Collapse of Lehman Brothers
Lehman Brothers were considered the fourth largest investment-banking firm in the United States but sooner, it had to face disintegration in 2008. Before 2008, it offered global financial services to all its customers but in the event of bankruptcy, it had to file for Chapter 11 bankruptcy. Nevertheless, it had to encounter such problems because the management failed to evaluate the risks and even the auditors did not indicate the management of the outcomes of such a step (Wiggins et. al, 2014). Moreover, the auditor’s concealed relevant information associated with this situation from the financial statements that could have assisted in avoiding such a tragedy (Ghandar & Tsahuridu, 2013). Hence, it can be said that appropriate and efficient approaches and regulations are very crucial in the modern environment, as it can result in an effective outcome as a whole.
In the housing market, there was a boom betwixt 2001 and 2008, and Lehman Brothers presumed every investment in such market to be very worthy and profitable in nature. As a result, it borrowed massively and invested all such resources in the mortgage markets. However, the sub-prime mortgage businesses of all the housing finance had become ineffective by the time. In addition, Lehman Brothers had also taken steps to invest resources into Real Estate business from its own capital (Wiggins et. al, 2014). As a result, it had expended billions of resources into vulnerable portfolios irrespective of what outcomes it would cost.
The Lehman Brothers firm was now totally or most probably depending on the loans received from the third parties, for investing the amount in the mortgage market. This information was not at all disclosed in the financial statements of the firm. The main cause of such decisions was the year from 2001 to 2008, which was seen as a period to increase the reputation of the firm as the duration and the conditions leading to the highlight of this period seemed to be very profitable. But these conditions which looked like a boon had already thrown the sub-prime mortgage business in the darkest pit and had destroyed it completely (Pilbeam, 2009). In addition to such mistakes, the firm totally lost their chance of revival when they had offered their own securities and assets as for private financing, real estates, and leveraged lending, which destroyed them completely. To carry out all these activities as to keep up their name in the market as in the past they borrowed heavily and huge amounts from various financers, all these risks had already alarmed the management of the firm of their collapse (Hoffelder, 2012). A clever move as thought by the firm was that they invested these huge amounts borrowed in risky portfolios in order to expand them and to be capable of paying off all the debts. This was rather a very foolish and dumb decision on the part of the firm. An overall summation of all these mistakes led to the firm’s collapse.
The various issues and facts that were required to be taken into account during the preparation of the financial statements were as follows:
Instruments that were utilized
An extension to the mistakes was added as the use of the Repo 105 transactions in a very absurd and wrong way. This was done to show a positive picture to the public and the shareholders of the firm so as to keep them interested in the firm, but the main target behind all this was to impress the other financial institutions using their financial statements so as to enable them to get more funds from those institutions and in an easy way (Hoi et. al, 2009). The firm knew well about their conditions and so they kept their securities as collateral and started utilizing the borrowed money to pay off their debts. This was a way to provide consistency to the securities as they were shown on the balance sheet. For executing such plans to accomplish the targets they were fully supported by the auditors of their firm (Cappelleto, 2010). Transactions made by the firm were cleverly shown as inventory sales of securities and on the other hand, the securities were decreased by the use of Repo transactions. It was also seen that the firm demanded loans against the securities from the third parties, and all these was not at all tracked and was never shown on the balance sheet because the firm used the loans as ‘Sale proceeds of investment securities’ (Wright & Charles, 2012). But the firm had something to show finally, and that was its liquid assets and such liabilities which were not exposed to any risks or that can be prevented from getting depleted.
The Lehman Brothers firm left no opportunity to get a chance of borrowing amounts from the third parties. In order to achieve it also threw its long-term assets and the investment securities in the bottomless abyss of trade (Guan et. al, 2008). All this was done for short-term borrowings in the form of commercial papers and Repo transactions. The firm reached such a condition where it was borrowing loans from other financiers on a daily basis and borrowing huge amounts, it was in the year 2008. Besides, the debts obligations also started to enter the financial managements which were no less than a catastrophe to the firm (Wiggins et. al, 2014). The firm didn’t realize the increasing rates of interest due to the debt obligations. Finally, the third parties and the financial institutions also refused to keep the long-term securities as collateral against the short-term loans and thus the firm was unable to clear its debts. As per Fazal (2013), the major backdrop for the firm was provided by concealing the transactions and other decisions which were supposed to be shown on the balance sheet. It was not only the mistake of the firm management but also on the part of the auditors as they didn’t aware the firm about the upcoming consequences (Elder et.al, 2010). The auditors were from Ernest and Young LLP. The firm might have been saved or the time of collapse could have been extended if the auditors had stood up against the absurd decisions of the firm.
ASA-707- Communication of relevant audit matters in the Independent Auditor’s Report
December 15, 2016, is the date when the auditing standard came into action. This step was taken by the government to set a positive standard of the financial statements. Its importance in the financial statements is to look out for matters of immense relevance to the enterprise and to report the same to the management of the auditing firm. All these matters are treated seriously by the auditing standard. Besides the target, there are advantages to this move too. This activity provides transparency to the financial statements and presents a clear picture of the condition of one’s company in front of the public interested in the tit and also to the shareholders (Manoharan, 2011). If in the case of the Lehman Brothers such standards would have been applied then they would have recovered the lost ground of the firm and there would have been a chance of their survival (Black, 2010). In order to save the company from incoming risks, the auditors should be honest enough to apply these auditing standards to the financial statements. This is a way to prevent big risks.
