CHAPTER 55
THE EXTERNAL AUDITS OF BENEFICIAL FINANCE:
BACKGROUND INFORMATION
TABLE OF CONTENTS
55.1 PURPOSE OF CHAPTER
55.2 PLAN OF CHAPTER
55.3 STATUTORY REQUIREMENTS FOR PREPARATION OF ACCOUNTS AND AUDITS
55.3.1 PREPARATION OF ACCOUNTS
55.3.2 AUDIT OF ACCOUNTS
55.4 APPOINTMENT OF AUDITORS
55.5 OBLIGATIONS UNDER THE TRUST DEED
55.6 EXTERNAL AUDITORS' RESPONSIBILITIES AND EXTERNAL AUDIT PROCESS
55.6.1 AUDITORS' RESPONSIBILITIES
55.6.2 PHASES OF THE AUDIT PROCESS
55.6.2.1 Planning the Audit
55.6.2.2 Execution of the Audit
55.6.2.3 Conclusion of the Audit
55.6.3 THE IMPORTANCE OF AUDIT WORKING PAPERS
55.6.4 MATERIALITY
55.7 AUDIT OF FINANCIAL INSTITUTIONS
55.8 INVESTIGATION OF THE EXTERNAL AUDITS OF THE ACCOUNTS 1985-1990
55.1 PURPOSE OF CHAPTER
The purpose of this Chapter is to provide salient background information to convey some understanding of:
(a) The statutory responsibilities under the Companies (South Australia) Code imposed on Beneficial Finance, as a limited liability company, and as a borrowing corporation as defined under the Code, to prepare and have audited accounts of the company.
(b) The responsibilities imposed on Beneficial Finance and its auditors by the requirements of the Debenture Trust Deeds which applied to the company.
(c) The nature of the external audit process and the responsibilities of the external auditor engaged to undertake the process.
The background information will also facilitate understanding of the issues and conclusions which have emanated from the investigation of the external audits of the accounts of Beneficial Finance, 1985 to 1990, in Chapters 54 - "The External Audits of Beneficial Finance: Introduction" to Chapter 60 - "The External Audits of Beneficial Finance: Findings and Conclusions".
55.2 PLAN OF CHAPTER
This Chapter comprises the following principal segments:
(a) Statutory requirements for Preparation of Accounts and Audits;
(b) Appointment of Auditors;
(c) Obligations under the Trust Deed;
(d) External Auditor Responsibilities and External Audit Process;
(e) Audit of Financial Institutions; and
(f) Investigation of the External Audits of the Accounts 1985 to 1990.
55.3 STATUTORY REQUIREMENTS FOR PREPARATION OF ACCOUNTS AND AUDITS
55.3.1 PREPARATION OF ACCOUNTS
Beneficial Finance was required by Section 267(1) of the Companies Code to keep accurate accounting records. The directors of a company are required to cause to be prepared a Profit and Loss Account, a Balance Sheet and, for holding companies, consolidated accounts pursuant to Sections 269(1), (2) and (3) of the Code. Section 269(8) of the Code further provides that a company's accounts will comply with certain prescribed requirements as set out in Schedule 7 of the Code and with applicable Australian Accounting Standards.
It is an explicit requirement of relevant sections of the Companies (South Australia) Code that accounts prepared by a company will be made out so as to give a true and fair view of matters dealt with in the accounts.
Section 269(7) requires that:
"The directors shall, before the profit and loss account and balance sheet ... are made out, take reasonable steps -
(a) to ascertain what action has been taken in relation to the writing off of bad debts and the making of provisions for doubtful debts and to cause all known bad debts to be written off and adequate provision to be made for doubtful debts;
(b) to ascertain whether any current assets, other than current assets to which paragraph (a) applies, are unlikely to realise whether directly or indirectly in the ordinary course of business their value as shown in the accounting records of the company and, if so, to cause -
(i) those assets to be written down to an amount that they might be expected so to realise; or
(ii) adequate provision to be made for the difference between the amount of the value as so shown and the amount that they might be expected so to realise; and
(c) to ascertain whether any non-current asset is shown in the books of the company at an amount that, having regard to its value to the company as a going concern, exceeds the amount that it would have been reasonable for the company to expend to acquire that asset as at the end of the financial year and, unless adequate provision for writing down that asset is made, to cause to be included in the accounts such information and explanations as will prevent the accounts from being misleading by reason of the overstatement of the amount of that asset."
