CHAPTER 50
REVIEW OF THE 1988 EXTERNAL AUDIT
OF THE STATE BANK
TABLE OF CONTENTS
50.1 PURPOSE OF CHAPTER
50.2 PLAN OF CHAPTER
50.3 BUSINESS OF BANK AND BANK GROUP
50.3.1 THE BANK
50.3.2 SUBSIDIARIES
50.4 ACCOUNTS OF BANK AND BANK GROUP
50.5 INVESTIGATION OF THE AUDIT PROCESS
50.5.1 PLANNING OF THE AUDIT
50.5.1.1 Matters noted
50.5.1.2 Conclusion
50.5.2 EXECUTION OF THE AUDIT
50.5.2.1 Preamble
50.5.2.2 Matters Noted - Investments
50.5.2.3 Matters Noted - Provision for Doubtful Debts
50.5.2.4 Matters Noted - Bank Acceptances of Customers
50.5.2.5 Matters Noted - Concessional Housing Reserve
50.5.2.6 Matters Noted - Provision for Taxation
50.5.2.7 Matters Noted - Provision for Self Insurance
50.5.2.8 Matters Noted - Superannuation Provision
50.5.2.9 Matters Noted - Contingent Liabilities
50.5.2.10 Matters Noted - Interest Income
50.5.2.11 Matters Noted - Other Accounts Inadequately Audited
50.5.2.12 Matters Noted - Other Inadequate Audit Procedures
50.5.3 CONCLUDING PROCEDURES
50.5.3.1 Preamble
50.5.3.2 Matters Noted - Settlement of Audit Issues
50.5.3.3 Matters Noted - Management Representations
50.7 CONCLUSION
50.1 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 1987-88 and significant features of the statutory accounts in respect of the 1987-88 financial year. The Chapter then reports on matters arising from the assessment of the audit process applied by the joint auditors in the audit of the accounting records and accounts of the Bank for the year ended 30 June 1988. The Chapter also concludes as to the appropriateness and adequacy or otherwise of the audit process undertaken.
50.2 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.
(c) Investigation of the Audit Process;
(i) Planning of the Audit;
(ii) Execution of the Audit; and
(iii) Concluding Procedures.
(d) Conclusion
50.3 BUSINESS OF BANK AND BANK GROUP
50.3.1 THE BANK
The Bank expanded its network of branches to include representative offices in New York and the Cayman Islands.
50.3.2 SUBSIDIARIES
The Bank Group expanded to include a merchant bank, Ayers Finniss Ltd, which commenced operations on 1 September 1987. In addition, on the 31 March 1988 the Bank purchased Oceanic Capital Corporation Ltd, which extended the Bank Group operations to include funds management and life and general insurance activities. The due diligence process conducted by the Bank in relation to the acquisition of Oceanic Capital Corporation Ltd is examined in detail in Chapter 17 -"Case Study in Acquisition Management: The Oceanic Capital Corporation" of my First Report.
The Beneficial Finance Group increased its profit by $9.2M (93.7 per cent) over the previous year to $19.0M while total reported assets increased by $526.2M (46.6 per cent) to $1,655.2M.
50.4 ACCOUNTS OF BANK AND BANK GROUP
On 25 August 1988 an unqualified Audit Report was signed by Peat Marwick Hungerfords and Touche Ross & Co in respect of the accounts of the Bank for the year ended 30 June 1988. The accounts presented comprised a Profit and Loss Statement, Balance Sheet, Sources 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 |
||||||||||||
|
|
|
|
|
Per Cent |
|||||||||
|
Profit and Loss Statement |
|||||||||||||
|
Income |
726.2 |
872.6 |
899.3 |
1091.0 |
21 |
||||||||
|
Operating Profit |
|||||||||||||
|
Before Tax |
40.8 |
55.5 |
52.1 |
69.5 |
40 |
||||||||
|
After Tax and Extraordinary items |
42.5 |
52.8 |
47.7 |
68.8 |
44 |
||||||||
|
Balance Sheet |
|||||||||||||
|
Assets |
|||||||||||||
|
Loans, Advances, Recievables |
4685.2 |
6126.9 |
5753.7 |
7467.7 |
30 |
||||||||
|
Other |
2162.1 |
3405.2 |
2140.0 |
3535.6 |
|||||||||
|
6846.3 |
9532.1 |
7893.7 |
11003.3 |
39 |
|||||||||
|
Liabilities |
|||||||||||||
|
Deposits and Borrowings |
5302.7 |
6608.7 |
6279.2 |
8070.9 |
29 |
||||||||
|
Other |
973.7 |
1951.3 |
1022.4 |
1922.0 |
|||||||||
|
6276.4 |
8560.0 |
7301.6 |
9992.9 |
37 |
|||||||||
|
Net Assets |
569.9 |
972.1 |
592.1 |
1010.4 |
71 |
||||||||
|
Capital, Sub-oridinated Debts, Reserves |
569.9 |
972.1 |
592.1 |
1010.4 |
71 |
||||||||
|
Doubtful Debts |
|||||||||||||
|
Expense for the Year |
7.7 |
14.5 |
18.8 |
26.3 |
40 |
||||||||
|
Provision at Balance Date |
19.2 |
28.5 |
32.3 |
51.9 |
61 |
||||||||
50.5 INVESTIGATION OF THE AUDIT PROCESS
50.5.1 PLANNING OF THE AUDIT
50.5.1.1 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 1988 which states:
"Reliance on Bank's Staff and Facilities
In discharging our responsibilities as auditors of the Bank we place very significant recognition on the work performed by the Internal Audit Department." ()
