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HI6026 - Audit, Assurance and Compliance -Holmes Institute
Assessment - Auditors and Legal Liability
Learning Outcome 1: Demonstrate an understanding of the reporting requirements of auditing standards
Learning Outcome 2: Demonstrate an understanding of the auditor's professional, legal and ethical responsibilities to their clients and third parties
Learning Outcome 3: Understand the audit planning procedures, evaluate the business risk and assess the internal control
Learning Outcome 4: Prepare auditing procedures for transactions and balances by conducting control and substantive tests
Question: Provide a brief description of the key events and the factual issues behind the case
• Explain the culpability or which parties were deemed responsible and why. Outline the damages imposed or the penalties and consider whether they were appropriate.
• investigate and explain the relevant issues in Auditing and Accounting raised by the case,
• The root-cause of the issues such as; market pressure, organisational culture, fraud etc.
Executive summary -
The title of the assignment is self explanatory and it is the auditors and the legal liabilities. Though after 2000 in many countries the government passed the limited liability law under companies' act 2006 which makes the auditor's liability limited to certain extend. But still auditors can be held liable legally under civil liability and / or criminal liability.
The liability of the auditor is joint and several and can be imposed up on any auditor if he / she is found guilty of taking due care in his / her or not working as per the terms of engagement, or even because of auditors negligence the company or any third party has suffered some loss then they can sue the auditor and get the compensation of their damages via court.
I have selected the Lehman Brother case which was highlighted in the year 2008. The company was earning so good and then suddenly when the U S housing crunch developed the company was running in loss and yet the balance sheet showed huge profits. How the company fell to become the most badly bankrupt company of the world has been discussed in detail in the report below.
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Auditor is a person who is qualified to review, verify and give an opinion on the accounts and statements which are being provided by the company which is under audit. He / she give a review up on the accounting and activities which have been transacted by the company. The main job of an auditor is to provide an opinion in report format at the conclusion of audit. The report provides the reader a fair and true view of the level of accuracy and adequacy that the company has been accounted for.
Where the company under audit has applied all the accounting policies, it has followed all the accounting procedures and standards. Moreover, the company has reported all the accounting transactions in the books of accounts and all data related to the accounting is in its place. This kind of company generally gets no misstatement from the auditors. Auditors are mainly of 2 types' internal auditor and external auditor. External auditors are independent, and companies hire them subject to their audit requirements. On the other hand internal auditors are not independent and generally audit the effectiveness of the company and its internal controls used up on financial reporting.
Auditors, though, provide a report on the financial statement of the company, but they also have legal liabilities attached while giving an audit report. It is true that like other professionals auditors can face legal liabilities, which may be civil liabilities or criminal liabilities up on their duties performed. Now a day the legal liabilities of the auditors are growing at a high pace. It is a must for an auditor to provide honest opinions in his / her report because their reports are responsible for increasing the reliability of the financial statement of the company to its users.
There have been many instances all over the world in which a false audit report has cheated the readers. So it is always advisable that the company do not interfere in the independence and competency of auditors. This saves the auditors from legal liabilities and companies from going bankrupt.
Auditor's liabilities -
Auditor's liabilities are of 2 types - liabilities for civil cases and liabilities for criminal cases. Civil liabilities are related to the conflicts among the auditor and organisations. Criminal case liabilities occur where the audit firms, auditors breach the government rules and regulation or laws imposed by government.
1. Criminal liabilities - all the people of the country are bound by the laws of the country without and exception and so are auditors, they are also bound by the laws of the country. Auditor can be held liable for fraud, insider trading, whistle blowing and leaks of information and so on.
2. Civil liabilities - these liabilities for audit professionals are further divided in to 2 sub parts these are - contract law and law of tort.
i. Contract law - this law comes in to existence where there is a breach in contract and parties seek remedy for such breach in the contract. For example where auditors did not comply with the terms mentioned in the engagement letter the shareholders of the company may seek action enforceable by law. This was the case between PwC and Tyco shareholders.
ii. Law of tort - this law comes to action where the auditor has neglected his / her duty of care towards a third party and because of such negligence the third party has faced some loss or / and damage.