The provisions of Section 275 of the Code require the directors of a company to place before the annual general meeting of the company accounts of the company for the preceding financial year, including group accounts in the case of holding companies. Also required to be placed before the annual general meeting are relevant directors' reports and auditors' reports.
Beneficial Finance was a borrowing corporation as defined under the Code. As a consequence, it was subject to Section 158(5), which requires preparation of Profit and Loss Accounts and Balance Sheets with respect to each financial year, and also with respect to the six month period ended 31 December each year. It was further required, as a holding company, by Section 158(6), to prepare consolidated Profit and Loss Accounts and Balance Sheets for each of those accounting periods.
55.3.2 AUDIT OF ACCOUNTS
The powers and duties of a company auditor as to the reports required on accounts are detailed in Section 285 of the Companies Code. Section 285(1) requires the auditor to make out a report to the members of the company with respect to the company's accounts, and with respect to the group accounts for a holding company. The section further specifies matters which must be addressed by the auditor in the report, and further matters with respect to which the auditor must form a opinion and report if there are deficiencies, failures, or shortcomings. Section 285(3), which deals with the content of auditors' reports, requires the auditor to state whether the relevant accounts are, in the auditor's opinion, properly drawn up to give a true and fair view, and are in accordance with the Companies Code and applicable Australian Accounting Standards.
Section 285(6) gives the auditor of a holding company certain rights which will enable the auditor to effectively audit the group accounts.
The auditor of a borrowing corporation has additional reporting responsibilities. Section 287(1) requires the auditor to provide any reports required to be made to the corporation or members, to also be presented to the trustee for debenture holders. Section 287 (2) specifically requires the auditor to report any matters likely to prejudice the interest of debenture holders to the borrowing corporation, in the first instance, and then to the Trustee for the debenture holders. I have taken the view that the performance of the auditor's duties under Section 287 falls outside the scope of Term of Appointment B.
55.4 APPOINTMENT OF AUDITORS
A company is required by Section 280 of the Companies (South Australia) Code to appoint an auditor or auditors for the company. The provisions of Section 277 require, amongst other things, that a person acting as auditor of a company is a registered company auditor, and that a firm acting as auditor has at least one member of the firm who is a registered company auditor.
Throughout the period reviewed, Beneficial Finance and its subsidiaries were audited by the firm of Price Waterhouse. The audit reports with respect to the Beneficial Finance accounts were signed by Mr A Giles for the firm, with the exception of the report on the accounts for the period ended 31 December 1990, which was signed by Mr A Herald.
55.5 OBLIGATIONS UNDER THE TRUST DEED
Beneficial Finance was a borrowing corporation and had raised funds through the issue of Debentures and Unsecured Notes. Companies legislation requires the issue of such securities by borrowing corporations to be governed by Trust Deeds and for a Trustee to be appointed to monitor the performance of the borrowing corporation on behalf of the holders of securities.
As noted earlier in this Chapter, the Companies Code imposes obligations on both the borrowing corporation and the corporation's auditor as to the provision of accounts and reports to the Trustee for security holders.
The provisions of the Trust Deeds, under which Beneficial Finance issued debentures and unsecured notes, from time to time reflect certain obligations imposed on the company and its auditors by the Companies Code. Under the Trust Deeds, Beneficial Finance was required to operate its business in a way that ensured compliance with specified financial criteria, such as gearing and liquidity ratios. The Trustee's capacity to monitor compliance with these ratios was supported by obligations under the Trust Deed for the company and its Auditor to provide financial reports and certificates which either demonstrated compliance with the relevant criteria or made representations as to compliance.
The Company and its Auditor were also obliged to provide representations to the Trustee that the Company had fulfilled its obligations in repaying the principle due, and interest due, under debentures issued.
