Lehman Brothers: Background, Reasons For Fall, And Clean Auditor Report

Background Of Firm

The firm came into existence in the early period of eighteen centaury when businesses were started growing. The founder of the firm Henry Lehman started selling the dry goods to farmers in United State of America in his name. After six years of trading, two brother of Henry Lehman become the partner in the firm and the name of firm changed to Lehman Brothers. With new persons new ideas came in the firm and firm started selling goods in swap of cotton in substitute of cash and earned high profits by selling the cotton received and considered this as first step towards the diversity in business and entered in merchandize industry. From the merchandize industry, firm moved to financial commodity market where the firm started to act as finance source of new small business. Almost after almost 25 years from start up the firm has made its first future contract which dealt in exchange of cotton, petroleum and coffee. The firm acts a fiscal agent for US government and appointed as advisor in railroad projects. The firm then entered into merchant banking business by financing the railroad projects and also acted as underwriter for some rail road projects. With this merchant banking industry the firm had supported many industries like airlines, cinemas, retail and has discovered new idea in the field of the finance with Private Placement in underwriting contract. The worked for US Government and acted as advisor in across the borders transactions. The firm has indulge in the development and support of business which were need of hour like technological support company in form of capital market and came up of new concept which was development of merchant banker called investor banker. So after the growth story of over 150 years, the firm came out be the first largest invest banker who operates across 40 countries in the world (HBS, 2014).

The Lehman Brothers has achieved new heights in its life and made remarkable inventions in finance field so that more business can grow and economy growth of any country can be increased. But due following reasons the firm has come in ambit of insolvency and files the application for bankruptcy to apex court of America:-

• Accounting Frauds– The most important reason collapse of the firm was that the management of firm has done accounting frauds for more than eight consequently years and same fact has not been identified and reported by the auditors of the firm. The firm used the Repo 105 transaction in manipulative manner to represent higher profitability and lower liabilities to attract stakeholders for more investment in firm and firm policies. The firm sells the short term financial bonds in exchange receive cash and paid the actual liabilities standing in the balance sheet with this cash. The sale was shown as operating business sale but in actual it was firm short term loans taken by the firm from different investor and the firm had to repay these loans after two years with interest on loans. This treatment generated misappropriation in amount of firm’s liabilities and assets created hay way situation leading to collapse of firm (Maux and Morin, 2011).
• Uneven proportion of funds in firm- The firms has done many joint venture and associates transactions in turn making the firm share capital critical and more than 3000 entities were involved in funding the firm making another reason for  fallback and crisis . (Dutta, 2010).

• No rival actions taken by Government– The firm’s insolvency position could be solved by having an additional urgent and emergency loan of funds from the federal bank of America in the form of reserves given by federal in America to make the company survive. But in the case of Lehman Brothers the federal denied the management of firm by rejecting the application of granting Federal Reserve due to non availability of true assets in the balance sheet which left the company with no option other than declared bankrupt (Johnson, 2012)

• Huge losses in Subprime Agreements- The firm has entered into high number of subprime agreements which hampered the profitability of the company with high pace. The subprime agreement means the agreement of loans to customers who have very low rating in terms of credit worth. The contracts generally entered by the firm to earn high interest on these loans without considering the risk in the agreements. The results of these transactions created high amount of accumulated losses in the firms resulting in collapse of Lehman Brother (Azadinamin, 2013).

• Crunch of Liquidity -The firm has problem of funds in payment of short term obligations which arises due the accounting manipulation done by the company in Repo 105 transactions by not recording the liability for bonds. And when the redemption period the firm faces the problem funds as firm has not anticipate the requirement in advance resulting in risky situations in the firm which was difficult to manage by the management of firm (Chadha, 2016)

Nature And Use

The clean audit report shows that auditor has given unmodified opinion stating that the financial statements of the firm for which audit has been done by him are free from significant misstatement and showing the true and fair picture of the affairs of the company both in financial and non financial terms. This report is use by the auditor to inform the shareholders of the firm that the management is using the funds provided by them appropriately for the purpose of achievement of defined goals and objectives and no mistake in terms of ethical accounting principles has been done by management and the management is working towards the maximization of wealth of the shareholders.

