Student Name: Student ID No:  Subject: Topic of the Assignment: Individual / Group Assignment: Total Word count: Level of AQF:  Executive Summary: This assignment is prepared to explain the purpose of the new Auditing Standard ASA 701 – “Communicating Central Audit or review Matters in the tending or Independent Auditor’s Report”, in order to help the users of the monetary Financial Statements to draw specific attention to significant matters which are considered to be “Key Audit Matters” for the current period under Audit (Gorodilov, 2013). The ASA 701 (in line with ISA701) was developed at the time of financial crisis that happened globally, precisely in the second half of 2000’s. During this period, there were huge collapses in the U.S markets, in particular, the Lehman Brothers, one of the world’s largest Financial Services firms. In September 2008, the firm filed for Corporate Bankruptcy (protection through re-construction); the United States Bankruptcy code (Chapter 11) (Brédart, 2014). This research report aims to list out the auditing issues that led to the firm’s closure and how the impending collapse was not forewarned in the E&Y Auditor’s report of Financial Statements for fiscal year 2007 that expressed an “unqualified opinion”.   Introduction: ASA 701 issued by the AUASB, is the Australian equivalent of the ISA 701 (issued by the IAASB) and reproduces substantial parts of the corresponding ISA 701 (January 2015). ASA 701 is applicable for reporting time period ending on and after the 15th December, 2016. Compliance with ASA 701 implies compliance with ISA 701. These standards apply in the audit of the full set of Financial Statements for all listed entities for the current period and retrospective periods, if required. (Asa 701, Auasb). Lehman Brothers, one of the well-established listed entities in the U.S.A faced its period of ups and downs. The details for its downfall due to the failure of premonition from the management’s side resulted in disclosing manipulative Financial Information to the users of Financial Statements. This went hand-in-hand with Lehman’s Auditors (E&Y) who also failed to forewarn the shareholders at large of their impending closure (Sule, 2010). The impact of such business practices shook the shareholder confidence and the rest is history. An Auditing Standard that will bridge the loopholes in such cases is explained in the report with Lehman Brothers case law. Lehman Brothers – The Beginning & Its Collapse: Lehman had record revenues with its investment banking business, with a business model devised by the executives in the management. The business model involved excessive risk-taking as well as high leverage (Grove and Clouse, 2013). In the 2003-2004, when the U.S. housing markets were booming, Lehman moved from investment banking to mortgage lending in the real estate sector. Lehman rushed headlong in some of the acquisitions, some of them being BNC Mortgage along with Aurora Loan Administrations or Services that specialized in the Alt-A loans. And all Alt-A loans were one type of loans that were made to the borrowers without afloat documentation. All these acquisitions seemed promising in the initial stages as the real estate business wing of Lehman enabled huge inflow into the capital markets, and helped in achieving faster growth than in the investing banking and asset banking sectors. In 2006, the firm securitized US$ 146 billion of security interest and recorded profits for every year from 2005-2007. The organization reported a record net income of US$ 4.2 billion in the year 2007. However, Lehman’s management could not anticipate the impact of the Global financial crisis that surrounded the U.S. sub-prime mortgage lending markets (Guhathakurta, 2012). The housing sector was cracking as the defaults on sub-prime mortgage repayments went up to a seven-year high, by the I fiscal quarter of the year 2007. Towards the end, Lehman had about US$ 700 billion worth in assets only US$ 25 billion (about 3.5% in equity), leaving the leverage ratio at 31. Issues surrounding the collapse: ⦁ There were many long-lived assets that were reported in the balance sheet, but the liabilities reported were repayable in less than 1 year. Lehman used the common practice of involving in borrowing and repaying through the “reputation” markets in daily lives, to survive in the business, which was considered to be a normal scenario in the investment banking business (Choi, Gutierrez and Martinez Peria, 2016). ⦁ Even though Lehman survived the some of the greatest disasters of the past, U.S. housing market collapse brought the Lehman Brothers to a standstill. Lehman’s plunge into the sub-prime mortgage lending market was the catalyst for the fall (Shan, 2011). Lehman’s deep involvement with the mortgage origination business resulted in the firm known as more of a real-estate hedge fund than as an