55.6 EXTERNAL AUDITORS' RESPONSIBILITIES AND EXTERNAL AUDIT PROCESS
55.6.1 AUDITORS' RESPONSIBILITIES
External auditors' responsibilities concerning the audit process are set out in the applicable pronouncements of the Professional Accounting Bodies in this country(), and in the common law. The following is a summary of the salient points:
(a) In forming the audit opinion, the auditors must perform sufficient tests to obtain reasonable assurance as to whether information contained in the underlying accounting records and other source data is reliable and sufficient as the basis for the preparation of the accounts.()
(b) Audit procedures must include an evaluation of the accounting systems and internal controls upon which audit reliance is to be placed in determining the nature, timing, and extent, of audit procedures.()
(c) The auditors must inform Management, or, in certain cases the Board of Directors, concerning any material weaknesses in internal control and accounting procedures of which the auditors become aware during the course of the audit.()
(d) The auditors must obtain appropriate and sufficient audit evidence through the performance of compliance and substantive procedures from which they could reasonably draw conclusions and base their opinions concerning the accounts and financial position of the reporting entity.()
(e) The auditors must bring to bear on the work they have to perform that skill, care, and caution, which a reasonably competent, careful, and cautious, auditor would use. What is reasonable skill, care, and caution, will be determined by the circumstances of the time.()
I consider it is relevant to note the context in which the audits in the years under review were conducted. In the year ended 30 June 1985, the Bank Group adopted a strategic plan, the prime objective of which was to increase the assets of the Bank Group to over $8.0B by 1990 from a base, at 1 July 1984, of $3.1B.() It was recognised by the Bank that, to achieve its objective of growth, the Bank and its subsidiaries would be required to compete vigorously with foreign banks entering the deregulated Australian financial market, and the Bank's policy was that it was ready to do so.() The Bank is a statutory instrumentality of the State of South Australia, whose debts are guaranteed by the State of South Australia. Section 21(1) of the State Bank of South Australia Act, 1983, provides:
"The liabilities of the Bank are guaranteed by the Treasurer."
In other words, any loss incurred by the Bank or any subsidiary which, for commercial reasons, the Bank must support, is a loss which would be borne effectively by the "shareholders", the people of South Australia. This is quite different from the situation with large public companies, where persons may choose to become shareholders, generally with the benefit of limited liability.
55.6.2 PHASES OF THE AUDIT PROCESS
The phases of the audit process, and the responsibilities of the external auditor in relation to each, are as follows:
55.6.2.1 Planning the Audit
The auditor should plan the audit to enable it to be conducted in an efficient and effective manner. Planning should cover the acquisition of knowledge of the client's business and systems, establishing the degree of reliance that the auditor can place on internal controls built into the financial accounting systems, and determining the nature, timing, and extent, of the audit procedures to be performed. An important part of the process is a review and evaluation of the role and function of any internal audit activity, and how this can be usefully utilised by the external auditor.
The external auditor acquires an understanding of the business and the environment (and the nature of any changes occurring in that business and environment) in which the client entity operates, in order to make an assessment of the inherent risk to which the client is exposed, and to isolate areas that are of special audit significance by virtue of their magnitude or inherent risk, or through past experience.
The external auditor also gains an understanding of the financial accounting systems, including internal control procedures, used for processing and recording significant transactions to assess the control risk of the client. The extent of internal controls in systems is important to the auditor. The accounts will be based on information flowing from the systems, and, by assessing the effectiveness of the controls, the auditor can form a view as to the reliability of the information generated by those systems.
During this planning phase, the external auditor decides on the nature and extent of audit evidence to be obtained. The auditor also sets levels of materiality by which he will assess the significance of any errors in the accounts.
Through this work, the auditor develops the audit approach, and documents the overall audit plan for the expected scope and conduct of the audit.
The final part of this planning phase is the preparation of a written audit programme showing the nature, timing, and extent, of audit procedures necessary to implement the overall audit plan.
