Audit Case – Lehman Brothers Holdings, Inc.

Case summary

Lehman Brothers is considered to be the largest corporate failure in U.S. history after it was declared bankrupt in 2008. In 2010, a report was released revealing multi-billion dollar “accounting-motivated” transactions to embellish Lehman’s apparent financial condition during 2007 and 2008.  The bank’s financial position was worsened by the 2007 plummeting housing prices since it had large investments in RMBS (residential mortgage-backed securities). Lehman engaged a large volume of Repo 105s to account for sales but could not find a U.S. law firm that would issue an opinion confirming that Repo 105s could be treated as sales. The company used a British law firm to qualify the Repo 105s as sales and this led to Lehman’s net leverage ratio to reduce by 10%. Lehman’s audit Firm Ernst & Young was criticized for not properly investigating the impact of Repo 105s on Lehman’s quarterly and annual financial statements and the audit firm has been faced with several lawsuits since then.

Question #1

Ernst & Young did not have a responsibility to be involved in the process of developing Lehman’s Repo 105 accounting policy mainly because the role of an auditor is to review a company’s financial statement to ensure that all the information is presented fairly according to the financial reporting framework and principles (Hines, Kreuze & Langsam, 2011). When a client develops an important new accounting policy, the audit firm has no role in the developing or applying that new accounting policy. Rather, the auditor only comes in to assess the financial statements, gather sufficient evidence, test and observe the financial statements to ensure that they are free from error. To do this, auditors use the financial reporting standards set by GAAP or the IFRS. If the audit firm realizes that the client firm is using a new accountant policy that is not in accordance with the accepted accounting standards, it is the duty of the audit firm to point out the error and advice the client firm accordingly. It is the responsibility of the client firm to adopt sound accounting policies while the audit firm has the responsibility to ensure that the accounting policies used are appropriate. 

Question #2

When applying accounting rules, intent does not matter as according to the FASB, the objective of financial reporting is to provide accurate financial information that could be used to make investment and credit decisions. This is according to the Statement of Financial Accounting Concepts No. 8 that requires companies to provide financially useful information that is accurate. Reporting entities should therefore be allowed to apply accounting rules only for the purpose on intentionally disclosing their financial data to investors, potential investors and the public. Compliance with accounting rules is irrelevant if the reporting entity adheres to these rules only to mislead or present false information about the financial position of the company (Azim & Ahmed, 2015).  The accounting rules require reporting entities to more than just technically comply with the rule but also ensure truthfulness, accuracy, transparency and fairness while reporting the information. This implies that Lehman had an additional responsibility of giving a faithful representation of its financial data and the accounting rules, particularly SFAC no. 8 is just a tool to help guide the reporting entity.

Question #3

Accounting motivated transactions refer to the transactions that are presented or structured in a way that achieves results that are not consistent with the actual economics of the said transaction. Since the purpose of financial reporting using the accounting rules is to “faithfully represent the phenomena that it purports to represent”, auditors have a responsibility to determine whether important transactions of a client are account motivated or fraudulent as one of the key roles of an auditor is to perform an audit to get an assurance that the financial statements are free from misstatements whether by error or intention (Asare, Wright & Zimbelman, 2015). This is according to AS 2401; however, even a well-planned and performed audit could fail to recognize an accounting motivated transaction and in this case, auditors have to exercise professional skepticism and objectivity. This implies that the audit should perform the audit with a questioning mind without considering past experiences with the entity. Further, the auditor should not be satisfied with evidence or financial data that appears not to be persuasive enough. However, this is just a strategy that auditors might use to identify accounting motivated transactions as some of these transactions might be difficult to detect.

Question #4

I certainly believe that Schlich or one of his colleagues should have reviewed that letter because having been given the job of auditing Lehman, reviewing the letter about the treatment of Repo 105s as sales of securities would have informed Ernst & Young on how to audit the Lehman’s financial transactions (Liu & Schaefer, 2011). While the audit firm was not required by law to review documents and letters from third parties such as the letter by the British law firm, it would have been wise for Ernest & Young to review the letter and its contents about the treatment of Repo 105s as sales of securities because Lehman’s heavily relied on the Repo 105 transactions to show that it was performing well financially. Further, the key role of auditors is to report whether or not the financial transactions of an entity are truthfully represented, it was the duty of the auditor to assess all the relevant information about the Repo 105s provided by the client and from elsewhere to ensure that there was no risk of withholding evidence or misrepresenting information (Asare, Wright & Zimbelman, 2015). Saying so, Schlich or one of his subordinates conducting the audit should have reviewed that letter. 

Question #5

According to AS 2710, entities might publish other information in addition to the audited financial statements and auditors are required to view this additional information while reviewing the accuracy and consistency of the financial information reported by the client. The financial highlights table and MD&A section of its annual report are part of the “other information” mentioned under AS 2710. However, while an auditor is not required to perform any accounting roles including corroborating other information provided by the client, the auditor should read and review other information to ensure that the information published in the financial statements is consistent with the information published in “other information” sections. According to AS 2710.04, if the auditor realizes that there is material inconsistency, he should make a conclusion on whether the financial statements or other information require a revision and have the client to revise the other information part (Lee & Xiao, 2018). In AS 2710.06, if the auditor identifies a persistent material misstatement, he should communicate the fact to the client and the audit committee.

Question #6

I believe that there was a material difference in the Repo 105 transactions because they reduced Lehman’s net leverage ratio from 17.8 to 16.1. According to the Statement of Financial Accounting Concepts No. 2, materiality is defined as the magnitude of the misstatement such that by using the published information, a person’s judgment while using the information will be changed or influenced by the misstatement. In this case, there is a significant difference between 17.8 and 16.1 and any investor or interested party in Lehman would have used this information to assess the leverage or liquidity of the company before making decisions on investment. Ernst & Young should have therefore considered the difference in Lehman’s net leverage ratio as a material indifference or a misstatement (Hines, Kreuze & Langsam, 2011). While the material difference might not be significant for the audit firm, it was definitely significant to other parties including investors, customers and the government.

Question #7

According to AU Section 110.02, the responsibility of an auditor is to perform an audit of a client’s financial statements to get the appropriate evidence that the statements do not contain any false information either by error or fraud. However, the auditor has no responsibility to perform an audit to get assurance that any misstatements that are not material to financial statements are detected (Lee & Xiao, 2018). Saying so, whistleblower allegations are important sources of information regarding the accuracy of financial statements and assurances given by the management. The auditor could use the whistleblower allegations to closely scrutinize the financial statements with a questioning mind to ensure that he or she does not miss or overlook any evidence of misstatement. Under such circumstances, the auditor will need to spend more time looking through the financial statements and other information to assess the accuracy, reliability and consistency of the information. The whistleblower allegations also question the reliability of the financial statements of the client and the auditor should therefore investigate these claims before concluding on the accuracy of the information.

Question #8

A few factors influenced Ernst & Young’s legal exposure in both state and federal courts. However, the same reason brought the defendant to both state and federal courts; the misconduct or negligent acts of the defendant that lead to damages on the plaintiff. In both the state and federal courts, the plaintiff has to show evidence that the Ernst & Young was negligent and that this led to damages or losses. If an auditor fails to carry out his responsibilities as required, he or she should be liable for the effect of their failure to effectively conduct the audit. Different states have different provisions and laws under which auditors can be sued. For instance, in some states, only the direct beneficiaries can sue an auditor while in some states, any third party who is a foreseeable beneficiary can sue an auditor (Beever, 1956).

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