VOLUME SEVENTEEN THE EXTERNAL AUDITS OF THE STATE BANK OF SOUTH AUSTRALIA

CHAPTER 49
REVIEW OF THE 1987 EXTERNAL AUDIT OF THE STATE BANK

TABLE OF CONTENTS

49.1 PURPOSE OF CHAPTER

49.2 PLAN OF CHAPTER

49.3 BUSINESS OF BANK AND BANK GROUP
49.3.1 THE BANK
49.3.2 SUBSIDIARIES

49.4 ACCOUNTS OF BANK AND BANK GROUP

49.5 INVESTIGATION OF THE AUDIT PROCESS
49.5.1 PLANNING OF THE AUDIT
49.5.1.1 Matters Noted
49.5.1.2 Conclusion
49.5.2 EXECUTION OF THE AUDIT
49.5.2.1 Preamble
49.5.2.2 Matters Noted - Investments
49.5.2.3 Matters Noted - Corporate Lending
49.5.2.4 Matters Noted - Provision for Doubtful Debts
49.5.2.5 Matters Noted - Bank Acceptances of Customers
49.5.2.6 Matters Noted - Concessional Housing Reserve
49.5.2.7 Matters Noted - Provision for Taxation
49.5.2.8 Matters Noted - Provision for Self Insurance
49.5.2.9 Matters Noted - Contingent Liabilities
49.5.3 CONCLUDING PROCEDURES
49.5.3.1 Preamble
49.5.3.2 Matters Noted - Subsequent Events Review
49.5.3.3 Matters Noted - Management Representation Letter

49.6 CONCLUSION

49.1 PURPOSE OF CHAPTER

Chapter 46 - "The External Audits of the State Bank: Background Information" presented information regarding the statutory obligations of the Bank and the Bank's auditors in relation to the preparation and audit of the accounting records and annual accounts of the Bank. The Chapter also outlined in general terms the elements of an audit process that would characterise an appropriate and adequate audit, governed principally by standards promulgated by the Professional Accounting Bodies of Australia.

This Chapter provides some introductory comments concerning important events in the business operations of the Bank during 1986-87 and significant features of the statutory accounts in respect of the 1986-87 financial year. The Chapter then reports on matters arising from the assessment of the audit process applied by the external auditors in the audit of the accounting records and accounts of the Bank for the year ended 30 June 1987. The Chapter also concludes as to the appropriateness and adequacy or otherwise of the audit process undertaken.

49.2 PLAN OF CHAPTER

The Chapter comprises the following principal segments:

(a) Business of Bank and Bank Group;

(b) Accounts of the Bank and the Bank Group;

(i) Profit and Loss Statement; and

(ii) Balance Sheet.

(i) Planning of the Audit;

(ii) Execution of the Audit; and

(iii) Concluding Procedures.

(d) Conclusion.

49.3 BUSINESS OF BANK AND BANK GROUP

49.3.1 THE BANK

The Bank expanded its network of branches to include representative offices in Hong Kong, Melbourne and Sydney. In addition, during the year work began on the construction of the State Bank Centre.

49.3.2 SUBSIDIARIES

The Bank Group expanded to include a residential real estate company with the purchase of a 50 per cent interest in Myles Pearce and Co Pty Ltd. The Beneficial Finance Group increased its profit by $1.6M (19.4 per cent) over the previous year to $9.8M while total reported assets increased by $86.0M ( 8.2 per cent) to $1,129.0M.

49.4 ACCOUNTS OF BANK AND BANK GROUP

On 27 August 1987 an unqualified Audit Report was signed by Peat Marwick Mitchell & Co and Touche Ross & Co in respect of the accounts of the Bank for the year ended 30 June 1987. The accounts presented comprised a Profit and Loss Statement, Balance Sheet, Source and Application of Funds Statement and Notes to the Accounts, for both the Bank and the consolidated Bank Group.

The following Table provides key information relative to the financial results of operations and the financial position of the Bank and consolidated Bank Group.

	Bank				Bank Group
	1986 $M		1987 $M	1986 $M		1987 $M	Per Cent Increase (Decrease)
Profit and Loss Statement

Income	547.7	726.2		690.3		899.3	31
Operating Profit

Before Tax	33.6	40.8		41.0		52.1	27
After Tax and Extraordinary Items	23.6	42.5		27.4		47.7


Balance Sheet

Assets
Loans, Advances, Receivables	3267.8	4,685.2		4211.7		5,753.7	37
Other	2202.9	2,161.1		2239.5		2,140.0
	5470.7	6,846.3		6451.2		7,893.7	22

Liabilities
Deposits and Borrowings	4263.0	5,302.7		5158.6		6,279.2	22
Other	815.6	973.7		882.0		1,022.4
	5078.5	6,276.4		6040.6		7,301.6	21

Net Assets	392.2	569.9		410.6		592.1	44

Capital, Subordinated Debt, Reserves	392.2	569.9		410.6		592.1	44

Doubtful Debts

Expenses for the Year	5.5	7.7		12.1		18.8	55
Provision at Balance Date	13.0	19.2		24.2		32.3	34

(1) The statutory accounts of the Bank and Bank Group disclose both the federal income tax obligation to the Australian Government in respect of the non-Bank subsidiaries of the Bank Group and the federal income tax equivalent obligation to the South Australian Government in respect of the Bank. In relation to the latter obligation, Section 22(1) of the State Bank of South Australia Act, 1983, requires the Bank in regard to its operating surplus to pay a sum to the Treasurer of South Australia, representing the equivalent of income tax that would be payable under Commonwealth Law.