It may be that, in the planning process, the auditor identifies requirements for special skills to enable performance of the programmed tasks. In a banking environment, these typically are in the areas of computer systems, treasury operations, and taxation.
55.6.2.2 Execution of the Audit
Actual performance of the tests of internal controls, financial transactions and account balances occurs during the execution phase.
Tests are of two types. Compliance tests are designed to obtain reasonable assurance that those internal controls in systems on which audit reliance is to be placed are operating satisfactorily. Substantive procedures are designed to obtain evidence as to the completeness, accuracy, and validity, of the data produced by the systems. They may be used to supplement the assurance gained from compliance testing of controls, or to gain assurance in areas where controls are inadequate or where it is more appropriate to rely on other evidence. Substantive tests take the form of tests of transactions and balances, use of evidence from third parties, and analyses of ratios and trends, including the investigation of unusual fluctuations and items.
Methods of testing include observation, inquiry, inspection and confirmation of third parties, computation and analytical review of significant ratios and trends, and includes the investigation of unusual fluctuations and items. Analytical procedures may include the comparison of financial information with comparable information from prior periods, budgets, forecasts, and similar industry information. The selection and timing of the tests for particular items will have been decided upon at the planning phase.
The amount of substantive testing to be undertaken of transactions and items appearing in the accounts is based on the external auditor's assessment of the risk of errors, the extent and results of the tests of controls (ie compliance testing), and the materiality of the transactions or account balances.
There is a close relationship between the results of the evaluation and compliance tests of the client's internal controls, and the level of substantive testing. If the external auditor has obtained a reasonable level of confidence in the financial accounting systems' ability to produce reliable information, through the general review of internal controls and compliance tests of their effectiveness, the substantive tests can be significantly decreased. There is, however, always a need for a certain level of substantive testing, the level varying according to the nature and circumstances of the entity under audit.
55.6.2.3 Conclusion of the Audit
After the external auditor has completed the audit programme, it is necessary to draw together and evaluate the evidence obtained during the execution phase of the audit. The external auditor has to form an opinion whether the accounts have been prepared in accordance with the applicable statutes and regulations and accounting standards, and whether the accounts give a true and fair view, and that there is adequate disclosure of all matters necessary to give a true and fair view. Adequate disclosure would necessarily include reporting by way of notes to the accounts, on the existence of `contingent' liabilities, and `events' that may have occurred subsequent to balance date, but which have an effect on the information provided in the accounts.
The audit process concludes with the external auditor issuing an audit report to accompany the reporting entity's accounts.
In addition to his audit report on the accounts, the external auditor may issue what is commonly called a management letter to the Board of Directors or Executive Management. This letter is designed to bring to the client's attention, at the appropriate level of management or the Board of Directors, significant matters which have come to the attention of the auditor in the course of the audit. Commonly they relate to deficiencies in internal accounting controls or areas where the auditor believes greater efficiencies can be achieved. These letters may include recommendations to improve the procedures used in compiling the annual accounts, or to strengthen control procedures for the prevention of error or loss. A management letter can never be regarded as a substitute for the issuing of a qualified audit report on the annual accounts.
Management letters are commonly issued at the completion of the audit, although, depending on circumstances, they may be issued more frequently. If a serious matter comes to light in the course of the audit, it is normal procedure for the auditor to report the matter promptly to the appropriate level of management or the Board of Directors.
55.6.3 THE IMPORTANCE OF AUDIT WORKING PAPERS
Audit working papers are the principal evidence of the audit work performed by the external auditor to support his opinion.()
The auditor should, in his working papers, document matters which are important in providing evidence that the audit was carried out in accordance with the auditing standards and practice statements of the Professional Accounting Bodies.()
The auditor should document his overall audit plan at the conclusion of the planning process.()
Statement of Auditing Practice - Documentation, AUP15, operative from January 1983 provides:
"4. Working papers should record the auditor's planning, the nature, timing and extent of the auditing procedures performed, and the conclusions drawn from the evidence obtained.
5. Working papers should be sufficiently complete and detailed for an experienced auditor to obtain an overall understanding of the audit. The extent of documentation is a matter of professional judgment since it is neither necessary nor practical for the auditor to document in his working papers every observation, consideration or conclusion made.
