Importance of Key Audit Matter in Annual Reports: Case of Lehman Brothers

This report discusses the importance of key audit matter in annual reports, using the case of Lehman Brothers as an example. It explores the impact of negligence in disclosing key audit matters and the role of ASA 701 in enhancing transparency. The report also analyzes key audit matters in the mining industry, focusing on CSR Limited, BHP Billiton, Fortes cue metal group, and Rio Tinto Limited.

AUDITING & ASSURANCE

Audit
Executive Summary
It is important for the organization to project the key audit matter in the annual report because it
is directly associated with the process of decision making. Any negligence in this regard can
make the things worse as it happened in the case of Leman Brothers. The report is primarily
based on ASA 701 that is communication of the key audit matter to the users of the report. It is
being done by referring to the case of Lehman Brothers where the absence of ASA 701 led to the
downfall. The importance of KAM is projected in this report and the selected industry is mining
where four companies are selected and discussed in the light of ASA 701.
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Audit
Contents
Introduction.................................................................................................................................................3
Key Issues Related to Auditing – case of Lehman brothers.........................................................................3
Key Audit Matters........................................................................................................................................4
ASA 701 & its relationship with the audit report.........................................................................................5
Mining Industry...........................................................................................................................................5
CSR Limited..................................................................................................................................................5
BHP Billiton..................................................................................................................................................6
Fortes cue metal group...............................................................................................................................7
Rio Tinto Limited.........................................................................................................................................8
Recommendation........................................................................................................................................9
Conclusion...................................................................................................................................................9
References.................................................................................................................................................10
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Audit
Introduction
Lehman Brothers attained a commendable position in the investment banking in the US
operating as an international bank. Lehman Brothers were regarded as one of the most reliable
banks in the United States until September 2008. The organization faced bankruptcy towards the
end of the third quarter of the year 2008 and therefore, declared itself as bankrupt and registered
for Chapter 11 Bankruptcy. There were several reasons attributed to the disintegration of the
company. The company failed to address the material risks and the auditors too didn’t bring into
the management’s notice about the consequences arising out of non-assessment of substantial
risks. Another possible reason behind the company’s bankruptcy could be the unprofessional
attitude of the auditors of the same (Wood, 2011). The auditors concealed key audit matters in
the financials of the company instead of disclosing them in their audit reports. This represents the
need for an organization and the auditors to adhere to all the accounting standards and auditing
standards.
Key Issues Related to Auditing – case of Lehman brothers
The auditors must have assessed the requirement of Repo 105 transactions for the company as
well as its utility in the financials of the same. Even the aforesaid company failed to procure
legal opinion from the United States firm pertaining to Repo 105 transactions. This signifies the
fact that this negligence was intentional on the auditors’ part in the exchange of monetary
benefits. The independence of the auditors of Lehman Brothers can be put into question. The
auditors of Lehman Brothers were paid a whopping amount of 29.5 million dollars for
conducting audit function in the company for the year 2007. This huge amount of payment made
to the auditors reflects the fact that the same must have been provided so as to conceal the
shortcomings of the company in its financials. The auditors were negligent enough towards
assessing the Repurchase 105 transactions opted by the company (Wood, 2011). The auditors
were required to assess these transactions so as to evaluate their effect on the financial ratios of
the company.
Lehman Brothers projected its equity at $22.5 billion and assets at $90 billion in the year 2007
that is the year prior to its disintegration. This area also reflects the presence of material
misstatements. Another KAM is the fact that the auditors offered a judgment so as to treat Repo
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Audit
105 transactions as off the balance sheet treatment. This was probably insisted so as to conceal
the KAM pertaining to Repurchase 105 transactions.
The auditors were unaffected with the fact that the net leverage of Lehman Brothers was
completely changed due to Repo transactions and therefore, this was how another KAM couldn’t
make it to the financials of the same. The management of the company made various impromptu
decisions pertaining to making investments and thereafter, failing in the same as well. The
management without a second thought and necessary evaluation made huge investments in the
housing market and also indulged into heavy borrowings for the same purpose. The housing
industry failed to perform as it was doing earlier and therefore, Lehman Brothers faced huge
losses (Ruhnke & Schmidt, 2014). If the auditors of Lehman Brothers had evaluated this decision
earlier, then the company might not have suffered from debts arising out of losses generated due
to investments failure in the housing industry. The company enhanced its assets to 691.1 billion
dollars from 312.1 billion dollars during the time when the housing industry wasn’t doing well.
This sudden rise is so good to be true and therefore, it highlights the presence of KAMs.
The auditors ignored the fact that the company was trying to manipulate the Repurchase 105
transactions by means of providing an exception in the financials SFAS # 140.