For the years ended 30 June 1985 and 1986, the federal income tax payment to the Australian Government and the income tax equivalent payment to the South Australian Government, were deducted from the `Operating Profit Before Tax' in arriving at the `Operating Profit After Tax and Extraordinary Items'. For the years ended 30 June 1987, 1988 and 1989, the financial reporting treatment changed in relation to the income tax equivalent payment to the South Australian Government. The payment was not treated as a deduction from `Operating Profit Before Tax'. It was treated as a distribution from retained profits. As a result, the `Operating Profit After Tax and Extraordinary Items' amounts for 1986, reported in the 1986 statutory accounts are not comparable to the 1987 amounts reported in the 1987 statutory accounts. However, the 1987 statutory accounts presentation included comparable figures for 1986 adjusted for the change in financial reporting treatment. The 1986 adjusted comparable figures were, Bank $34.2M and Bank Group $38.0M.

The change in financial reporting treatment and presentation was not explained in the Notes to the Accounts.

(2) The Extraordinary Items related to principally:

. profit of $0.54M realised by the Bank on the sale of premises;

. an adjustment to profit of $0.67M throughout the Group due to a Tax Effect Accounting adjustment resulting from a change in tax rates effective 1 July 1986; and

. profit of $0.4M arising from the sale of real estate business operations by Executor Trustee and Agency Company of South Australia Limited.

49.5 INVESTIGATION OF THE AUDIT PROCESS

49.5.1 PLANNING OF THE AUDIT

49.5.1.1 Matters Noted

The Investigation reviewed the audit working papers to ascertain what procedures had been carried out by the joint auditors on:

(a) an overview of the Bank's systems of internal control and the approach to be taken to assess the adequacy of those systems on which reliance was placed; and

(b) an overview of the quality and reliability of the work of the Internal Audit department and the approach to be taken to assess the adequacy of that work.

Satisfactory conclusions in these two areas would be vital to any decision to be made by the joint auditors to rely on the Bank's system of internal control and on the work performed by the Internal Audit department and to assess audit risk.

The audit working papers prepared by the joint auditors evidence a degree of reliance on the Internal Audit department of the Bank. There is a reference to the significance of the internal audit function in the Audit Approach Memorandum for the year ended 30 June 1987 which states:

"... the key factor in the Bank's internal control is the internal audit function. This department undertakes extensive audit procedures at branches and head office divisions, including the use of computer software and an integrated test facility.

The extent of our reliance on the internal audit function is expected to be considerable." ⁽⁾

In their submission dated 21 December 1992 the joint auditors explained the procedures carried out by them in relation to internal controls, internal audit and computer controls:

"The overall approach to the audit of the State Bank of South Australia was substantive. This is demonstrated by the Account Level Planning Summary ... [which states] that it was planned that "no" reliance was to be placed on internal controls to modify the extent of substantive audit work carried out in the critical audit areas.

In the audit of the Bank, the areas considered to contain the greatest audit risk were Corporate and Treasury. The audit approach taken in these risk areas was substantive, that is, there was no reliance placed on internal controls in critical audit areas. In relation to certain minor areas of lesser audit risk, some reliance was placed on internal controls. A broad outline of the audit approach adopted by the joint auditors is depicted by the following table:

	Corporate	Treasury	Retail

Audit Risk Management	High	High	Low
Internal Control/Internal audit reliance	Low/High	Low/High	Low/High
Substantive Audit Approach - Control Risk	High	High	Low

It will be appreciated that there are areas of variable risk within each of the Bank's major operations which are identified in the above table. For example, low risk areas such as foreign exchange and money markets within Treasury would permit a higher reliance on internal control/internal audit and a less exacting substantive audit.

... the joint auditors did not rely either on internal controls in forming their opinion on critical audit areas or in relation to the EDP environment. In order to rely on internal controls in an EDP environment, it is necessary for the auditor to satisfy himself that it is possible to rely on general controls within the EDP environment. Often, the cost/benefit of testing EDP controls is so prohibitive that it is inefficient to attempt to test those controls ... In many instances, weaknesses in general EDP controls and/or in EDP application controls may preclude audit reliance on those controls. In such instances, the auditor should seek to accomplish audit objectives through either reliance on manual user controls and/or the performance of substantive procedures. The joint auditors cite as authority for this view, Statement of Auditing Practice "The Effects of an EDP Environment on the Study and Evaluation of the Accounting System and Related Internal Controls" AUP 4-1, more particularly paragraphs 17 and 18. The fact that an auditor may choose not to rely on controls does not necessarily indicate that those controls are inadequate for the business. The auditor is under no obligation to form such an opinion.

