Once this has happened, the auditor is in a position to assess the risk of material misstatement in the financial statements. The auditor should consider, for example, management's selection and application of accounting principles in assessing the risk of fraud. Some red flags identified in the alert are when the transaction is overly complex; whether or not management has discussed the accounting of such transactions; if management is placing undue emphasis on accounting treatment of a transaction; if transactions involve third parties, including special purpose entities; and if the transactions do not have sufficient substance.
The alert prescribes a course of action for situations when an auditor believes that there is a significant risk of material misstatement. The auditor must identify his or her findings in an engagement...
Yet the auditors at Ernst & Young signed off on the statements. This PCOAB alert highlights the course of action that the auditors should have undertaken. They should have questioned management about the transactions and could have withheld signature on the financial statements until the nature of the Repo 105 transactions was disclosed. This would have allowed investors to understand the true financial health (or lack thereof) at Lehman Brothers in advance of the company's collapse.