The auditors did not feel the urge to investigate the whistle-blower allegation against the
company as well. The auditors did not feel the need to investigate the change in the net leverage
ratio of the company that moved to 16.1 in 2007 from 15.3 in 2003 while the leverage ratio of
the company moved to 30.7 in 2007 from 23.7 in 2003. The auditors must have investigated the
net leverage ratio of the company as it is the basis on which the management takes the necessary
decisions.
The CEO of the company took approximately $500 million as compensation while the senior
management of the company too made generous profits. The auditors must have investigated this
area keeping this in mind that when the compensation is based on performance then there are
huge possibilities for material misstatements to take place (Suphatsorn & Phapruke, 2011).
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Audit
Key Audit Matters
The introduction of new standard ISA 701 deals with the issues pertaining to KAMs and its
necessary disclosures in the audit reports of the company. ISA 701 is applicable for all the
entities no matter what the size of the same is. ISA 701 is all about conveying KAMs in the
auditors’ report (Tepalagul & Lin, 2015). Mandatory disclosure of KAMs in the auditors’ report
has facilitated utmost transparency in the same. It has enhanced the appropriateness of the
auditors’ report which makes it reliable and desirable in the eyes of the users of the same. The
presence of adequate disclosures in the financials of the company is of great utility to the users as
they can easily make decisions pertaining to making investments in the company (Mock et.. al,
2013).
ASA 701 & its relationship with the audit report
Lehman Brothers would not have collapsed if there was an appropriate implementation of ASA
701. ASA 701 is applicable for all the financial statements that are to be made for the period
after December 15, 2016. ASA 701 was implemented so that the auditors can learn the
significance of identifying audit matters and labeling the crucial ones as KAMs which needs to
be further communicated to the management of the company along with their professional
judgment regarding how the same can be dealt by them. ASA 701 is introduced with an aim to
facilitate the presence of transparency in the financials of the company that will allow the users
of the same to gather an insight into the company’s actual well being. This will allow the users of
the financial statements to make necessary decisions regarding investing in the securities of the
company or not (Livne, 2015).
The auditor of the organization is required to disclose all the material data that is important for
the organization. He can determine all the facts and figures after conducting the audit process for
the particular financial year. Most of the factors should be mentioned in the audit report so that
the organization can depict a clear and transparent view of the financial position. It is very
important for the organization to determine the criteria’s for disclosure to be made by it because
it can hamper the process of decision making (Moroney & Trotman, 2016).
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Audit
Mining Industry
CSR Limited
Valuation of assets
It was observed that the organization had a very huge base of assets which helped them to
implement various presumptions like forecast variations, inflation, growth rates, and other
tractors. Also, it was observed that the company considered this matter to be a key audit matter
in the report filed by it. These matters are will help the organization to determine the future cash
flow of assets and hence can very profitable to it. The auditors clearly discussed the need for
assessment of asset impairment charges and other assumptions that are needed to be evaluated
for conducting the audit process in an ethical manager (CSR Ltd, 2018). All the facts and figures
verified by the auditors so that there is no material misstatement in the accounts of the
organization. Various testing and impairment models were used by the organization for making
accurate decisions which were also needed to be evaluated. Hence, it can be stated that the
auditors of the organization were evaluating every asset in order to determine the overall
performance of the company.
Provision of product liability
It was observed that the organization was liable to pay a product liability that amounts to 312.4
million dollars for the particular financial year. There was various type of judgment that was
needed to be made in relation to this transaction. A clear audit process should be conducted in
order to analyze the complications of all the transactions present in this regard. The advice of
external professional auditors was also taken in order to determine the materiality of the financial
statements owned by the organization.
BHP Billiton
One of the most important it matters that impacted the audit process of BHP Billiton is as
follows:
Taxation
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Audit
The organization worked on a very large global scale because of which it was needed to pay tax
in different countries. Also, the estimation of the organization to determine the prices of
contingent liabilities, tax, and other expenses was made difficult and hence was further
considered as a key audit matter. The in-house auditors tried to take help of the external
professional auditors of different countries for analyzing the transactions of BHP Billiton. The
auditors also analyzed whether the organization was able to disclose all the material statements
not because they were needed by the stakeholders of the organization to make proper decisions.
Proper analysis of the structure used by the country should be made in order to determine all
these values because all these values are very volatile with respect to the environment (BHP
Billiton, 2018).
Valuation of assets
One of the most important and significant figures for an organization is to conduct the asset
valuation program. BHP Billiton conducted the asset valuation program that helped it to
determine various values and hence it was mentioned in the key audit matters of the annual
report. The organization also stated that various type of material misstatement present in the
accounts with respect to the asset valuation and impairment charges. Hence, a proper analysis
was to be conducted in order to find such issues that were present in the groups for valuing the
assets and scrutinizing their impairment expenses (BHP Billiton, 2018). Prices of other
commodities and various other objects of the organization were being influenced because of the
statements present in the valuation of assets. Hence, this was stated to be a key audit matter for
the annual report that was presented by the organization.