investment bank. ⦁ Its huge portfolio of mortgage securities eventually led to the shutdown of its BNC Mortgage unit and cut down on jobs (Et (2007)). ⦁ Even though the firm gained momentum in April 2007 to some extent, there were no reliable associations that could bring the firm back to the normal state, as the valuation of Lehman’s mortgage portfolio started to be questioned by the managers of hedge funds (Hofmann, 2011). ⦁ With the discharge of credit situation in 2007 August, Bear Sterns – the second largest underwriter of mortgage-backed securities collapsed too (March 2008). The situation worsened for Lehman, leading to speculations again on its fall in the Wall Street, as its shares fell as much as 48% (Grove and Patelli, 2013). Audit Issues & E&Y’s role in the Collapse: Cushioned Financial Statements were a result of the Management’s risk taking that led to a series of failures. E&Y’s role in signing of the Financial Statements under the audit period goes beyond verifying the Financial Information prepared by the Management and casts an additional responsibility to ensure that disclosures form a part of each and every significant transaction, for shareholders to rely upon and take informed decisions. The gist of the possible warning signs that could have been indicated by the Auditor’s in their report for 2007 are given below. This is an illustrative list based on the details available about the case and is not exhaustive. ⦁ Lehman did a colossal miscalculation regarding future profits, despite the cracking U.S housing market by the first quarter of 2007. In March 2007, when Lehman’s stock went down to a 5 year period low, Lehman’s profitability was at question, even though Lehman in its I quarter reported record revenues and profits stood at a high of US$ 4.2 billion (Christopoulos, Mylonakis and Diktapanidis, 2011). ⦁ In the CFO’s post conference call to the shareholders, he made a mention that no problems could be foreseen in the subprime lending market, and that the U.S. economy will be unaffected. He also mentioned about the risks posing the delinquencies surrounding the housing market were well understood by the firm and would not have any negative impact on revenues of the firm (The causes and effects of the Lehman Brothers bankruptcy, 2010). ⦁ In the II fiscal quarter of the 2008, Lehman had reported losses of US$ 2.8 billion (Lehman’s very first loss after it was spun off through the American Express) as well as that it was planning to raise another US$ 6 billion from the investors. This cushioning was to show improved leverage and liquidity, in order to manage their balance sheet. Shareholders were unaware that the management employed an accounting trick, which they called as “Repo 105”, inside the Lehman group. E&Y Auditors were cognizant of the Repo 105 transactions and did not disclose about its scope and violations to the Generally Accepted Accounting Principles-GAAP, in its Audit Report (Hines, Kreuze and Langsam, 2011). ⦁ Throughout the fiscal year 2008, Lehman made fake claims of availability of liquid cash of billions of dollars to repay its counterparties. However, the most of the reported amounts as per balance sheet numbers were encumbered or not available or put to use in business. Lehman also reported US$ 41 billion in liquid funds, 2 days before the unveiling of the true picture. On September 12, 2008, it was found that the real funds totaled up to US$ 2 billion only and this eventually led to no means than to file a bankruptcy on September 2015 (Connerty, 2011). Key Audit Matters (KAM) – What ISA 701 says? KAM that are highlighted in the Independent Auditor’s report, are matters which are special importance in the current period review of the Financial Statements, after discussing the same with the management or those charged with the Governance functions. Auditors must ensure that the specific audit process relating to KAM are designed with the context in mind of conducting the examination of the Fiscal Statements, completely. Some of the bases of identifying the KAM are defined by areas that pose significant risks, for e.g. in the areas were the auditor encountered trouble to obtain sufficient audit evidence and due to internal control deficiencies, if any, identified during the course of audit, that may cause significant modifications to the to the pre-planned procedural approach in the audit. All KAM as per the Auditor’s independent judgement must be discussed once with those negatively charged with administration to find out whether they must form part in the Auditor report. The Auditor communicates KAM in Auditor report after identifying them, preferably after the place for the disclosure regarding the aspect of an belief on the Fiscal Statements under the Audit. It is to be noted that the attender by himself does not express an opinion on individual matters identified as