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 or on the work performed by Internal Audit in critical audit areas. In relation to certain minor areas of lesser audit risk, some reliance was placed on internal controls and the work of Internal Audit. 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 |
Medium |
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 or the work of the internal auditors 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" AUP4-1, 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.
This approach is documented in the audit files on the Account Level Planning Summary: Planned Control Reliance Heading - in every audit area this column is marked N indicating that no reliance on controls was planned."
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 work papers, however, the above submissions clarify the joint auditors' planning in relation to reliance on internal controls, Internal Audit and computer controls.
50.5.1.2 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.
50.5.2 EXECUTION OF THE AUDIT
50.5.2.1 Preamble
Chapter 46 - "The External Audits of the State Bank: Background Information" sets out background information on appropriate audit procedures.
50.5.2.2 Matters Noted - Investments
The existence of investments was tested by the joint auditors by examination of scrip and third party confirmation procedures.
However, there is no evidence in the audit working papers that the joint auditors tested purchases and disposals of investments to achieve the objectives listed in Chapter 46 -"The External Audits of the State Bank: Background Information".
Total investments in the balance sheet at 30 June 1988 were $1.083B.
In their submission() the joint auditors state that purchases and disposals of investments were tested by Internal Audit and provided work paper references in support. These work papers referred indicated that Internal Audit tested only a minor category of investments and the work did not extend to testing gains and losses on disposal. There is no assessment by the joint auditors of the Internal Audit work.
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.
50.5.2.3 Matters Noted - Provision for Doubtful Debts
The Provision for Doubtful Debts as calculated by the Bank at 30 June 1988 was $28.45M and comprised the following:
(a) Specific provision of $10.763M determined at 30 June 1988 relating to an assessment of individual loans.()
(b) General provision of $17.687M determined at 30 June 1988 by applying risk percentages to balances outstanding and commitments for different categories of lending.()
The Investigation noted a number of matters concerning the procedures carried out by the joint auditors with regard for the provision for doubtful debts. In this section of the Chapter matters concerning specific provisions will be discussed, then matters concerning the general provision, then a number of other matters concerning audit procedures with regard to provisioning, and finally my conclusion with regard to the appropriateness and adequacy of procedures carried out in relation to the provision for doubtful debts.
(a) Specific Provision for Doubtful Debts
The audit manager's preliminary conclusion as a result of Touche Ross & Co audit testing of the Corporate Banking specific provision for doubtful debts was that there appeared to be a total shortfall in the specific provision of approximately $10.15M.()
Possible additional provisions, to that noted above, which were isolated but not considered as part of the shortfall of the specific provision totalled $8.25M.() The only comment in the audit working papers as to why these accounts were not considered in the shortfall was:
"Other general provision may be required in respect of "A Ltd" [$5.0M], Renouf Corporation [$1.25M] and Ariadne [$2.0M]."()
No evidence was noted in the audit working papers as to the resolution or further consideration of these accounts in relation to specific provisions or the general provision for bad and doubtful debts.
In total, these additional provisions ($10.15M and $8.25M) exceeded the existing specific provision for Corporate Banking.
The Touche Ross & Co audit manager justified not adjusting the $10.15M additional provisions on the basis that the general provision covered any shortfall in the specific provision. This argument is inappropriate as evidenced in the accounting policies of the Bank.()
"Note 1 Principal Accounting Policies
(f) Specific provisions for doubtful debts are made for loans and advances where full recovery is considered to be doubtful. A general provision is also maintained at a level appropriate to the composition and size of total loans advances and receivables, to cover unidentified losses"() [Emphasis Added].