... the following summarises the approach adopted in relation to Computer Controls:

. A preliminary evaluation of EDP general controls was completed;

. It was decided that no reliance would be placed on EDP application controls; and

. The audit approach was therefore either substantive or alternatively reliance placed on manual user controls on the basis that such manual user controls were subject to audit."⁽⁾

The Audit working papers were reviewed by the Investigation. I am satisfied that the approach set out in the submissions from the joint auditors noted above was not clearly set out in the workpapers, however, the above submissions clarify the joint auditors' planning in relation to reliance on internal controls, Internal Audit and computer controls.

49.5.1.2 Conclusion

Based on the evidence examined by the Investigation, I have formed the opinion that planning in relation to the audit was appropriate and adequate.

49.5.2 EXECUTION OF THE AUDIT

49.5.2.1 Preamble

Chapter 46 - "The External Audits of the State Bank: Background Introduction" sets out background information on appropriate audit procedures in this area.

49.5.2.2 Matters Noted - Investments

There is no evidence in the audit working papers that the joint auditors tested purchases and disposals of investments other than equities to achieve the objectives listed in Chapter 46 - "The External Audits of the State Bank: Background Information". At 30 June 1987 the book value of fixed interest investments was $858.492M.

In their submission⁽⁾ the joint auditors described the work done, but this did not address the objectives referred to in Chapter 46.

Based on the evidence examined by the Investigation, and for the reasons set out above, I am not satisfied that the joint auditors performed appropriate and adequate audit procedures in relation to the Bank's purchases and disposals of investments during the year, however, I have no reason to believe any such failure to perform appropriate and adequate audit procedures resulted in a material mis-statement in the Bank's accounts.

49.5.2.3 Matters Noted - Corporate Lending

At 30 June 1987, the Bank's corporate loan portfolio amounted to $482.0M. There is no evidence in the audit working papers as to the portion of this total which was subjected to audit examination. In addition, there is no evidence in the audit working papers that the joint auditors confirmed any loan balances with the Bank's corporate borrowers.

The Internal Audit department tested corporate loans to ensure that the advances were properly recorded, approved and adequately secured.⁽⁾ Loans selected were tested for existence by agreeing the selected account to the loan file. However, there was no evidence in the audit working papers that Internal Audit sought to obtain third party confirmations of any loans.

In their submission⁽⁾ the joint auditors stated that, "In the audit of the Bank, the areas considered to contain the greatest audit risk were Corporate and Treasury. The audit approach taken in these risk areas was substantive, that is, there was no reliance placed on internal controls in critical audit areas."

In their submission⁽⁾ the joint auditors stated that Corporate lending was subject to testing by Internal Audit, including confirmation of balances with borrowers, and that they considered the work done by Internal Audit appropriate and adequate in the circumstances. It appears from the submission that despite Corporate Lending being designated as having high audit risk all audit work carried out was performed by Internal Audit. The Investigation could find no evidence in the audit file of the work performed by Internal Audit in this area being planned with Internal Audit other than a note ⁽⁾ stating that, "The number of accounts reviewed ... was agreed with G Curyer in about 8/86", about a year prior. Similarly the Investigation found no evidence that the results of the Internal Audit's work had been critically assessed by the joint auditors.

Although the joint auditors acknowledge that they did not carry out a circularisation themselves, they state that this was done by Internal Audit. However, a re-examination of the audit workpapers referred to by the joint auditors shows the confirmation sample to have been of cheque accounts and not corporate loans.

Testing by Internal Audit was carried out during the year. For this work to be relied upon at year end implies a degree of reliance on internal control which is counter to the general substantive audit approach which the joint auditors claimed to adopt.

Based on the evidence examined by the Investigation, and for the reasons set out above, I am not satisfied that the joint auditors carried out appropriate and adequate audit procedures in relation to Corporate Lending balances, however, I have no reason to believe any such failure to perform appropriate and adequate audit procedures resulted in a material mis-statement in the Bank's accounts.

49.5.2.4 Matters Noted - Provision for Doubtful Debts

The provision for doubtful debts at 30 June 1987 of $19.2M as calculated by the Bank comprised:

(a) a specific provision of $6.830M relating to an assessment of individual loans; and

(b) a general provision of $12.370M determined by applying risk percentages to balances outstanding and commitments for different categories of lending.