There are many reasons which led to their collapse. It is also obvious that the absence of the ASA-707 at that time was a major drawback whose presence could have saved the firm or extended the duration of collapse. Some of the major reasons for such a disastrous downfall of the Lehman Brothers are as follows:
With proper consent and help from the auditors, the firm was successful in hiding the impact on the balance sheet due to the Repo 105 transactions. They understood the fact that if the conditions are disclosed then public will think a lot before investing in the firm which would have been a disaster for them so they made such decisions (Messier, 2013). The auditors also played a major role in concealing the important facts and figures.
Lehman brothers adopted the policy of Repo 105 and Reverse Repo imaging them as sales and repurchase of investments. After some time they also took over a Repo 108 policy to use utilities in the form of securities. All this was done only after the consent of the auditors who didn’t warn the firm about the consequences that would follow (Hoi et. al, 2013).
The firm had kept its securities as collateral which was never shown on the balance sheet. The values of liabilities were also minimized in order to fool the public and show that the firm is paying off the debts by selling the securities. It was the duty of the firm to show the debts in the balance sheet till the date they are completely paid off. This was simply done to frame a positive picture of the firm (Arens et. al, 2013).
The leverage ratio was very smartly decreased by the Lehman Brothers in the year 2008 than the one in the year 2007. But it didn’t sustain for long as it was the result of the repo transactions. The firm cleverly paid the debts of the transactions when the fiscal quarters were over and this helped to show the securities as consistent.
Key Audit Matters for Lehman Brothers
The Lehman Brothers were bound to produce a true sales permit for treating the Repo transactions as sales under FAS 140. This permit would prove the transactions to be legal. The firm after getting rejected to get the permit from the United States made collaboration with the UK finances. But the deal had a condition that all the trade related to securities would be done inside the UK only (Wiggins et. al, 2014). Agreeing to such conditions the firm entered many transactions worth billions of dollars. The auditors had the knowledge of the consequences but never revealed it.
The Lehman Brothers paid no heed in buying back the securities worth billions. Besides, they made a very clever more to show all these transactions as small fluctuations and they didn’t disclose such clauses in the financial statements. This was a big mistake. Purchase of the securities at minimal rates was depicted as derivatives (Manoharan, 2011).
Thus, the above-mentioned points clearly point out the major mistakes on the part of the auditors and their contribution in disastrous decisions. It also points that if the ASA-707 existed then the auditors would have been bound to follow the strict morals of the ethical audit process and this would have saved the company from collapsing (Jubb, 2012).
Recommendation & Conclusion
Auditors are responsible for conducting an ethical operation during their audit process. In addition, proper reporting of frauds or errors must be done so that the efficacy of audit report is not hampered. Moreover, the auditor must take into account relevant auditing standards during such processes. Nevertheless, they are just watchdogs and not bloodhounds of a company and must be able to interpret the company affairs in an adequate way. This is the main reason why they are not liable to third parties who have primarily depended upon their judgment regarding the financial statements. Furthermore, auditors must not follow an immoral path in response to ineffective affairs of the management. This is the reason why Lehman Brothers had to face downfall as there was a major opening between its regulatory requirements and actual implementation of the same. On a whole, this also depicts gaps in the regulatory system that must be immediately replaced by effective and stricter auditing standards.
References
Arens, A. A, Best, P. J, Shailer, G. E. P & Loebbecke, J. K, 2013, Assurance Services and Ethics in Australia, 9th ed, Australia: Pearson.
Ghandar, A & Tsahuridu, E 2013, The Auditing Handbook 2013, Australia: Pearson.
Jubb, C 2012, Auditing: A Business Risk Approach, Australia: Cengage
Messier, F. W 2013, Auditing and Assurance Services – A systematic approach, 9th ed. Australia: McGraw Hill.
Black, W. K 2010, Epidemics of “Control Fraud” lead to Recurrent, Intensifying Bubbles and Crises, Working paper, University of Missouri-Kansas City.
Hoi, C. K, Robin, A & Tessoni, D 2009, ‘Sarbanes-Oxley: are audit committees up to the task?, Managerial Auditing Journal vol. 22, no. 3, pp. 255-67.
Manoharan, T.N 2011, Financial Statement Fraud and Corporate Governance, The George Washington University.
Pilbeam, K 2009, Finance and Financial Markets, Palgrave Macmillan
Cappelleto, G. 2010, Challenges Facing Accounting Education in Australia, AFAANZ,
Wright, M.K. & Charles, J 2012, ‘Auditor independence and internal information systems audit quality’, Business Studies Journal vol. 4, no. 2, pp. 63-84
Wiggins, R.Z, Piontek, T & Metrick, A 2014, The Lehman Brothers Bankruptcy A., viewed 15 May 2107 https://som.yale.edu/sites/default/files/files/001-2014-3A-V1-LehmanBrothers-A-REVA.pdf
Guan, L, Kaminski, K. A & Wetzel, T. S 2008, ‘Can Investors Detect Fraud Using Financial Statements: An Exploratory Study’, Advances in Public Interest Accounting vol. 13, pp. 17-34.
Hoffelder, K 2012, New Audit Standard Encourages More Talking, Harvard Press.
Hoi, C. K, Robin, A & Tessoni, D 2009, ‘Sarbanes-Oxley: are audit committees up to the task?, Managerial Auditing Journal vol. 22, no. 3, pp. 255-67.
Elder, J. R, Beasley S. M.& Arens A. A 2010, Auditing and Assurance Services, Person Education, New Jersey: USA
Fazal, H 2013, What is Intimidation threat in auditing?, viewed 15 April 2017, https://pakaccountants.com/what-is-intimidation-threat-in-auditing/.
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