​​Lessons From Lehman and Reflections on Auditors' Risk Assessment

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​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.



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