KAM. Hence, the “opinion expressed” in the Financial Statements need not be modified in connection with the disclosures relating to KAM. If a particular KAM has a connection to any related disclosure, he may have to reference the KAM to the disclosure given. Audit Forewarnings & Recommendations applying ISA 701: The following points enlist the forewarnings that could have been highlighted in the E&Y Audit report forming a part of Financial Statements, so that the users could have cautioned themselves against the impending collapse: 1. REPO 105: The accounting trick “Repo 105” (Normal repurchase and sale transactions) involved selling of assets with immediate re-purchase obligation arrangements. These financing events got reported as “Sold” items in the Bank’s balance sheet. Hence the vital GAAP of the substance to transaction was missing (Das, 2012). Repo 105 successful utilization of the bookkeeping rule, where, if resources sold were valuable at just more than Hundred percent of the cash accepted, the transaction should be named a true merchandising as well as the assets can be removed from the Lehman’s books of accounts in order to improve the leverage ratio. With this trick, almost US$ 50 billion worth of assets was eliminated from the whole balance sheet numbers in order to move the leverage ratio to 12.1 that stood at 13.9 prior to this. Lehman Senior Matthew Lee expressed to the auditors along with the Audit Committee in a written letter in June 2008, that Repo 105 was incorrectly used according to him. The auditors overlooked the advice and missed to inform the Audit Committee about the issue raised by him, even though there were specific requests from the Audit Committee to the E&Y. Also, the allegations were not fully investigated by E&Y and it cast a doubt about E&Y’s professional standards (Quax, Kandhai and Sloot, 2013). This is because, the accounting behind the usage of Repo 105 was not proper, and the usage of an unethical accounting trick clearly violated the GAAP. The accounting behind Repo 105 require each and every legitimate proceedings to have proper business purpose respectively for it to be applied in the books of accounts. In Lehman’s books, the accounting principle used existed solely for the purpose of manipulating the Financial Information. While the business decisions regarding use of accounting tricks like REPO 105, was largely considered to be within the realm of acceptable business practices, this was the driver behind the collapse and the after-math that intensified the U.S Financial crisis. Also, the action to manipulate the financial statements indicates that these offences could possibly be under the purview of “colorable claims, as the top management and the auditors responsible for the shareholders and public at large have been a part of the story. 2. Going Concern: E&Y signed Audit report for the fiscal year 2007 and 2008 with unqualified opinions, despite the Management disclosures that the Financial Statements containing all the relevant and true information was “forward-looking” and the business did not foresee any challenges of the “Going Concern” in doubt, even though the company’s survival in 2008 purely existed on acquisitions to clear off its losses. It is to be noted that the existence of a physical uncertainty to the concept of going concern is, by itself a KAM, and hence a different section needs to be given in the Audit report where the disclosure about the “Going Concern” of the organization is mentioned. Where there is a material uncertainty identified as well as adequate revelation is built in the Fiscal Statements, projected ISA 570 (altered) requires the attender to include a content in the Audit report to attain attention to the entire note in Economic Statements, especially, the disclosures relating to the circumstances that might cast a important doubt on all the entity’s cognition to proceed as a Departure Concern (Sormunen, 2012). E&Y report disclosed that the Going Concern accounting principle holds good and would not have any uncertainties surrounding the firm. This was a fatal mislead for all the users of the Financial Statements of Lehman. Why the forewarning could not have been done in E&Y Audit report: Besides the fact that the CEO, CFO and the E&Y auditors went hand-in-hand in all the Inflated Financial Information, it cannot be purely the responsibility of the Auditor’s for the mishap as Laws, Regulations or ethical modular may limit the Auditor’s cognition to act the Cardinal Audit Matters as of investigations, listener confidentiality, well as data protection requirements. The ISAs cannot override the law and regulation which governs an examination of Financial Authorities and relevant ethical needs, as there might be possible conflicts between the listener’s legal as well as ethical obligations to ensure that the communication is done in accordance