Joint and several liabilities -
It is important to note that the auditors are liable in only and only those cases where the auditors have breached their responsibility of work within their professional competence and neglected the work under due diligence and care. The auditor has not acted independently in terms of conducting audit. So, where an auditor fails his / her obligations he / she will be liable for the penalties because it is their own failure. In addition to this, the parties who have suffered the consequences due to the auditors negligence they will seek adequate compensation from the auditors.
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Case study -
In the year 2008, a famous scandal of U S A is taken up for this assignment which is related to usage of loopholes of accounting to misstate the assets and profits of the Lehman Brother Bank. It was the Lehman Brother Scandal, 2008;
The bubble -
Lehman was one of the firms which started mortgage business. It started acquiring mortgage loans companies and financing companies. In 1997 Lehman acquired Colorado lender, Aurora loan service, 3 years later in 2000 it acquired West Coast mortgage lender, B N C Mortgage L L C. the company was expanding massively, by the end of 2003 it has issued loans worth $ 18 billion, in next year the that is in 2004 the company provided loans worth $ 40 billion. The acquisitions of various companies on first hand seemed promising, they were generating revenues. The real estate business was also recording revenue in market. The recorded growth was 55 % within 2 years. This was the lucrative illusion of the faster rate of growth of investment banking and asset management businesses which played their part well.
The bank was reporting a record profit year after year for a period of 3 years in continuity.
The Colossal miscalculation -
In the beginning of the year 2007, the Lehman bank's stocks were priced around $ 86.00 per share in the stock exchange. This meant that the capital worth of the Lehman was around $ 63 billion. But the bubble was having a leak, within the first quarter of the year 2007; the defaults in subprime mortgage were the highest in the last 7 year. In march, 2007 the company recorded and reported its first quarter's profit, the company witnessed first biggest drop in its stock in last 5 years.
Lehman has invested in real estate hedge funds and by the year 2008, the company supported its balance sheet with assets worth $ 680 billion whereas this was being handled by $ 22.5 billion, which was the capital of the Lehman Bank. It was evident from the balance sheet position and financial statements that if there is a decline in real estate by just 4 % to 5%, the firm will loss all its capital.
Lehman has borrowed massive funds to make investments in real estate, this lead to bankruptcy of the Lehman bank. The Lehman leveraged its funds via borrowing and its investing in real estate. Maximum investment in real estate was made in in - house assets, which was not suitable for the market at all. The risk taking of Lehman was evaluated by its leverage ratio, which is nothing but assets divided by owner's equity. In 2003 the leverage ratio of Lehman was 26 : 1 and in 2008 it reached to 34 : 1. Being an investment bank Lehman was out of the ambit of limitation of risk - taking as the case with other depository banks.
By the end of 2007, the Lehman was in a critical situation it has closed B N C Mortgage and its goodwill was reduced by $ 30 million. The company was facing losses because it has held on to large areas in subprime and to make things worse for Lehman the lower rated interest mortgage trances were making it difficult for Lehman to hold its positions.
Fall down begins -
By end of July 2007, the credit crisis began to submerge; there was failure of 2 Bears Stearns hedge funds, which made the stocks of Lehman fall steeply. After some time the U S housing revived but Lehman Bank chose to be dominating the mortgage market. In the year 2007, Lehman pushed itself to buy maximum no. of securities. The company has invested 4 times in mortgage as compared to its equity.
In the 4th quarter, 2007 the stock prices of Lehman increased, this was majorly because the global markets reached new highs. This on one hand increased the values of shares and securities in the stock market and on the other hand the global market gave a push to the fixed income assets. Though, it was certain that the push was for a small period of time, which could have been utilized fully if the Lehman Company could have reduced its huge mortgage portfolio. The company did not realize that it was its final chance to redeem its huge mortgage list and convert it to some profitable funds.
