Importance of KAM in the Downfall of Lehman Brothers

This report discusses the importance of Key Audit Matters (KAM) in the downfall of Lehman Brothers and highlights the implementation of Auditing Standard ASA 701. It also examines how major banks in Australia provide KAM in their annual reports.

Auditing & Assurance

ASA 701
Executive Summary
The investors and stakeholders needs to be aware of the happenings in the organization
because it helps them in taking relevant decision. However, the concealment of facts can lead
to major issues as was seen in the downfall of Lehman Brothers. The present report grabs an
insight into the downfall of Lehman Brother and the importance of KAM in the current
scenario. Looking at the audited reports of Lehman Brothers it can be said that the same
lacks the presence of ASA 701. This is because of the fact that if the requirements of the
ASA 701 were followed by the auditors of the Lehman Brothers in their audit function, then
there must have been adequate communication and necessary disclosures pertaining to KAM
not just with the management of the company but also with the users of financial statements.
The second part highlights the manner in which the banks provide the KAM in their annual
report. The overall observation that can be gained is that the banks have ensured a strong
emphasis on the KAM and that will help the related parties to know about the happenings.
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ASA 701
Contents
Introduction...........................................................................................................................................4
Concealment of the facts and other important matter in the case of Lehman Brother........................4
Auditing Standard ASA 701- Communication of Key Audit Matters in the Independent Auditor’s
Report....................................................................................................................................................5
ANZ bank...............................................................................................................................................6
Westpac bank........................................................................................................................................7
Macquarie Bank.....................................................................................................................................8
AMP Bank Ltd........................................................................................................................................9
Conclusion...........................................................................................................................................11
References...........................................................................................................................................12
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ASA 701
Introduction
Lehman Brothers were one of the most renowned international banking institutions in the
United States. The company topped the list of the international banking institutions in the US
and the same ranked at number four in the investment banking domain prior to September
2008. The sudden failure of the company shook the entire banking institutions of the US. The
company filed for Chapter 11 Bankruptcy as it went bankrupt. The sudden failure of the
company was on account of numerous reasons. The top-level executives of Lehman Brothers
were ignorant or rather just over-confident of the success of the company. The management
of the entity was casual enough to identify the potential and underlying risks and evaluation
of the consequences arising out of such risks. The auditors too in their audit processes failed
to alert the management of the entity regarding the repercussions that could arise out of mere
negligence on the management’s part. Moreover, the auditors were also seen to misrepresent
the financials of the company (Livne, 2015). If the auditors acted diligently in performing
their audit function in Lehman Brothers then the company would have not disintegrated. This
calls for the necessity of an organization to implement effective internal control mechanisms
and incorporate strict rules and regulations (Nicolaescu, 2013).
Concealment of the facts and other important matter in the case of
Lehman Brother
The housing industry excelled ever since 2001 and until 2008. The management of the
aforesaid company was tempted with this boom in the housing economy and therefore, opted
to make huge investments in the same considering that this step would allow it to reap higher
revenues. For this purpose, the management of the company indulged into huge borrowings
and employed the same along with all its revenues in the mortgage industry (Sharp, 2010).
This decision without any doubt backfired and harmed the company’s well being in no time.
The situation got worsened when the subprime mortgage business of housing finances also
failed. Lehman Brothers also suffered the consequences arising out of making billions of
investments in risky portfolios. The company opted to employ heavier investments sourced
from its own capital in real estate, private financing, and leveraged lending (Sharp, 2010).
Globally, most of the investors are facing heavy losses owing to the current crunch faced by
the industry. Also, the existence of the practice of non-compliance has been prevailing for a
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ASA 701
long time now. ASA 570 is one such accounting standard that makes it mandatory for the
auditors to depict utmost transparency in their audit reports.
ASA 570 has recently been restructured into a better version and the same has minimized or
eradicated the use of deceitful mechanisms that were previously incorporated thereby,
enhancing the operations of an organization. The implementation of ASA 570 is gaining
importance at a fast pace as the auditors are seen conducting their audit function with utmost
genuineness and professionalism.
Auditing Standard ASA 701- Communication of Key Audit Matters in
the Independent Auditor’s Report
ASA 701 is an accounting standard formulated very recently. It is applicable on all such
financial statements that are prepared on or after December 15, 2016. ASA 701 deals with the
identification and evaluation of key audit matters. This new accounting standard makes it
mandatory for the auditors to conduct their audit function diligently by means of
communicating such key audit matters to the management of the company that is traced from
auditing the financials of the same (Niemi & Sundgren, 2012). This will reflect transparency
in the audited financials of the company and therefore, it will be easier for the investors to
assess the financial well being of the company and then arrive at appropriate decisions.
The auditors must be diligent enough in performing their audit processes so as to identify the
presence of KAM. KAM must be assessed upon its identification and the consequences
arising out of these matters must be determined in an appropriate manner. The auditors must
alert the management of the company about the presence of such key audit matters and the
consequences arising out of such matters upon negligence (Kaplan, 2011). It is ultimately the
management of the company that decides what matters and information are to be presented in
the financials of the same. The directors often prioritize the well being of an organization.