The Bank's total provision for doubtful debts was 0.48 per cent of total loans, advances and bills discounted ("total loans") as at 30 June 1987. This was significantly less than the loan loss provision percentages of the major Australian banks and the other state banks. The audit working papers note that the average provision for doubtful debts as a percentage of total loans for the major banks and the other state banks was 1.165 per cent with a range of 0.598 per cent to 1.753 per cent (using 1986 comparatives).⁽⁾

The joint auditors have submitted that:

"it is generally accepted in banking circles that there is no one correct provision level and whilst the Bank's 1987 level was the lowest of the four major trading Banks, the State Banks of New South Wales, Victoria and South Australia and the Rural and Industries Bank of Western Australia (using 1986 comparatives) it should be borne in mind that its rates of loan losses to total loans was almost the lowest in 1986 and prior years and was, for example, one fifth of NAB's ratio and one sixth of Westpac's ratio in 1986. This is not an unusual result when comparing a growing book of new business compared to banks with a more mature loan portfolio." ⁽⁾

The joint auditors have submitted that they were unable to draw any conclusions from this comparison as to the possible impact on the adequacy of the Bank's general provision because each of the bank's compared had a different risk profile and the figures excluded acceptances and off-balance sheet risks.⁽⁾

I do not accept that it was not possible to draw any conclusions from the above comparison. The joint auditors saw fit, in my opinion rightly, to review comparative figures. In my opinion, it should have been possible for the joint auditors to analyse the comparative figures in much the same way as they have done in their December 1992 submission. That is, in my opinion, the analysis should have alerted the joint auditors to the need for additional enquiries in order to gain reasonable assurance that the provision would be adequate, having regard to the growth in the Bank's receivables as a result of the significant growth in new business. As is noted in Chapter 51 - "Review of the 1989 External Audit of the State Bank" and Chapter 52 - "Review of the 1990 External Audit of the State Bank" I accept the submissions of the joint auditors in relation to the proper approach to determining the level of provisioning for a new receivables portfolio. The joint auditors submitted that it was relevant in connection with the audit of the provision for doubtful debts with respect to branch portfolios to have regard to the fact that the loan portfolio had been recently extended and had, therefore, recently been through extensive credit approval procedures.⁽⁾ In my opinion, in order for the auditor to rely upon this matter, he should obtain reasonable assurance that the systems and controls concerning credit approval and new lending procedures are satisfactory.

(a) Specific Provision for Doubtful Debts

The Internal Audit department tested the specific provision for doubtful debts for the Corporate Lending department to ensure that the balances for corporate accounts were not overstated.⁽⁾ The audit working papers note that the joint auditors reviewed the Internal Audit department's audit files.

The audit working papers note that the specific provision for doubtful debts comprised provisions in relation to the following categories of loans:

"Accounts with Loan Recoveries
Instalment/Commercial Loans	$ 604,900
Statement Accounts	$386,900
Accounts with Legal Department
excluding Corporate	$5,766,262
Accounts with Corporate	$ 655,000
	$7,413,062	"

The specific provision for doubtful debts in relation to instalment/commercial loans was agreed by the joint auditors to a summary of bad and doubtful debts prepared by the Bank dated 21 January 1987 and summaries of loans for which no previous provision had been made dated 15 April 1987 and 17 June 1987 which had been manually adjusted to record any changes for the period to 30 June 1987.⁽⁾

Statement account loans were retail overdraft accounts. The specific provision for doubtful debts in relation to these loans was agreed by the joint auditors to a summary of bad and doubtful debts prepared by the Bank dated 21 January 1987 which had been manually adjusted to record any changes for the period to 30 June 1987.⁽⁾

Beyond agreeing the total provision appearing in the general ledger to this summary there is no evidence in the audit files as to how the joint auditors satisfied themselves as to the adequacy of the level of provisions for each account.

The specific provision for doubtful debts in relation to corporate loans was agreed by the joint auditors to a summary of accounts on which the Bank could face a possible loss of $25,000 or more. This summary was prepared by Mr T L Mallett, Chief Manager, International Banking and was dated 31 May 1987.⁽⁾

The audit working papers also note that the joint auditors had discussed each loan in the summary with the Mr G D Curyer, Corporate Audit Manager, Internal Audit department.

The working papers note that Mr Curyer was:

"... satisfied that the list is complete and that the provisions are adequate at this point in time."

Apart from discussions with Mr Curyer, the audit working papers contain no details as to how the joint auditors satisfied themselves as to the recoverability of delinquent loans.

There is no evidence in the audit working papers of what procedures were performed by the Internal Audit department to ensure that the summary was complete and the provisions were adequate. Nor is there evidence of what procedures were performed by the joint auditors to ensure the accuracy of the information provided by the Internal Audit department.

Given the reliance placed on Internal Audit by the joint auditors in this area the following requirements of AUP2 should have been observed:

"16 Where ... the external auditor intends to use specific internal audit work as a basis for modifying the nature, timing and extent of his procedures, he should review the internal auditor's working papers to satisfy himself that:

. The scope of work and related audit programmes are adequate for the external auditor's purposes.