with this ISA (Shim, Lee and Rho, 2015). The ISAs structure of documentation and disclosure requirements for the KAM may sometimes be complex and the auditor has to take into account the potential conflicts that may arise due to the overriding laws in force. In cases like these, Auditor may have to discuss the problems with the management and may also resort to legal advice in disclosures to be made in the Audit report. The details regarding the basis and description of the Key audit matters typically would be at a high level (A35, Kam). Areas of important management judgement and significant different transactions might often be known as important risks. However, designation of the substance like a significant threat, including a substance known as a important risk due to crime, does not inevitably mean that this matter will be discovered to a KAM. In a few circumstances, exertion encountered at the time of the audit might constitute a range limitation that needs a alteration to the Perceiver’s opinion (A20, limitation on audit disclosures). Some factors have an influence in the Auditor’s risk assessment, for example: high estimation uncertainty, economic conditions that restrict his ability to obtain sufficient and appropriate audit evidence. Also, changes within the entity’s scheme and business model or illiquid market conditions can have a worldly impact on the fiscal statements. Such situations demand the auditor to ensure that key areas have been discussed and communicated with the management, since such business impacts majorly involve significant management judgement. The discussion of KAM by itself is not a substitute for the disclosures to be made by the auditor in the audit report as a part of monetary statements that have to be based on the relevant financial coverage framework of the organization. In case the discussions with the management entail any changes to be made or a remedy to be taken for a material statement in the commercial statements, or a significant non-disclosure of information by the management is found to be in place by the auditor, he is needed to expressed a adapted opinion in according to proposed ISA 705. Some KAM might be viewed like a sensitive, due to their nature as well as the fact that matters might not be unveiled in the economic statements, for e.g., in cases of a fraud hazard specifically known in the context of use of the entity and a confidential lack in an internal relation. In such conditions, the attender may promote the direction as well as those positively charged with administration to make applicable disclosures within the economic statements that consider such other data, so that remark can be ready-made to those complete disclosures inside the statement of KAM in the listener’s report, instead than the attender providing primary information. Conclusion: It is the primary responsibility of the Executives of Management for the running of business and taking management decisions. The collective impact due to the firm’s failure in weak management decisions has been entirely on the users of the Financial Statements who could have been well informed about the impending dangers associated with the concern by the E&Y in their disclosures to the Financial Statements. Even though, such historic scandals and bankruptcies have been a part of the business world every now and then, shareholders need transparency in making informed decisions before taking the step to investing their hard earned money. The happenings around Lehman Brother’s collapse shook the markets, the public and the shareholder confidence in investment in age old companies that existed. The flip side is that there were stringent measures taken as a result of the exposure of the scandal. This led to laws getting stricter and ISA 701, ASA 701 are some of the measures taken by the respective Accounting Boards charged with Governance in avoiding such illegitimate and inaccurate preparation of Financial Statements followed by authentication by the Auditors in their Audit Report, as that is the basis on which users of Financial Statements rely upon to make informed decisions.  References Gorodilov, M. (2013). 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Nature and Extent of the Description of a Key Audit Matter in the Auditor’s Report (Ref: Para. 10, under Communicating Key Audit Matters (Ref: Para. 9–12) A20. Under Significant difficulty during the audit (Ref: Para. 8(b)) – Limitations of Scope of KAM. Acronyms: ISA – International Standards on Auditing, IAASB ASA – Australian Standards on Auditing, AUASB IAASB – International Auditing and Assurance Standards Board (IFAC) AUASB – Auditing and Assurance Standards Board (Australia) IFAC – International Federation of Accountants (Established under Swiss Civil Code) E&Y – Ernst & Young, one of the “Big Four” accounting firms. Repo – Repurchase arrangement