Therefore, it may happen that the directors in order to uplift the financial performance of an
organization chose to conceal certain facts from its investors which if presented would come
in the way of enhancing the share capital for the same. In this regards, the role of an auditor
plays an important role in determining the actual performance of an organization. Therefore,
an auditor must be diligent and a thorough professional in delegating his responsibilities and
must be free from any kind of influence and biases (Geoffrey, Joleen, Kelli & David, 2016).
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ASA 701
Para 9 of the ASA 701 states that all the significant aspects must be reviewed thoroughly by
an auditor so as to ensure that the financials of the company do not represent any sort of false
information by whichever means. This will ultimately benefit the users of the financial
statements in making constructive decisions (Livne, 2015). There are numerous advantages to
this new standard. ASA 701 initiates the presence of transparency and fairness in the
financials of the company by means of offering adequate disclosures pertaining to key audit
matters and portraying the actual financial performance of the same (Rezaee & Kedia, 2012).
This safeguards the interests of the investors as they are most likely to construct effective
decisions on account of the genuineness portrayed in the financials of the company. The
ultimate benefits are derived by an organization itself as the capital of the same will be
enhanced pertaining to new investments received from various investors (Matthew, 2015).
The key audit matter that is ASA 701 has been discussed in the light of major banks of
Australia.
ANZ bank
Provision for credit impairment
ANZ Bank put forth its pre-determined notions with respect to the consequences of adopting
AASB 9 Financial Instruments as of October 1, 2018. Making such disclosures eased out the
process of auditing for the Group for the financial year 2018. The disclosures pertaining to
the consequences arising as a result of budgeted credit losses from the loans and advances
were given a lot of emphasis along with the explanations given by the company on the same.
The methodology used by the organization in the determination of expected credit losses is
too complicated. Therefore, the explanations provided by the company are of great
significance in understanding the appropriate use of the methodology used by the same in the
calculation of ECL (ANZ Bank, 2018). The organization incorporates a series of pre-
determined notions such as the determination and input of forward-looking information in the
application of accounting standard requirements to the prototypes.
Checking the vital control over the risk of counterparty for loan of wholesale
In order to identify risks or certain exposures with respect to wholesale loans, the lending
policies of the company was assessed along with the key controls that were implemented so
as to balance the counterparty risks. The timeliness of and the rightness of counterparty risk
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ASA 701
assessments, the performance of annual loan assessments and risk grading were also put to
test by the auditors of the company (ANZ Bank, 2018). The external macroeconomic factors
and the internal factors which are familiar to the counterparty risks could be the probable
reason owing to these risks.
Valuation of financial instruments held at fair value:
The financial instruments of ANZ Bank comprise of certain policy liabilities, derivative
assets, and liabilities, assets available for sale, trading securities, certain debt securities and
investments backing policy liabilities. The valuation of these financial instruments of the
organization was done at their fair values. ANZ Bank maintains these financial instruments
for the purpose of managing its foreign exchange risks and interest rate. The financial
instruments held by ANZ Bank are mostly sold to consumers as risk management products.
This is an area of KAM for ANZ Bank owing to various reasons. Firstly, these financial
instruments held at FV constitute 14 percent and 24 percent of the organization’s liabilities
and assets respectively. Secondly, there is an enhancement in the risks pertaining to
procedures of transaction management when a huge volume and multiple ranges of financial
instruments are bought or sold in international geographies which could result in
inappropriate valuation (ANZ Bank, 2018)
The auditors while performing their audit function for the purpose of valuation FI held at FV
comprised of assessing internal controls regarding the genuineness and completion status of
data transfers lying in between transaction processing mechanism. The company’s risk
management mechanism and finance systems were also assessed so as to trace the presence
of underlying inconsistencies in the valuation process and transaction management of the
financial instruments. The rights and change management controls are also assessed by the
auditors for the ascertainment of key valuation mechanisms.
Westpac bank
Provisions for impairment charges
The company chooses to self evaluate such impairment provisions for loans that surpasses a
particular portal pertaining to estimated future cash repayments and sale proceeds that are
realized out of collateral securities owned and held by an organization against these loans.
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ASA 701
The auditors in their audit processes chose to prioritize the assessment of impairment
provisions for loans of Westpac Bank (Westpac Bank, 2018). This is highly due to the size of
its provisions for impairment charges on loans and also on account of the unaccepted
justifications offered by the company concerning the need behind the same.
The key mechanisms of the audit procedure conducted by the auditors with respect to
impairment provisions for loans comprised of evaluating the controls present in the
information technology mechanisms of the company which ultimately assists in managing
and transferring the underlying data amidst impairment prototype and source mechanisms
(Westpac Bank, 2018). Also, the controls implemented so as to trace a drop in the credit
quality of individual risks were assessed by the auditors.