6. All significant matters which require the exercise of judgement, together with the auditor's conclusion thereon, should be included in the working papers."
The failure of audit working papers to document significant matters, including those requiring the exercise of the external auditor's judgement, would, in my opinion, be a significant omission which would call into question the adequacy of an audit.
55.6.4 MATERIALITY
The concept of materiality is an overriding concept which governs the preparation and presentation of accounts, and also the application of Australian Accounting Standards and applicable Approved Accounting Standards. Unless explicitly stated otherwise, these accounting standards need only be applied where they have a material consequence.()
When performing the audit of an entity's accounts, the auditor needs to establish an appropriate level of materiality to allow the consideration of matters arising in proper perspective. If, for instance, a detected error is less than the level of materiality appropriate for its consideration, the auditor may choose not to insist upon its correction. If the error is above that level, and thus deemed to be material, the auditor will take steps to have the matter suitably resolved.
The concept also has applicability when deciding upon the extent of audit testing to be performed, as the auditor is concerned to detect errors or mis-statements that are material in effect.
The general test of materiality, which must be applied subject to the circumstances, is that:
"... an item of information is material if its omission, non-disclosure or mis-statement would cause the financial statements to mislead users when making evaluations or decisions." ()
In deciding whether an item is material, its nature and its amount should both be taken into account, although in particular circumstances either alone may have to be recognised as the decisive factor.() Guidelines for quantitative assessment of materiality are set out in Australian Accounting Standard AAS5.()
In my opinion, a relevant circumstance affecting decisions as to materiality is the underlying financial condition and stability of the reporting entity. As the entity gets into difficulty, materiality will have finer limits because, with increasing financial distress, users of accounts will want to know more and there is less room for error.()
There are clearly some matters the omission of which, by their nature, can render accounts false or misleading, regardless of the amount involved. For example, Section 269 of the Companies (South Australia) Code sets out certain requirements, which apply without any qualification as to materiality. The accounts of a company and its subsidiaries must be consolidated, or presented in group accounts, and the identity of the subsidiaries and their contribution to consolidated profit stated by way of note, regardless of the materiality of the amounts involved.() Similarly, the accounts must comply with the prescribed requirements in Schedule 7, which apply regardless of materiality unless otherwise stated.()
Both the Companies (South Australia) Code and the Australian Accounting Standard on materiality contemplate that circumstances can arise when disclosures of material matters over and above strict compliance with statutory requirements and accounting standards may be necessary in order to ensure that the accounts give a true and fair view.()
55.7 AUDIT OF FINANCIAL INSTITUTIONS
Banks and other financial institutions have the following characteristics which distinguish them from other business entities:
(a) They have custody of large volumes of cash and negotiable securities whose physical security has to be assured. This applies both to storage and transfer of such items, and makes financial institutions especially vulnerable to misappropriation and fraud. Such institutions therefore establish formal operating and accounting procedures, well-defined limits for individual discretion, and rigorous systems of internal control.
(b) Financial institutions engage in a large volume and variety of transactions, many having high value. This necessitates complex accounting systems, sound internal control procedures, and widespread use of computers.
(c) Financial institutions generally need, and have well developed, internal audit functions to monitor their internal control systems.
(d) Financial institutions often assume significant contingent commitments, without any transfer of funds. These transactions may not involve accounting entries to the primary records, and consequently the failure to record such items may be difficult to detect. Information on these transactions is generally presented in the notes to the accounts, rather than in the balance sheet.
(e) Financial institutions continue to develop new products and practices that may not be matched by a concurrent development of Statements of Accounting Standards and/or Auditing Practices. The absence of specific Statements may mean that the financial accounting and reporting treatment of some items will need to be determined from basic principles to ensure adequacy of disclosure of the items in the accounts of the client.
Accordingly, the external audit of a financial institution can be expected to contain the following features:
(a) A heavy reliance on the system of internal control, involving a high level of understanding of the systems in use, and a high level of testing of the integrity of those systems.