Fortes cue metal group
Revenue generated from the sales of iron ore
It was clearly observed in the year 2017 that the organization was able to earn a profit of total
value of 8335 million dollars by selling the iron ores. The huge amount earned by the
organization made it necessary for the accountants and auditors to state it as a key audit matter
and analyze the transactions carefully. Proper audit procedure should be determined by the
organization in order to treat the noncash adjustments that were being made in the accounts of
the firm. Proper values of sales conducted by the organization and the income earned by the
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Audit
company were to be mentioned in the annual report of the organization. There were various
kinds of promotional pricing adjustments present in the expenses of commodity data that
required hi payments (Fortescue group, 2018). Also, various groups within the organization were
affected because of this transaction.
Financing of ore carriers
It was observed that the organization was trying to invest in various kinds of financial contracts
that can help it to achieve greater revenue in the future. The Organization was also to receive a
refund of 234 billion dollars which can be used by it to carry out the operations that were needed
to be conducted (Fortescue group, 2018). It was also clearly mentioned by the auditors and
accountants of the organization that each and every transaction should be clearly analyzed in
order to depict a transparent view of the company's business in the reports maintained by it.
Rio Tinto Limited
Restoration, environmental and closure provisions
It was observed that the organization had and provision amounting to $9975 million for the
particular year. This amount consisted of various restorations, closure and environmental aspects
that were associated with the organization. The organization's efficiency to manage these kinds
of transactions on long term skills shows its ability to conducts the tasks easily. These provisions
are accounted after the anticipation of timing and quantity of future expenses that are to be
incurred by the organization (Rio, 2018). An effective discount rate for the future expenses of the
organization in order to get the net present value of the assets is also determined by the auditors.
The legal liabilities and other obligations that were to be fulfilled by the organization needed a
proper evaluation of all the anticipations that were to be made by the management structure of
the company. However, the method of restoration and rehabilitation was given proper focus by
the auditors.
Provisions associated with non- specific tax situations
The organization conducts its business in several different countries because of which various
types of problems are being faced by it in relation to the law and taxation policies. The
operations of the organizations are also being influenced because of these matters. The total
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Audit
value of the current and noncurrent assets of the organization amounted to 2190 million dollars
for the particular financial year (Rio, 2018). Different kind of tax provisions was maintained by
the organization for all the uncertainties that can be faced by it in the future. The provisions
made by the organization were based on the interests of management that were to be presented as
value of payable tax amount.
Mining Industry Analysis
The companies in the mining industry have been considered to comment regarding the key audit
matter of the industry as a whole. As per the analysis, it is witnessed that the mining industry
includes the key audit matter in their annual report. The auditor provides the written description
that rests upon their professional judgment. As seen from the analysis that key audit matters are
unique to the companies. Going by the study of four companies of Key Audit matter it can be
commented that the results rest entirely on the companies. There was a number of key audit
matters that was projected by the individual companies. As seen from the study that the key audit
matter for the industry was in the area of impairment, asset valuation, and taxation and that the
auditors have provided a complete disclosure in this regard.
For the mining industry, taxation seems to be the major key audit matter because being a mining
company involves operations in various parts of the world with a completely different tax
structure. Further, the companies are also involved in sales of cross border. Therefore, this
element has been dealt cautiously by the auditor in the key audit matter segment of the reporting.
The estimation of various variables such as income tax provision, expenses, and contingent
liabilities can impact the organization as a whole thereby this segment was provided the major
emphasis (Tepalagul & Lin, 2015). The procedures used in this scenario comprises of testing of
key control, working with the tax specialist of the countries where the company has its major
operations. Moreover, the consistency, as well as assessment of the Group in regard to the
disclosure pattern has been dealt
Another major key audit matter for the audit industry is the valuation of the assets. Being
exposed to various assumptions and factors such as inflation, rate of growth and other prediction
there is a tendency to record the asset at a very price. It is highly prevalent in the case of the
mining industry as assets are subjected to various assumptions. Hence, from the study, it has
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Audit
been noted that the auditors had their main role in the valuation of the assets and the projection
of the future cash flow of the assets. It has been common parlance that the key assumption was
checked. Majorly, the rate of assets was checked on a sample basis. The genuine mode of the
impairment testing models was ascertained. From the discussion, it can be seen that the mining
industry had some prominent key and another matter that was considered with proficiency by the
auditors and a complete view has been provided. An overall assessment of the mining industry
delivers an answer that the key matter has been properly projected and the auditors have done
their part in terms of assessment and dealing with the same. Hence, it can be commented that the
mining industry has properly reflected the KAM in their auditor report.