. The work was properly planned and the work of assistants properly supervised, reviewed and documented.

. Sufficient appropriate evidence was obtained to afford a reasonable basis for the conclusions reached.

. Conclusions reached are appropriate in the circumstances and any reports prepared are consistent with the results of the work performed.

. All significant exceptions or unusual matters disclosed by the internal auditor's procedures have been brought to the attention of management at the appropriate level, and properly resolved.

The external auditor should document his conclusions in respect of the specific work which he has reviewed.

17 The external auditor should also test the work of the internal auditor which he intends to use. The nature, timing and extent of his test will depend upon the external auditor's judgement as to the materiality of the area concerned to the financial statements taken as a whole, and the results of his evaluations of the internal audit function and of the specific informal audit work, in terms of the criteria specified in paragraphs 11-16. His test may include examination of items already examined by the internal auditor, examination of other similar items, and observation of the internal auditor's procedures."

The joint auditors have submitted that they were aware of the procedures undertaken by the Bank in assessing the provision for doubtful debts and that they considered the Bank's provisioning policy to be conservative.

The joint auditors further submitted that the "Review of Lending Portfolio" as at 31 May 1987 set out very stringent provisioning criteria, as follows:

". instalment loans greater than $50,000 in excess of three months (no accounts noted).

. Any advances in excess of approved arrangements by $25,000 or more for a period exceeding one month (15 accounts noted).

. International banking transactions where settlement/reimbursement in default (no accounts noted).

. Any accounts on which the Bank could face a possible loss of $25,000 or more (5 accounts noted).

This criteria was more stringent than the joint auditors would have normally considered on the basis of materiality of the Bank's accounts." ⁽⁾

"The accounts in the listing were reviewed by the Corporate Audit Manager from Internal Audit and were discussed with the joint auditors. The Corporate Audit manager was an experienced lending manager.

From discussion with the Corporate Audit Manager the joint auditors were satisfied that:

. appropriate enquiries and review of advances had been made to ensure the listing was complete.

. loan files including details of the type and valuation of securities were appropriately considered during review by Internal Audit.

To the extent that instalment and mortgage loans required provisions the amounts were not material on both an individual account basis and in total when compared to the Bank's assets and result." ⁽⁾

The audit working papers include a list of individual amounts which comprised the specific provision for doubtful debts in relation to accounts with the legal department.⁽⁾ These items were listed on a tape listing and the audit working papers note that the amounts had been:

"Extracted from Mortgage Loans Diary Cards".

The Mortgage loan diary cards were a record maintained by the Bank of correspondence and transactions between the Bank and the client for whom the diary card was maintained.

The joint auditors have submitted that:

"to the extent that any of these accounts were considered material to the assessment of the provision for doubtful debts they were reviewed by Internal Audit and the results of the review discussed with the joint auditors." ⁽⁾

The joint auditors discussed certain loans with Mr D McKenzie of the Legal department and compared the provisions made for certain loans with the provisions made as at 30 June 1986.⁽⁾ The results of these discussions were documented in the audit working papers, however, they do not record any details of the type or the valuation of any security which was held for the loans.

The joint auditors have submitted that:

"while the working papers may not have shown any details of the type or valuation of security these were considered and discussed with Bank management at the time of concluding the audit comments." ⁽⁾

The audit programme for the provision for doubtful debts⁽⁾ is signed by the audit manager to indicate that Lending Credit Committee minutes had been reviewed by the joint auditors. The Lending Credit Committee was responsible for reviewing the level of provisioning and making recommendations to the Board. The audit working papers do not include any documentation of the results of that review.

The joint auditors have submitted that:

"the internal auditors reviewed these minutes as part of their program. To the extent required the minutes were taken into account in reviewing the loan files and in the assessment of the provision for doubtful debts. Significant matters noted in the minutes were discussed with the joint auditors." ⁽⁾

(b) General Provision for Doubtful Debts

The Bank altered the method for calculating its general provision for doubtful debts as at 30 June 1987. The effect of the change was to reduce the total general provision for doubtful debts by $4.5M from what it would have been had the method at 30 June 1986 been continued. However, in the case of the general provision applicable to corporate loans the provision was reduced by $6.871M. The joint auditors have submitted that the overall reduction of $4.5M was partially off-set by an additional provision made at year end of $1.67M.⁽⁾ I am not aware of the reasoning behind this additional provision.

The audit working papers note in respect of the reduction in the general provision for doubtful debts applicable to corporate loans that:

"... reductions acceptable given low level of w/off in last 2 years." ⁽⁾

The Bank had experienced rapid growth in its Corporate Banking department. As a result the level of bad debts in the previous two years would not have been an accurate indicator of the possible level of bad debts not yet identified in the portfolio at that time.