This was acknowledged in the audit work papers where Mr J Patton, Touche Ross & Co supervisor states:
"While I feel there is a shortfall of $10 million approx. in the specific provision we can take comfort from the fact that the Bank has made a general provision of $11 million approx. However, the purpose of the general provision is to provide for unknown problems which may occur in the future and is related to total risk assets rather than specific accounts. As a result the Bank should seriously consider the status of each of the accounts listed above and determine whether a provision is required at 30 June, 1988. For our part, we should bring the above accounts to the attention of the Board in our post audit report".()
Mr Patton went on to comment on the particular aspect of audit testing on the provision for doubtful debts, that:
"... it is fair to say that the current specific provision of $3,247,000 is too low. It is evident as shown above that further specific provisions need to be considered at 30 June, 1988."()
No adjustment for the additional provision of $10.15M or $8.25M was made to the Bank's 1988 financial statements.
The only documented facts before the Investigation which concern the provisioning of the accounts considered by the Touche Ross & Co managers are those documented in the managers' review as recorded in the work papers. The process by which the audit partners concluded on those facts that no provision was required, and any additional information which led them to that view, is not available to this Investigation.
Mr B H Edwards gave evidence that it was his usual practice to prepare his own review notes recording his consideration of the accounts in question and any additional information which he gained in the course of his review.() Mr Edwards informed the Investigation on 12 May 1993 that his review notes in connection with the 1988 audit could not be located and he presumed that they had been lost.() I accept Mr Edwards' evidence that review notes would have been prepared by him, and would have contained any updates provided by management. I accept that there is nothing suspicious about the loss of these working papers.
Neither Mr Edwards nor Mr T J Whimpress were able to give detailed evidence as to the nature of any additional information that might have been provided to the joint auditors after the managers documented their review of the accounts.() Mr Edwards stated that many of the inquiries he would have made would have been to seek assurances from management of the bank that they had made a reasonable assessment of the need for a provision, and that he could rely on the soundness of their judgment.()
Mr Edwards gave evidence that his initialling of the manager's Overall Memorandum dated 24 August 1988, recommending that the audit report could be signed, did not indicate that he agreed with everything in that memorandum.() In fact, Mr Edwards said that he disagreed with the manager's recorded view that "the specific provision may well be understated, however the general provision would then be used to the extent of any shortfall".() Mr Edwards also said that he disagreed with the proposition recorded by the manager in the Overall Memorandum that "it is not possible to accurately quantify any loss on these accounts at this time and accordingly any future profit and loss effect is also unknown"() Mr Edwards said that he did not regard it as necessary to record his disagreement with those statements on the manager's work paper when Mr Edwards initialled it on 24 August 1988, because it was only evidence of his review, and he had concluded on the basis of the information in his own review notes that the provisions were not understated.() In my opinion, it is inappropriate that Mr Edwards' disagreement with a significant matter in the manager's Overall Memorandum, which contained a reasoned recommendation that the audit report could be signed, was not noted on the Overall Memorandum itself.
Accordingly, I am not in a position to conclude whether the joint auditors had sufficient appropriate audit evidence to support the acceptance of management's specific provision for doubtful debts. On the basis of the information contained in the work papers available to the Investigation, I could be not be satisfied that the conclusion of the joint auditors was supported by the audit evidence available to them.
(b) General Provision for Doubtful Debts
Touche Ross & Co had primary responsibility for the audit of the general provision. The procedures performed were to compare the risk factors to the prior year for reasonableness, agree the total provision to the docket approved by the Board and to check the additions. In my opinion, the risk factors should have been checked for reasonableness by reference to available data concerning other financial institutions, anomalies in factors and lending categories should have been explained, and the lending figures which formed the basis of the calculation reconciled to the general ledger and commitment register. The following comments are made concerning the Touche Ross & Co work on the general provision:
(i) The joint auditors did not challenge the basis of the risk factors used to determine the general provision at 30 June 1988. The joint auditors have submitted that the risk factors used were established by the Board in July 1987, having regard to the Bank's 1987 business experience.() In my opinion, the joint auditors should have considered whether such percentages remained appropriate for the Bank given the nature of the Bank's current operations, however, I have no reason to believe that the failure to carry out appropriate and adequate audit procedures resulted in a material mis-statement in the accounts.