Hurling to failure -
The company was having a high degree of leverage and the huge mortgage has made company vulnerable and highly volatile to the down going market conditions. The fall of Bears Stearns lead to fall in share prices of Lehman and the Lehman Company saw a massive cut down in its value of shares. A month later people again gained trust with Lehman as the company came up with a fresh issue of preferred stock. The company was able to raise funds amounting to around $ 4 billion. These preferred shares were convertible to Lehman shares at a premium of more than 30 % of the price at the provide time period.
In the second quarter the Lehman Company announced its first loss of around $ 3 billion, the loss was spun off and the Lehman Company announced that the investors has provided funds to the Lehman Company amounting to $ 6 billion. The Lehman Company also said that its liquidity, to $ 45 billion, the assets have been declined by the company of an amount of $ 147 billion, moreover the Lehman Company has also reduced its exposure by 20 % and the company has also pushed down the leverage ratio from 32 : 1 to 26 : 1.
Too late to revive -
By the first week of September 2008, the shares were soaring and no aid was available. The credit default swap was rising and the shares and securities were falling steeply. The Lehman Company reported a loss of $ 4 billion. In the same month the company was declared bankrupt and its stocks soared to 93 % low.
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Auditors' role in Lehman failure -
The auditor of the Lehman Company was Ernst and Young, the Ernst and Young is blamed to window dress the financial statement of Lehman Company. The Attorney general of New York Mr. Andrew Cuomo filed a civil case against the Big Four audit firm E & Y, this was in context with the alleged role played by the audit firm in collapse of Lehman Brothers. The main plot was that the Lehman Company committed an enormous accounting fraud and the auditors kept on providing the company a clean audit report. These clean audit reports were not just for the failing years but the audit firm E & Y have been auditing the Lehman company since 2002 and till the last year of the company that is 2008.
The suit company earned audit fees which was around $ 150 million. The suit on the audit firm is demanding a refund of all the fees in addition to this they attorney is claiming compensation for damages. E & Y should be held responsible as the audit firm could have whistle blown about the Lehman Brothers about the malpractices in accounting policies. The audit firm is accused of covering the actual financial conditions of Lehman Company; moreover the Lehman Company used ‘Repo 105" to cover up the balance sheet to make it look better for the reader of the annual report. The use of ‘Repo 105" was not even disclosed in the notes to accounts.
Recommendation and improvements -
The above case could have better outcomes and the Lehman Brother bank could have saved itself from bankruptcy. If the auditors would have intervened in time and stopped and reported the malpractices which were being presented every year after year to the users of the company.
Audit strategy -
Apt use of planning, scope and direction of work would have saved Lehman Brothers from going bankrupt. The auditors should have characterized their engagement with clear and crisp clauses and should have adhered to these engagements without any compromises. The reporting objectives should have been reviewed and check after every working paper was attached. The reporting objectives need to be review and monitored after frequent intervals. The timing of audit is also an important part of audit plan, nature of communication received from the third party or the management need to be kept safely and reviewed and verified, it should not be trusted without using due diligence and prudence. Has the engagement team put in efforts using the major factors the result could have improved many folds and the company could have saved itself from being bankrupt.
The result of preliminary engagement must be verified by senior auditors and commented immediately for any change, if required. The knowledge of auditor on other engagements should also be verified from the management and the third party as the case may be.
Audit program -
If the audit firm has used apt and adequate audit plan of action where the work was indicative in itself, audit test and procedures would have followed correctly and as per the set standards and the responsible persons should have been held accountable for such massive breach in audit opinion and audit report would have set things in a different manner.
Auditor's liabilities are limited by limited liability, still this limited liability clause does not allow the auditor to get involved with the client and lose their independence while reporting their opinion in the audit report. If this happens and there are damages to public, investors and users of the financial statements who relied upon the audit report and permitted such malpractices to creep in and set a fake picture of accounts for the public. Moreover in the given review it is clear that the auditor has legal liabilities attached to their work and they cannot escape these liabilities.
If due to their negligence or ignorance in fulfilling due diligence the client or any third party suffers then they are liable to compensate for the damages. The third party can even sue the auditors for civil case and in extreme case even for criminal case too. So it can be concluded that the auditor should not lose their independence and they should always give a true and fair opinion on the financial statements they audit with being biased.
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