Lessons From Lehman and Reflections on Auditors' Risk Assessment

Many, if not most companies use quarter and year-end financial reports in their risk assessment process. But those financial statements and reports may not be a good indicator of risk levels. Consider the following:

  • Lehman and, apparently, other financial institutions used accounting transactions (called “Repo 105”) at or near quarter-end to “window-dress” the balance sheet. They sold assets for cash to a third party with a commitment to repurchase them in the new quarter. This enabled them to improve their liquidity and certain ratios used by investors and others to assess their performance and financial condition. If internal audit used the quarter or year-end financial statements to assess risk when the organization uses such accounting devices, then liquidity and asset risks are both understated.
  • Some years ago, I was chief audit executive of a large oil refining and marketing company. Management made adept use of commodity futures and swaps to hedge the cost of its crude oil purchases and the value of its refined products (gasoline, jet fuel, etc.) However, it closed many of those positions just before quarter-end — only to put them on again right after quarter-end. In addition, the board approved a limited amount of speculative trading in the same or similar derivatives. These were always removed before quarter-end. As a result, the financial statements filed with the SEC included disclosures that only addressed the positions retained at the end of the period. Fortunately, I was well aware of the trading and used the maximum levels permitted by the trading policy to establish risk levels — and not the quarterly or annual financial reports.
  • At another company, the levels of accounts receivable varied significantly during each quarter. Management’s practice was to drive sales towards the end of each quarter. This led to a significant amount of each quarter-end’s accounts receivable balances being current. The credit and collections department similarly focused extra effort at the end of each quarter to collect amounts due. As a result, the aging of receivables at quarter-end was always significantly better than during the middle quarter. The audit risk assessment should be based on that higher risk level.
  • Many companies have what is commonly called a “hockey stick” trend in sales: sales during the last days and weeks of the quarter are dramatically higher than during the earlier weeks and months. This will generally mean that inventory levels (and therefore the perception of inventory risk) are lower at quarter-end.

What is the lesson? Rather than using quarter or year-end financial statements to assess risks, understand how activities, balances, and risk fluctuate during the period — and select the level most indicative of the risk in the business. In most cases, this will be the peak level rather than the level reported in the financial statements.

Posted on Apr 28, 2010 by Norman Marks

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  1.  Norman: This is an interesting selection of earnings-manipulation scenarios. However, it seems to me that the latter two of the three represent essentially ethical, if not entirely transparent efforts by management to put the best face on the companies' performance. Lehman's Repo 105 activities however were distinctly different. These were conducted in order to conceal the actual, extremely dire financial condition of a company soon to crumble into bankruptcy while deceiving investors and regulators.  Much different from what you describe in the company you worked for an in the AR example

  1. Peter, thank you for your comments. Lehman certainly used their Repo 105 transactions to window-dress their financial statements. The SEC is investigating the extent to which other financial institutions use repos for window dressing instead of (or in addition to) obtaining financing. Lehman and EY assert that the transactions were in accordance with SFAS 140. At most, the nature and extent of the Repo 105 transactions should have been disclosed - but the balances would not change.

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