Lehman Brothers and Enron Scandal – Auditing Assignment Help
Introduction
The conventional framework of any business, nowadays, suggests separation of ownership from management. Though seemingly this might make things better for both the owners and the management as a way to focus on their region of work, but occasionally such form of a setup has bring around financial disaster to the companies.
Anticipation of information gap as a result of ownership separation from management, and period of financial crisis for the company, has propelled company to resort to some sort of monitoring, control and governance, both internally and externally. The reasons behind opting for corporate governance mechanism are associated with the agency theory and financial crisis that the companies witness. The theory of agency addresses the conflict of interest between owners and management that often leads the latter to opt for unethical and sometimes illegal means to satisfy their quota of financial benefit. In a similar manner, periods of crisis are a testing time for any organization; however, most of the companies under question resort to ingenious method to upgrade their financial standing under questionable circumstances.
Recent times have produced examples of financial scandals that lead to dissolution of companies all together such as Enron, WorldCom, Lehman Brothers and many others. The author of Auditor Independence: Auditing, Corporate Governance and Market Confidence, Ismail Adelopo underlined the reality of these financial meltdowns, that they adversely affected the market system and its key players, and also highlighted the inadequacy of the audit procedures of company’s financial statements and position (Adelopo, 2016). Thus, in wake of these catastrophes, setting up of Audit committees as a corporate governance mechanism came into full force, within which, the major emphasize was placed on Auditor Independence.
Lehman Brothers and Enron Scandal
Lehman Brothers
Financial services firm, Lehman Brothers filed for Chapter 11 Bankruptcy Protection in September of 2008, which, to date, is the largest bankruptcy filling in the United States history.
Before its collapse during the financial crisis, Lehman Brothers were indulged in devious activities and business venture that made the firm vulnerable to any kind of financial meltdown. In the early of 2000, this financial firm moved into business of mortgage orientation, and gradually started to dominate the subprime market. Their interference in mortgage business led them in possession of assets worth $680 billion against firm capital support of only $22.5 billion. This made, the apparently investment bank into a real estate hedge fund (Dosdall & Rom-Jensen, 2017).
This act of leveraging or gearing employed by Lehman Brothers was exposed to the firm’s auditing employee, yet the auditors kept company’s real financial standing a secret from the shareholders. Anton R. Valukas, one of the bankruptcy examiners examined the case of Lehman brothers, and found that Repo 105 transactions were utilized by the company to enhance the actual financial position of its operations. Following this discover, a New York attorney general sued the company’s employee auditing firm, Ernst & Young, for concealing firm’s real financial position and assisting company in their fraudulent activities.
Enron
Similar to the case of Lehman Brothers is the case of Enron, an American energy company that went bankrupt in the year 2002. The path to fallout of Enron started with their first devious activity of Revenue Recognition, where the company under question used ‘Merchant Model’ that allowed them to record entire value of their trade as revenue, which meant that the trading revenues were highly inflated.
The second ingenious activity that Enron recognized was Mark to Mark Accounting; this allowed the company to evaluate income as the present value of net future cash flow after a long term contract was signed. In other words, profits from projects that had not been signed were recorded in the revenue column of the firm’s profit and loss account. However, the viability of the contract and fluctuating cost of the contract were difficult to estimate, consequently to match profit and cash, the amount noted down were vastly different, and exaggerated. And despite these discrepancies, auditors forwarded misleading report to the investors and other stakeholders of the firm(Dowd, 2016).
Third, the concept of special purpose entities was adopted by Enron to fulfill a temporary purpose to manage risk associated with special assets by creating companies of limited partnerships. Enron primarily used these special purpose entities to conceal their debts and minimize their liabilities in the company’s balance sheet.
One of the surprising information about the audit committee hired by Enron was that they lacked the technical knowledge to question the different treatments used by the firm to overstate their revenues and understate their liabilities. Additionally, the members of the audit committee were under pressure from the management to not exercise independency and objectivity while auditing Enron’s financial position, thus leading it to go for bankruptcy.
Auditing Firms as Capitalist Enterprises?
Auditing committee, though being an entity that mitigates risk for capital market and several stakeholders, isin the end, an organization that is being run to earn profit. These firms rely on their clients to shoulder their expenses that are being occurred while the same client’s economic performance and position is being evaluated. The report published by The Institute of Internal Auditors listed Economic interest of Auditing Firms as a threat to independency and objectivity of Auditors. The first reason being, Auditors most of the time have their economic interest in the organization at stake because the board of directors are paying their fees, thus the pressure to report financial performance according to the directors exist.
Second, the report asserts that often the Auditors have stock option or invested in the organization financially, thus, reporting faulty practices and negative outcome can jeopardize auditor’s own financial interest or can result in negative financial returns.
Third, auditing of a certain department, which is also responsible for scouting and selection of auditing firm, can be done favorably, while overlooking any illegal activity so that the future contract and employment condition of the auditing firm is not disturbed.
In wake of how independence of Auditors can be impaired due to fee dependency, it is of crucial importance to rectify this issue at a national and international level. Financial crisis of 2007-2008, and dissolution of companies such as Enron, WorldCom, Lehman Brothers and such provide us with the backdrop as to why economic interest of auditing firms should not silence the auditors at all. According to (Sikka, 2009) unqualified audit reports have failed to ensure the market of actual financial positions of the organization, and has ultimately lead to collapse of financial institution and organization, that were to be bailed later on.
For illustration, the Global Financial Crisis of 2007, which victimized global financial market, but its impact were majorly seen in the US market were cause by the silence of auditors in face of adverse, and illegal activities that the businesses were carrying out at that time. One example of this is that few banks posed subprime mortgages at highly inflated value, which is a traditional way of hiding losses. Despite, these warning signs, to secure their economic interest, auditors provided green signaled to those corporations who should have been given a red flag. This cause public to invest in a market, that was already on its way to failure, just because of the dependency of auditor on the clients that were paying them their fee or ‘seemingly’ responsible of the future of the audit concern.
Why Auditor Independence is Important?
With the evolvement of technology and information, the stakeholders of any firm, including the management and employees are now heavily invested in the organization’s operations and their economic performance and position. Hence, to bridge the gap between the need of the stakeholders and fulfilling that particular need, Auditing firms perform the role of an arbitrator. This constitute is a source of reliance to the stakeholders when scouting company’s current standing and financial position in the market. At this point, the independence of Auditor is quite crucial to both the organization, and shareholders.