In the case of Lehman Brother, the auditor had played the important role in supporting the management by issuing the clean report which deceive the shareholders trust in firm and created the major global crisis. Below are the main reasons for supporting the management by issuing the unmodified opinion:-

• Wrong Assumption on Accounting Policy-Ernst and Young the among the one of the top audit firm was the auditor of Lehman Brother and have issued qualified report for all the years in which the firm has used wrong accounting policy for recording and classify Repo 105 transactions. The basic reason for issuing the clean report in these transaction that the management has convinced the auditor that the accounting treatment done by them is another interpretation of the Repo 105 transaction as the firm is investment banking and these transactions were their operations so should considered as Income and not recorded in balance sheet. And as a result of this understanding of the auditor in relation to the accounting policy of the company the auditor fails to inform the shareholders about the finance transactions worth 50 million dollar (Chatterjee, 2015, Mc 2010 and Inman, 2014).
• Excessive Reliability on Previous Audit Report– The auditor the statement before the court declared that the current year auditor always relay on the previous year auditor in trials after crisis and fraud. The auditor said that if one policy has been adopted in 2000 and it has been considered good and the same been continued in next year the auditor will check in detail of that policy as reduces the current year risk. But in actual it is wrong belief of the auditor and this wrong belief help the management of the firm in getting the clean report from the auditor (Coenen, 2010).
• Financial benefits by management for Clean Report– The firm has paid very high fees to the auditor during the last few years of its survival before declaring the bankruptcy. This situation shows that the audit fees given to the auditor was mainly for issuing the clean report and for creating the false trust of the shareholders on the firm and its management (Goldstien, 2014)

Reasons Causing Fallback

After the Global Crisis, it has been found that auditor and audit report also plays the important and significant role protecting the stakeholders from the error and frauds which were the cause of the financial crisis. To increases the roles, duties and responsibilities of the auditor in to protect the interest of stakeholders or public at large and to enhance the quality of reporting, new audit standard has been issued that ASA 701- Communicating Key Audit Matters in the Independent Auditor Report in 2015 and made applicable on public accountants from 1^st January,2016. This standard helps the investor to made auditor liable for damages if caused due to non reporting of Key Audit Matter by the auditor in his report (AASB, 2015).

The main content of the standard comprises the objectives for which the standard has been issued along with the procedures of finding out the Key Audit Matter and its communication by the auditor in the audit report to sponsors of the company. The Key Audit matters are defines as the matter and communicated to auditor by those charge with governance and out of these matters the matters having significant high risk and call for auditor notice. The determination of the Key Audit Matter is done by the auditor after keeping in mind the following:

• Matters having high risk of material mistakes as assessed or matters which has been ascertain as ISA 315 having magnificent risk
• Matters which have high chances of management judgments and reflects in financial statements demanding high considering of the auditor professional judgments for example accounting estimates done by management in impairing the asset.
• Areas effecting the result of audit of important transactions done in the period for which the report is being prepared by the auditor

The auditor should informed about the identified key matter using different heading in the auditor report – Key Audit Matter  and describing the reasons for considering the particular matter and as Key Audit Matter for reporting and the steps taken during audit for the assessment and reducing the impact of the Key Audit Matter on the Financial Statements of an entity.

If the application of the New Auditing Standard ISA 701 has been done in the year before the fallback of the Lehman Brother, the impact of the fallback can be reduced the reasons can cured because of which the bankruptcy has been filed by the firm in 2008. And if the auditor had report the Key Audit Matter in the Independent Report issued for Lehman Brother, then the accounting frauds may be identified at the earlier stage and corrective actions can be taken by the shareholders of the company and its management. The following Key Audit Matter would have been disclosed by auditor in his audit report:

• Repo 105 transaction and accounting policy in adopted by the firm for its treatment -The auditor should that the firm is showing the Repo 105 transactions as revenue from operations rather than showing them as balance sheet item.
• Subprime contacts and their quantum- The auditor should report that the firm is entering into huge number of the subprime contracts in anticipation of future higher interest but due to fall in property market in US, the defaults in receiving the payment of loan and interest has increased impacting the profitability of the company.
• The auditor should report the firm noncurrent true assets are finishing year after year and the firm has not take any steps in future to safe the firm from risk of non available of the assets in the balance sheet (Masytoh, 2010).  

The above study concluded that the auditor is key player in presentation of the affairs of any company in front of the public as whole and being an independent professional party stakeholders beliefs on his report for making decisions and beliefs about the affairs of the company which can witnessed in the case of Lehman Brother where the reporting of the auditor manager the fraud till eight years.

The study recommended that the auditor should fulfill his duties and responsibilities with professional due care and should hurt his objectivity and integrity in any form. New developments like ISA 701 should taken place time to time in the society by the professional bodies which can create the check in the reporting of the auditor. 

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

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).