There is no evidence as to how the joint auditors assessed the adequacy of the risk percentages applied to specific loan categories or sought to determine whether different risk percentages should have been used in calculating the general provision for doubtful debts as at 30 June 1987.

The joint auditors have submitted that it is appropriate for a bank to reassess its provisioning formulae from time to time based on economic conditions and current write-off experience and that they considered the proposed risk factor changes and were satisfied that the new rates would ensure that the general provision was maintained at an appropriate level given the general economic climate and debt write-off experience around that time.⁽⁾

When assessing the adequacy of the general provision for doubtful debts there is no evidence that the joint auditors considered whether the rapid growth in the loan book in a normally competitive market had been gained at the expense of credit quality.

The joint auditors have submitted that;

"Based on published banking industry statistics in 1986 the joint auditors were aware of the following growth indicators for the industry (PMM 1987 Survey of Financial Institutions in Australia, published in May 1987);

		Increase in Assets [%]		Increase in Profit [%]	Return on Total Assets [%]

All Banks	1984	25.7		40.8	0.90
	1985	20.9		17.8	0.85
	1986	23.7		6.7	0.71

State Banks	1986 (1985 in brackets):

The Rural & Industries Bank of Western Australia		39.7	(34.1)
State Bank of New South Wales		20.9	(35.8)
State Bank of Victoria		35.9	(3.2)

State Bank of South Australia		59.5	(27.5)

The joint auditors were aware of the business strategy of the directors of the Bank to significantly increase the assets base of the Bank compared to the industry. This strategy is also evident from the above analysis. The joint auditors applied this knowledge in their audit of the Bank." ⁽⁾

The joint auditors have submitted that they:

"... were aware of the results of the internal auditors' review of lending commitments which had shown an increasing proportion of all the new facilities granted by the Bank were on an unsecured basis. The joint auditors were also aware that it was then a feature of the Australian banking industry's lending practices in a deregulated market to lend on an unsecured basis (evidenced by the growth in negative pledge lending), but at a higher interest rate (to reflect a higher lending risk). These factors influenced the joint auditors' approach in reviewing the Bank's provisioning process". ⁽⁾

The joint auditors have submitted that there is no generally accepted requirement for calculating the general provision for doubtful debts and that the nature of such a provision is often questioned.⁽⁾

I note the following comments made in the joint auditors' submission:

"in practice, banks use a variety of methods to estimate general provisions for doubtful debts. It is a fact that no single method is considered preferable or ideal. The method used must be logical, fit the bank's circumstances and the basis for calculating the allowance must be comprehensive and take into consideration the range of risks and the range of the various types of lending. The objective of all methods should be to estimate the amount of uncollectable loans based on conditions at the balance sheet date." ⁽⁾

There is no evidence in the audit working papers that the joint auditors:

(i) determined the accuracy of the information included in the summaries dealing with doubtful instalment, statement account and corporate loans by reviewing the current loan files in relation to the items listed;

(ii) determined the completeness of the information included in any of these summaries by selecting possible doubtful debts and ensuring they were included in the summaries prepared by the Bank; and

(iii) assessed the information included in the Bank's files relating to potential bad debts to arrive at their independent view as to the level of provisions required.

The joint auditors have asserted that they adequately covered the above matters, however, having regard to the evidence before the investigation I am not satisfied that they did.

Based on the evidence examined by the Investigation, and for the reasons set out above, I have formed the opinion that:

(a) the joint auditors did not carry out appropriate and adequate audit procedures in relation to the provision for doubtful debts; and

(b) the joint auditors did not obtain sufficient appropriate audit evidence to justify accepting management's assertion that the provision for doubtful debts was not materially mis-stated and to support their opinion that the accounts of the Bank gave a true and fair view.

Accordingly, I am not satisfied that the provision for doubtful debts was free of any material mis-statement.

49.5.2.5 Matters Noted - Bank Acceptances of Customers

Chapter 46 - "The External Audits of the State Bank: Background Information" provides a discussion of this matter and a consideration of the joint auditors' submissions on the subject. The conclusion which follows draws on that discussion.

There is no evidence in the audit working papers that the joint auditors performed any work to verify the figure of $641.850M appearing in assets and liabilities in the accounts of the Bank as at 30 June 1987 in relation to "Bank Acceptances of Customers", other than ensuring that the amount of the asset shown in the accounts was equal to the amount of the liability.

In their submission on this matter ⁽⁾ the joint auditors stated that their procedure was to agree the acceptance balances to records maintained by the Bank. However, there is no indication given as to how these records were tested for accuracy and completeness. I note that these procedures deemed adequate by the joint auditors in 1987 were extended in 1989 when acceptances were subject to confirmation procedures.

Based on the evidence examined by the Investigation, and for the reasons set out above, I am not satisfied that the joint auditors performed appropriate and adequate audit procedures in relation to "Bank Acceptances of Customers", however, I have no reason to believe any such failure to perform appropriate and adequate audit procedures resulted in a material mis-statement in the Bank's accounts.