(b) Reliance upon the effectiveness of the internal audit function to the greatest extent possible, but with a corresponding level of inquiry into, and assessment of, the effectiveness of the internal audit operations.
(c) A considerable understanding and evaluation of the various risks and exposures involved in the activities of the financial institution, both for the purpose of designing an appropriate audit approach, and for the purpose of determining the appropriate disclosures of exposures in the accounts. In a financial institution these risks can be broadly grouped into `product and service' risks and `operating' risks.
(i) Product and Service Risks
The most significant product and service risk in a bank is usually credit risk, which is the risk that a customer or counterparty will not discharge its obligations. Associated with the credit risk is the risk that securities may diminish in value due to factors affecting the value of the underlying assets. Other product and service risks include:
. Liquidity Risk: the risk of loss arising from the possibility of the financial institution's not having sufficient funds to meet its obligations;
. Interest Rate Risk: the risk of loss arising from the sensitivity of earnings to future movements in interest rates;
. Currency Risk: the risk of loss arising from movements in the exchange rates applicable to foreign currency assets, liabilities, rights, and obligations;
. Market Risk: the risk that the value of assets, obligations, and exposures, may change by reason of market factors affecting interest rates, exchange rates, security prices, property values, etc; and
. Fiduciary Risk: the risk of loss arising from factors such as failure to maintain safe custody or negligence in the management of assets on behalf of other parties.
Product and service risks increase with the degree of concentration of a financial institution's exposure to any one customer, industry, geographic area or country.
(ii) Operating Risks
Operating risks arise out of the need to process high volumes of transactions accurately within short timeframes. This need is almost always addressed through the use of large scale computer systems, with the resultant risks of failure to process executed transactions in a timely manner, loss of data arising from system failure, and wide-scale error arising from a breakdown in internal controls.
(d) A sensitivity to external factors such as the state of the economy, the competitive position, and the regulatory framework due to the extent that these factors affect the volatility of the various risks.
55.8 INVESTIGATION OF THE EXTERNAL AUDITS OF THE ACCOUNTS 1985-1990
The Investigation assessed the appropriateness and adequacy of the external audits of the accounts of Beneficial Finance Corporation Limited and its subsidiaries for the years ended 30 June 1985 to 30 June 1990.
It is important to emphasise that the year by year assessment did not take the form of a re-performance of the audits of the accounts. The investigation entailed the review and evaluation of the audit process applied by the external auditor in each year in relation to the accounting records and the accounts of Beneficial Finance, including the procedures adopted by the auditors with regard to planning of the audit, execution of the audit, and concluding and reporting on the audit.
It must also be borne in mind that the investigation of the external audit process is not the same as an assessment of the accuracy of the accounts of Beneficial Finance. For example, if the external auditor's conduct of the audit had been inadequate, the only conclusion that could be drawn with confidence would be that there was not a proper basis for the audit opinion expressed by the auditor. Whether the accounts comply with the statutory requirements, and give a true and fair presentation of the entity's results of operations and financial position would depend upon other matters. Conversely, it is conceivable that the conduct of the audit might have been adequate without the auditor detecting an error or irregularity in the accounts.
The Investigation was undertaken with expert assistance from three of the major Australian firms of Chartered Accountants, being Coopers & Lybrand, Deloitte Touche Tohmatsu, and Ernst & Young.
The review and evaluation of the annual audit process included an analysis of the external auditor's audit methodology, review of external audit evidence obtained and documented in the external auditor's working papers and correspondence between Beneficial Finance and the external auditor, and direct inquiry of external auditors engaged on the audits of Beneficial Finance. Conclusions drawn in relation to the appropriateness and adequacy of the external audits were made in consideration of the Professional Accounting Bodies' Accounting and Auditing Standards and the statutory requirements applying at the relevant times.
The issues and conclusions which have arisen from the Investigation of the external audits of the accounts of Beneficial Finance are presented in the following Chapters; Chapter 54 - "The External Audits of Beneficial Finance: Introduction" to Chapter 60 - "The External Audits of Beneficial Finance: Findings and Conclusions".