Fair values of financial assets and financial liabilities
Financial assets and financial liabilities together constitute financial instruments (FI). It is
important for an organization to ensure that the valuation of FI is done at its FV. The
financial instruments owned by Westpac Bank that must be measured at its fair value are life
insurance assets and liabilities, derivative assets and liabilities, available-for-sale securities,
trading securities, and other instruments. The financial instruments owned by the
organization are segregated into 3 groups based on their factors that determine their prices.
Level 1 is for quoted market prices, Level 2 is for market observable prices while Level 3 is
for such FI that is hard to value instruments (Westpac Bank, 2018).
The auditors evaluated the control mechanisms so as to understand the efficiency of the
valuation model and to confirm whether the inputs of these valuations are reliable. The
process of valuation along with derivative valuation adjustments was also monitored by the
auditors. The auditors also reviewed the unit pricing controls stressing the fact that adequate
attention was paid to the concern.
Macquarie Bank
Provisions for loan losses
Macquarie Bank has provisions for impairment charges on loans. Upon recognition of
provisions for impairment charges on individual loans, the company formulates its
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ASA 701
impairment provisions. Also, the company has both specific and collective provisions for
impairment charges on loans. The collective provision for impairment is of great utility for an
organization at it helps in concealing losses that have not been individually recognized. The
collective impairment provisions can be ascertained by means of an appropriate judgment
that is necessary so as to construct the models that are to be used and the selection of
assumptions that are to be incorporated (Macquarie Bank, 2018).
The auditors in their audit function evaluated the structure and efficiency of mechanisms
pertaining to identification and ascertainment of impairment charges on loans.
Valuation of financial assets and liabilities held at fair value
The financial assets and liabilities held by the company at FV and that which falls in Level 3
are instruments that are hard to value.
The auditors whilst conducting audit processes chose to evaluate the internal mechanisms
incorporated by the company by means of assessing the structure and appropriateness of the
same. The auditors also reviewed the process for testing valuations of Level 3 financial
instruments along with the accuracy of inputs, governance, and review of the same
(Macquarie Bank, 2018).
AMP Bank Ltd.
Information technology (IT) environment
AMP Bank Limited relies highly on its IT mechanisms. The overall functioning of the
company relies largely on its IT mechanisms and IT controls. Information technology
controls allow the company to have an enhanced program change management and user
access management and ensures whether there is adherence to necessary information
technology requirements (AMP Bank, 2018).
The auditors conducted audit processes in AMP Bank Limited by means of ensuring if the IT
controls are functioning adequately or not and whether the alterations in mechanisms are
pertinent to financial reporting or not. The auditors customized their audit functioning so as
to evaluate the financial impact arising out of such IT mechanisms and in order to confirm
whether these IT mechanisms encouraged the automation processes or not.
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ASA 701
Goodwill and Intangible Assets
The goodwill of the company is on account of its old acquisitions and the treatment of the
same was done by means of apportioning it to the CGUs at the date of acquisition. The
goodwill of the company was evaluated to be at $2130 million as of December 31, 2018. The
goodwill of the company was duly impaired on the basis of drawing comparisons with the
forwarding value of the cash generating units with that of its recoverable amount (AMP
Bank, 2018). The FV of the cash generated from units decides the recoverable amount for the
cash generating unit.
The auditors performed their audit function with respect to goodwill and other intangible
assets by means of thorough evaluations. The auditors evaluated the rates of future inflation
and risk discount rates. The auditors assessed other key assumptions in the impairment
mechanisms such as forecast upcoming business growth rates and forecasts of budgeted
future lapse. The auditors evaluated whether the reallocation of goodwill and the mechanisms
incorporated by the company for the impairment of its goodwill and other intangible assets
are in accordance with the AAS and other necessary requirements.
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ASA 701
Conclusion
To conclude, it can be said that an auditor must consider KAM during the representation of a
company’s audit reports. An auditor must assess the mechanisms employed by an entity
while construing its financials prior to his audit function. The auditors must make sure that
the financials of the company depicts utmost transparency and has provided all disclosures
pertaining to key audit matters of the same. This will ease out the decision-making process
for the users of the financial statements of the company. The auditors must make sure that
they are performing diligently and are free from any type of influence or biases or such other
activity that puts the entire profession into question.
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ASA 701
References
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https://corporate.amp.com.au/content/dam/corporate/aboutus/files/AMP_2018_AR.pdf
[Accessed 19 May 2019]
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https://shareholder.anz.com/sites/default/files/anz_2018_annual_report_final.pdf [Accessed
17 May 2019]
Geoffrey D. B, Joleen K, K. Kelli S. and David A. W. (2016) Attracting Applicants for In-
House and Outsourced Internal Audit Positions: Views from External Auditors. Accounting
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practice. The Accounting Review. 86(2), pp. 367–383. Available from
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https://static.macquarie.com/dafiles/Internet/mgl/global/shared/about/investors/results/
2018/Macquarie-Group-FY18-Annual-Report.pdf? [Accessed 19 May 2019]
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Accounting Review. 24(3), pp. 1-34. Available from
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Westpac Bank .(2018) Westpac Bank Annual report & accounts. Available from:
https://www.westpac.com.au/content/dam/public/wbc/documents/pdf/aw/ic/
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