49.5.2.6 Matters Noted - Concessional Housing Reserve

The amount of the "Equalisation of Interest - Housing Advances Reserve" appearing in the Bank's balance sheet as part of Capital and Reserves at 30 June 1987 was $50.691M. Neither the accounts nor the audit working papers provide any details of the nature of this Reserve or the method by which it was created. The increase in the Reserve during the year was $8.169M but the accounts do not indicate the source of this increase.

Total capital and reserves at 30 June 1987 were $569.9M for the Bank and $586.1M for the Bank Group.

Based on the evidence examined by the Investigation, and for the reasons set out above, I have formed the opinion that the joint auditors did not carry out appropriate and adequate audit procedures concerning the "Equalisation of Interest - Housing Advances Reserve" and its presentation in the Bank's accounts, and it was inappropriate for the joint auditors to accept management's treating this balance as a reserve forming part of the Bank's capital and reserves. The question of whether the accounts of the Bank at 30 June 1987 were as a result materially mis-stated, is considered in the section headed "Conclusion" at the end of this Chapter.

49.5.2.7 Matters Noted - Provision for Taxation

As noted in Chapter 46, 1987 was the first year that the Bank treated the State income tax as a distribution. A change of this nature should be described in the accounts together with the reasons for the change, a matter with which Mr J H Richardson, a partner of KPMG Peat Marwick, agreed in his oral evidence ⁽⁾ in support of KPMG. However, the 1987 accounts contain no such explanation, and neither was the Investigation able to find evidence within the audit workpapers that the joint auditors had considered the matter of the change and its disclosure.

Based on the evidence examined by the Investigation, and for the reasons set out above, I have formed the opinion that:

(a) the joint auditors did not give appropriate consideration to the tax presentation in the 1987 Profit and Loss Statement of the Bank; and

(b) the presentation in the Profit and Loss Statement of the amount payable under section 22(1)(a) of the State Bank Act, 1983, was inappropriate.

The question of whether the accounts of the Bank at 30 June 1987 were as a result materially mis-stated is considered in the section headed "Conclusion" at the end of this Chapter.

49.5.2.8 Matters Noted - Provision for Self Insurance

The Provision of Self Insurance contained in the Bank's 1987 accounts amounted to $4.6M. There is no evidence in the audit working papers that the joint auditors gave consideration to the appropriateness of the accounting treatment adopted by the Bank in forming their opinion on the accounts or that they appropriately tested the balance.

Based on the evidence examined by the Investigation, and for the reasons set out above, I have formed the opinion that:

(a) the joint auditors did not obtain appropriate and adequate audit evidence to justify accepting management's assertion that the provision was not materially mis-stated; and

(b) the balance was materially mis-stated.

The question of whether the accounts of the Bank at 30 June 1987 were as a result materially mis-stated is considered in the section headed "Conclusion" at the end of this Chapter.

49.5.2.9 Matters Noted - Contingent Liabilities

The disclosure of contingent liabilities in its annual accounts is particularly relevant to a bank and provides information concerning some of the important risks to which a bank is exposed. Note 17 to the accounts for the year ended 30 June 1987 showed contingent liabilities for the Bank of $4,238.0M and for the Group of $4,773.0M.

There is no evidence in the audit working papers that the joint auditors determined whether:

(a) the contingent liabilities disclosed by the Bank were recorded accurately; and

(b) that all contingent liabilities of the Bank were recorded.

In their submission the joint auditors describe their audit procedures with respect to contingent liabilities. These include:

". detailed audit testing of supporting documentation;

. inspection of Board minutes;

. due consideration to audit results and knowledge of the business; and

. discussions with management and documentation of a formal management representation letter confirming the full population had been captured." ⁽⁾

The Investigation could find little evidence in the audit file of the detailed audit testing mentioned or of the discussions with management documented by a formal representation letter.

The joint auditors also say that they believe the liaison between the Bank's legal and accounting departments compensated for any risk. The risk is not stated in the context of this liaison, but is presumably the risk that contingent liabilities might be overlooked and not disclosed. How the effectiveness of this liaison was tested is not commented upon.

The joint auditors mention a workpaper prepared by the Bank's staff and showing the compilation of the contingent liabilities. They claim this workpaper was checked with the Bank staff responsible for its preparation. There is no evidence on the workpaper of this, or more importantly, of any checking by the joint auditors with the underlying records.

In addition, there is no evidence in the audit working papers that the joint auditors obtained from, and discussed with, management, a letter of representation detailing significant claims against the Bank, both lodged and potential, including a description of their nature and an estimate of their likely financial consequences.

Based on the evidence examined by the Investigation, and for the reasons set out above, I am not satisfied that the joint auditors performed appropriate and adequate audit procedures to gain reasonable assurance of the accuracy and completeness of the disclosure made in the accounts in respect of contingent liabilities, however, I have no reason to believe any such failure to perform appropriate and adequate audit procedures resulted in a material mis-statement in the Bank's accounts.

