (Hossain, Chapple, & Monroe, 2018). 

After the collapse, the entire investor community demanded such measure which can help them to get informed about the potential signs which cast doubt upon the going concern ability of the entity. In response to that, the AASB brought a revision into the ASA 570, Going Concern. Now the ASA 570 requires the auditor to mandatorily report the risks and warning signs that they notice in relation to the going concern of the organisation. This acts as a help to the investors in making wise decisions in light with correct information. This reporting is made by adding a separate paragraph in audit report with the name of “material uncertainty related to going concern” (Brunelli, 2018). 

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

The following description is upon the key audit matter paragraph reported in the audit report of the organisations working in the “Utilities” sector. In addition to this, the usefulness of this report revolves around the raised understanding for readers about the auditing issues and detailed information about world of finance.

Key audit matterCorporation in which the matter is identified and discussion
  • carrying value of Property, plant & equipment and intangible assets
In the corporation APA Group, this is identified as a key audit matter by the auditors Deloitte. It has been distinctly presented in the key audit matter Para to bring specific knowledge toward investors about their significance. The manner of their allocation to several cash generating units is reflected. Investors are informed about the management estimations used in valuation about discount rates, future contract renewals, assumptions about inflation and (Auditing and Assurance Standards Board., 2013).
  • Hedge accounting
In the corporation APA Group, this is identified as a key audit matter by the auditors Deloitte. Hedge accounting has been implicated in business through the use of Derivative transactions and balances. It is shown as a key audit matter to inform investors about the foreign currency exposure in which organisation is involved along with the manner in which organisation has hedged the same.
  • unbilled Revenues and the unbilled distribution costs
The audit of AGL Energy Limited is undertaken by Deloitte. The first key audit matter defined in Key audit matter Para relates to unbilled Revenues. The auditor has warned investors about the use of judgements by management in estimation of consumption of gas and electricity. The estimation has been significant particularly for the period of reporting date and last date of invoice. This is a matter to be informed to the investors to make them understand the high use of estimations in reporting revenues that are unbilled yet. The same thing is reported as a key audit matter for the unbilled distribution costs.
  • Financial instruments
This is also considered as a key audit matter for AGL Energy Limited. This is because of the high end use of assumptions in relation to valuation, future rates, market prices, etc. The estimations are put upon by judgement of management of entity. The investors have to consider the financial figures that are entirely based upon market expectation. 
  • Recoverable amount of investments using the equity method
The auditors of Spark Infrastructure Trust are Deloitte. Recoverable amount of investments using the equity method is disclosed as a key audit matter by the auditor. The major investments about which information is disclosed in key audit matter Para relates to TransGrid, SA power Networks and Victoria Power Networks. The investors are informed about the valuation of $2,326 of investments which is on account of the use of equity method.
  • recognition of revenue
The auditors of the Ausnet Services had been KPMG. There are complex regulatory frameworks revolving around recognition of revenue and billing. These complexities relate to revenue recognition and billing of distribution of electricity and gas.
  • valuation of non-current assets
The investors are informed about the regulatory framework existing in Victoria for the valuation of these assets making this a key audit matter for Ausnet Services.
  • Valuation and Accounting for derivatives
This is a key audit matter because it is important to inform the investors about the size and complexity of derivative portfolios held by Ausnet Services. The portfolio held by entity is operating in risky environment.

The above analysis clearly shows the effective communication undertaken by the auditors in their audit report which have added to the communicative value of their communication. In relation to the revised ASA 570, Going Concern, no reporting is made by the auditors in the audit report. It implies accuracy of the “going concern” assumption undertaken by the management. There are no potential warnings existent in the financial statements which make the going concern assumption to a risk. Had such kind of requirement as laid by ASA 701 in relation to key audit matters existed earlier, when Lehman Brothers was in operation, the investors would have been wiser (Goodwin, & Wu, 2016).

Conclusion

With the changes in the economic condition, every organization needs to strengthen its transparency and recording frameworks. An efficient audit practice helps organization to determine the leverage and audit risk associated with the audit plan of the company. It is analysed that the high leverage ratio as well as the risky operating practices of Lehman Brothers has shown that company needs to keep the transparency in the books of accounts. The investors upon the knowledge of these important aspects about business would have made investment decisions in a transparent environment. Nonetheless, strong relationship exists behind the introduction of ASA 701 and the collapse of Lehman Brothers. It reveals that all the financial books of account should be transparent to the investors and stakeholders if company wants to sustain in the market. The understanding about the actual state of financial statements would have proved to be more relevant for the investors and have let them understand the actual operating environment.  It is required out of the auditors in the current scenario that they report everything in relation to the risky events and transactions. Ethical principles must prevail over any profit interest and the auditors must reflect the true opinion. ASA 701, Communicating Key Audit Matters in the Independent Auditor’s Report and revised ASA 570, Going Concern lays the same requirement. Proper follow up of such standards would certainly prevent any future collapse.

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