May 20, 2012

MF0013 [Internal Audit and Control] Set2 Q5

Q.5 Lehman Brothers Holding filed for Chapter 11 bankruptcy protection following the massive exodus of most of its clients, drastic losses in its stock and devaluation of its assets. 
In context with this case, examine internal control and risk assessment system.

Ans:

 Introduction:- 
Lehman Brothers Holdings Inc. was a global financial services firm which, until declaring bankruptcy in 2008, participated in business in investment banking, equity and fixed-income sales, research and trading, investment management, private equity, and private banking. It was a primary dealer in the U.S. Treasury securities market. Its primary subsidiaries included Lehman Brothers Inc., Neuberger Berman Inc., Aurora Loan Services, Inc., SIB Mortgage Corporation, Lehman Brothers Bank, FSB, Eagle Energy Partners, and the Crossroads Group. The firm's worldwide headquarters were in New York City, with regional headquarters in London and Tokyo, as well as offices located throughout the world. 

On September 15, 2008, the firm filed for Chapter 11 bankruptcy protection following the massive exodus of most of its clients, drastic losses in its stock, and devaluation of its assets by credit rating agencies. The filing marked the largest bankruptcy in U.S. history. The following day, the British bank Barclays announced its agreement to purchase, subject to regulatory approval, Lehman's North American investment-banking and trading divisions along with its New York headquarters building. On September 20, 2008, a revised version of that agreement was approved by Judge James Peck. 

During the week of September 22, 2008, Nomura Holdings announced that it would acquire Lehman Brothers' franchise in the Asia Pacific region, including Japan, Hong Kong and Australia. as well as, Lehman Brothers' investment banking and equities businesses in Europe and the Middle East. The deal became effective on 13th October 2008. 

Lehman Brothers' investment management business, including Neuberger Berman, was sold to its management on December 3, 2008. Creditors of Lehman Brothers Holdings Inc. retain a 49% common equity interest in the firm, now known as Neuberger Berman Group LLC. It is the fourth largest private employee-controlled asset management firm globally, behind Fidelity Investments, The Capital Group Companies and Wellington Management Company.

A March 2010 report by the court-appointed examiner indicated that Lehman executives regularly used cosmetic accounting gimmicks at the end of each quarter to make its finances appear less shaky than they really were. This practice was a type of repurchase agreement that temporarily removed securities from the company's balance sheet. However, unlike typical repurchase agreements, these deals were described by Lehman as the outright sale of securities and created "a materially misleading picture of the firms financial condition in late 2007 and 2008." 

On March 11, 2010, Jenner & Block, a court-appointed examiner, published the results of its year-long investigation into the finances of Lehman Brothers. This report revealed that Lehman Brothers used an accounting procedure termed repo 105 to temporarily exchange $50 billion of assets into cash just before publishing its financial statements. The action could be seen to implicate both Ernst & Young, the bank's accountancy firm and Richard S. Fuld, Jr, the former CEO. This could potentially lead to Ernst & Young being found guilty of financial malpractice and Fuld facing time in prison. 

Risk Assessment is an important dimension of internal control system. SA 315, “Identifying and Assessing the Risk of Material Misstatement Trough Understanding the Entity and its Environment”, states that: 
The objectives of the auditor to identify and assess the risks of material misstatement, whether due to fraud and error, at the financial statement and assertion levels, through understanding the entity and its environment, including the entity’s internal control, thereby providing a basis for designing and implementing responses to the assessed risks of material misstatement. This will help the auditor to reduce the risk of material misstatement to an acceptably low level.” Obviously, you are thinking, what is „risk? In simple term „risk is the variability of actual happening from the expected happening associated with a given event. In financial world, risk is the variability of the actual return from the expected return associated with a given asset. 


Auditing is primarily related to forming an opinion on financial statements of an enterprise. For forming an opinion, auditor has to rely on the accuracy and reliability of financial data and the effectiveness of internal control system. Naturally that means he is taking a risk. In this unit, we will discuss how auditors assess those risks. In this unit, we will also discuss the internal control system applied in Bank and Insurance companies. Banking and Insurance companies by nature entails a huge amount of risk and resultantly, internal control systems in context of these organizations have special importance for sound business operations.

Internal Control and Risk Assessment:- The nature and extent of the procedures performed by the auditor to obtain an understanding of the accounting and internal control systems generally depend on: 
  • Nature of policies or kind of procedures, 
  • Changes in operating environment, 
  • Size and complexity of the business, 
  • Way of documentation of business operations, 
  • Auditor’s assessment of inherent risk. 


The auditor should make a study of internal control relevant for his audit. Although most controls related to audit are relevant for financial reporting but all controls relevant for financial reporting may not be relevant for audit. It is the judgment of auditor to decide whether a control individually or in combination with other is relevant for audit or not. Auditor normally classified audit risk for assessment into control risk and inherent risk. Control risk signifies that a material misstatement could occur but would not be prevented or detected by internal control system. Inherent risk signifies the chances that recording of transactions have been done either erroneously or under the influence of management fraudulent activity.


Assessment of control risk 
Assessing control risk is the process of evaluating the effectiveness of an entitys accounting and internal control systems in preventing or detecting material mis-statements in the financial statements. After having a basic idea of the accounting and internal control system, the auditor should make an initial assessment of control risk for the appropriate assertions in the financial statements. When planning the audit approach, the auditor should consider the initial assessment of control risk (in conjunction with his assessment of inherent risk) to determine the appropriate detection risk to accept for the financial statement assertions. 


Some of the procedures performed to obtain understanding of the accounting and internal control systems may not have been specifically planned as tests of control but they may provide evidence about the effectiveness of both the design and operation of policies and procedures relevant to certain assertions and, consequently, serve as tests of control (e.g. in obtaining understanding of the system pertaining to cash, the auditor may have obtained evidence about the effectiveness of bank reconciliation process through inquiry and observation). 


Relationship between the assessments of inherent and control risks: In many cases, inherent risk and control risk are highly interrelated. Also management often reacts to inherent risk situations by designing accounting and internal control systems to prevent and detect mis- statements in such situations, if the auditor attempts separately to assess inherent and control risk when they are highly interrelated, there is a possibility of inappropriate risk assessment. As a result, audit risk may be more appropriately determined in such situation by making a combined assessment. The auditor, in forming his opinion on financial information, needs reasonable assurance that transactions are properly recorded in the accounting records and that transactions have not been omitted. 


Internal controls, even if fairly simple and unsophisticated, may contribute to the reasonable assurance the auditor seeks. The auditors control risk assessment, together with the inherent risk assessment, influences the nature, timing and extent of substantive procedures to be performed to reduce detection risk to an acceptable level. The assessed levels of inherent and control risks cannot be sufficiently low to eliminate the need for the auditor to perform any substantive procedure for significant account balance and transaction classes. Consequently, regardless of the assessed levels of inherent and control risks the auditor should perform some substantive procedures. 


The higher the assessment of inherent and control risk, the more assurance the auditor must obtain from the performance of substantive procedures. When both inherent and control risks are assessed at a high level, the auditor should also consider whether substantive procedures will provided sufficient assurance to reduce detection risk to an acceptable level. When the auditor determines that detection risk cannot be reduced to an acceptable level, he should either qualify or disclaim the opinion or, if this is not practicable, withdraw from the engagement.

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