49.5.3 CONCLUDING PROCEDURES

49.5.3.1 Preamble

Chapter 46 - "The External Audit of the State Bank: Background Introduction" sets out background information on appropriate audit procedures in this area.

49.5.3.2 Matters Noted - Subsequent Events Review

There is no evidence in the audit working papers that the joint auditors performed a review of events occurring subsequent to balance date and up to the date of signing their report on the Bank's accounts for the year ended 30 June 1987 on 27 August 1987, with the exception of reviewing minutes of Board meetings up to 23 July 1987.⁽⁾

In their submission, ⁽⁾ the joint auditors claim that the review of subsequent events was an ongoing matter, and a record was only made when a matter arose which required consideration. In my opinion the procedure of reviewing subsequent events is sufficiently important for the enquiries made to be documented as part of the audit evidence.

Based on the evidence examined by the Investigation, and for the reasons set out above, I am not satisfied that the audit procedures adopted with respect to the review of events subsequent to balance date were appropriate and adequate, however, I have no reason to believe any such failure to obtain appropriate and adequate audit evidence resulted in a material mis-statement in the Bank's accounts.

49.5.3.3 Matters Noted - Management Representation Letter

There is no evidence in the audit working papers that the joint auditors obtained written or oral representations from management on matters which were material to the accounts. The audit working papers include a draft letter of representation from the Board in relation to the accounts for the 1987 financial year, ⁽⁾ but, this letter of representation had not been signed by the Directors or by management.

In their submission ⁽⁾ in respect of the 1986 year's audit the joint auditors state that, although their internal audit guides support the obtaining of written management representations, this is not a mandatory requirement and that the requirements of their internal audit guides were met by the review of Board papers in conjunction with the final Bank accounts.

In their submission ⁽⁾ the joint auditors note that AUP25 states, "Written representations from management should be obtained to confirm matters discussed and where other audit evidence cannot reasonably be expected to exist." Again, they state they were able to satisfy this requirement by review of the Board papers.

In my opinion the review of Board papers is an inadequate substitute for written representations from management and/or the Board addressed to the joint auditors. There is no assurance that the Board papers cover all matters of concern to the joint auditors. They are prepared for a different purpose and addressed to persons whose existing knowledge of matters may be quite different from that of the joint auditors.

Based on the evidence examined by the Investigation, and for the reasons set out above, I have formed the opinion that the audit procedures with regard to management representations on significant matters were inappropriate and inadequate, however, I have no reason to believe this failure to perform appropriate and adequate audit procedures resulted in a material mis-statement in the Bank's accounts.

49.6 CONCLUSION

In my opinion, the audit opinion expressed by the joint auditors on the accounts for the year ended 30 June 1987 was inappropriate, and the carrying out of the audit process leading to that opinion was inadequate, in the following respects:

(a) the joint auditors failed to deal adequately with the significant matters noted in the section on "Concluding Procedures" above;

(b) the joint auditors did not carry out appropriate and adequate audit procedures to gain reasonable assurance that certain amounts shown as assets and liabilities as noted in the "Execution" Section above were not materially mis-stated;

(c) the "Provision for Self Insurance" of $4.6M was materially mis-stated;

(d) the joint auditors wrongly accepted management treating the balance of the "Equalisation of Interest - Housing Advances Reserve" of $50.7M as part of the Bank's capital and reserves; and

(e) operating profit and extraordinary items after tax was over-stated by $17.72M due to the statutory State Government charge in lieu of Federal income tax being treated as a distribution of profit rather than as a charge against profit.

By reason of the foregoing, the joint auditors' opinion that the accounts and group accounts for the year ended 30 June 1987 complied with Section 269 of the Companies Code, Australian Accounting Standards and Applicable Approved Accounting Standards, and gave a true and fair view, was inappropriate, in that there was not a proper basis for that opinion.

In my opinion, for the following reasons, the accounts failed to give a true and fair view, by virtue of items (c), (d) and (e). First, item (c) was, in my opinion, material in relation to the reported profit of the Bank for the year of $40.8M before tax. Second, item (d) was, in my opinion, material by its nature, and in relation to the Bank's reported capital and reserves of $569.9M. Third, item (e) was material in relation to the Bank's reported after-tax profit of $42.5M.

CHAPTER 49 REVIEW OF THE 1987 EXTERNAL AUDIT OF THE STATE BANK

49.1 PURPOSE OF CHAPTER

49.2 PLAN OF CHAPTER

49.3 BUSINESS OF BANK AND BANK GROUP

49.4 ACCOUNTS OF BANK AND BANK GROUP

49.5 INVESTIGATION OF THE AUDIT PROCESS

49.6 CONCLUSION

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CHAPTER 49
REVIEW OF THE 1987 EXTERNAL AUDIT OF THE STATE BANK