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Audit
Recommendation
It is very important for the auditor to clearly analyze the financial reports of the organization and
maintain a proper audit report. It is one of the most important responsibilities of an organization
to properly evaluate all its books of accounts so that no miss-statements are present in the books.
Proper auditing standard should be used while preparation of the audit reports of the
organization. The auditor should try to find the vulnerabilities present in the books of accounts so
that they can help the organization to get a proper view of the financial status entertained by
them. There are various situations in which the auditor is held responsible for the loss that is
being incurred by third parties because of improper audit procedures. Hence it is the duty of the
auditor to clearly analyze the statements of the organization so that no misappropriation is left in
the management report. The collapse of Lehman brothers Limited also stated that there was used
at present between regulations and actual implementation of the audit procedures because of
which the regulatory mechanism was harmed which further lead to inefficient decision making
of the organization. The failure of the organization clearly depicted the faults present in the
regulatory mechanism that required proper supervision and control of the auditing standards.
Conclusion
After a clear analysis of this report, it can be stated that the application of ASA 701 is very
important to maintain the key audit matters that affect the business of the organizations. The
standard will help the organization to maintain all the key audit matters which will further help to
improve the transparency in the audit reports. Important rules are being implemented by the
organization for the implementation of these standards because they safeguard the investors from
getting unworthy information. Hence, proper auditing framework should be made by the
organization for satisfying all the material requirements of the stakeholders. The responsibilities
and roles of the auditor in the organizational business are really very important, and also they
affect the company's goodwill which can further help them to improve the value of the
organization.
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Audit
References
BHP Billiton. (2018) BHP Billiton 2018 annual report and accounts. Available from
<https://www.bhp.com/-/media/documents/investors/annual-reports/2018/
bhpannualreport2018.pdf> [Accessed 20 May 2019]
CSR Limited. (2018) CSR Ltd 2018 annual report and accounts [online]. Available from
https://www.csr.com.au/-/media/corporate/files/annual-reports/2018_annual_report_-
for_31_march-2018.pdf [Accessed 18 May 2019]
Fortescue group. (2018) Fortescue group 2018 annual report and accounts. Available from:
https://www.fmgl.com.au/docs/default-source/annual-reporting-suite/fy18-annual-report.pdf
[Accessed 18 May 2019]
Livne, G. (2015) Threats to Auditor Independence and Possible Remedies. Available from:
http://www.financepractitioner.com/auditing-best-practice/threats-to-auditor-independence-and-
possible-remedies?full [Accessed 19 May 2019]
Mock, T. J., Bédard, J., Coram, P., Davis, S., Espahbodi, R. and Warne, R. (2013). The audit
reporting model: Current research synthesis and implications. Auditing: A Journal of Practice
and Theory. 32, 323-351. Available from:
https://doi.org/10.2308/ajpt-50294 [Accessed 19 May 2019]
Moroney, R. and Trotman, K.T. (2016) Differences in Auditors' Materiality Assessments When
Auditing Financial Statements and Sustainability Reports. Contemporary Accounting
Research, 33(2), pp.551-575. Available from: https://doi.org/10.1111/1911-3846.12162
[Accessed 18 May 2019]
Rio Tinto., 2018. Rio Tinto annual report 2018 [online]. Available at
<http://www.riotinto.com/documents/RT_2018_annual_report.pdf> [Accessed 20 May 2019]
Ruhnke, K. and Schmidt, M. (2014)Misstatements in financial statements: The relationship
between inherent and control risk factors and audit adjustments. Auditing: A Journal of Practice
& Theory, 33(4), pp.247-269.
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Suphatsorn, T., & Phapruke, U. (201 1). Internal audit planning strategy of Thai- firms: an
empirical investigation of antecedents and consequences. International listed. Academy of
Business and Economics, 11 (2). Available from:
https://pcaobus.org/Standards/Auditing/Pages/AS2101.aspx [Accessed 20 May 2019]
Tepalagul, N. and Lin, L. (2015). Auditor Independence and Audit Quality A Literature
Review’, Journal of Accounting, Auditing & Finance vol. 30, no. 1, pp. 101-121. Retrieved from
https://doi.org/10.1177/0148558X14544505
Wood, D A. (2011) The Effect of Using the Internal Audit Function as a Management Training
Ground on the External Auditor's Reliance Decision. The Accounting Review . 86(6), p. 39-56.
Available from: https://doi.org/10.2308/accr-10136 [Accessed 19 May 2019]
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