(ii) An anomaly in the risk factors concerns the 0.08 per cent factor used for the London branch international banking in comparison to the lowest Australian corporate banking factor of 0.20 per cent. This amendment would have led to an increase of $821,760 (4.6 per cent of the general provision). The risk factor used represented the stage reached in the phasing in of a 0.25 per cent risk factor over 5 years. The joint auditors submitted that it is normal and reasonable practice in banking to build up a general provision over a period so that the increase in the general provision would be brought to account over the life of the loan book in order to obtain a proper matching of income and costs.() In my opinion, the joint auditors did not adequately consider whether it was appropriate in the circumstances to accept a 0.08 per cent general provision in respect of the London branch portfolio.
(iii) The concessional housing loan portfolio, which was tested as part of the specific provision, was not included as part of the calculation of the general provision. The inclusion of the concessional housing portfolio at the lowest risk factor used in the calculation would increase the general provision by $181,775 (1 per cent of the general provision).
(c) Other inadequate audit procedures
The following comments are made regarding the work carried out by Peat Marwick Hungerfords in relation to their audit work on the retail, international and housing doubtful debt specific provisions.
(i) There was no evidence in the work papers to indicate that the joint auditors had tested for omissions (ie completeness of the provision). Tests which would partly address this were signed off as completed by Mr M H Penniment, the Audit Manager, but without any documented evidence to support this conclusion. In my opinion the specified procedures were inadequate, and in my opinion further tests should have been carried out including reviewing lending committee minutes and relevant correspondence to/from the Bank's legal department.()
The joint auditors have submitted that while there was no formal documentation to support their testing the completeness of the provision, this matter was considered in a number of ways:()
"... discussion with Bank management;
. discussion with Internal Audit; and
. review of diary cards and arrears reports in the legal and credit quality departments."
Having reviewed their submission I am not satisfied that the joint auditors carried out appropriate and adequate audit procedures, however, I have no reason to believe that the failure to carry out appropriate and adequate audit procedures resulted in a material misstatement in the accounts.
(ii) Audit program steps for the testing of samples relating to mortgage, concessional housing and instalment loans were not followed, to:
"... assess the recoverability of the loan from correspondence, security actually held, bank inspection reports, diary cards, discussions with various officers etc.." ()
The audit work papers evidence that the assessment of loan recoverability was sourced from "Comment per Diary Cards"(), or similar document, which in my opinion is insufficient and not in accordance with the audit program, which represents the Peat Marwick Hungerfords response to the risks identified.
There is no evidence in the audit work papers that the source for the testing noted above, namely, the various loan area arrears reports or the Diary Cards, have been tested. In my opinion, this represents reliance on internal controls to ensure the completeness and accuracy of the arrears reports and Diary cards, without audit steps being taken to ensure that reliance was warranted.
Having reviewed their submission, I am not satisfied that the joint auditors carried out appropriate and adequate audit procedures, however, I have no reason to believe that the failure to carry out appropriate and adequate audit procedures resulted in a material mis-statement in the accounts.
(d) Joint Auditors' overall submissions
Mr B Lander QC submitted on behalf of the joint auditors that I should accept that doubtful debt provisioning at 30 June 1988 was not shown by subsequent events to be inadequate, and that I should infer from this that the external audit concerning the provision for doubtful debts at 30 June 1988 was appropriate and adequate.() In my opinion, I ought not enter into this kind of inquiry, which relies on hindsight. Further, for the reasons set out in Chapter 45 - "External Audits of the State Bank : Introduction", namely, that my Terms of Appointment require me to determine whether the auditor did or did not have sufficient appropriate audit evidence to support his opinion, I do not in any event consider that matters occurring after the signing of the audit report could safely support any inference as to the appropriateness and adequacy of the audit.
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.
50.5.2.4 Matters Noted - Bank Acceptances of Customers
There is no evidence in the audit working papers that the joint auditors performed any work to verify the figure of $1,362.9M appearing in assets and liabilities in the accounts of the Bank as at 30 June 1988 in relation to "Liability on Acceptances", other than ensuring that the amount of the asset shown 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 1988 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.
50.5.2.5 Matters Noted - Concessional Housing Reserve
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.
Note 13 to the 30 June 1988 accounts of the Bank discloses a "Concessional housing" reserve. The balance of this reserve increased by $6.961M during the financial year ended 30 June 1988, to $57.651M.
The concessional housing scheme was a service provided by the Bank as part of the State Government Home Ownership Made Easy program. The scheme provided low interest mortgage loans to assist low and middle income earners to buy a home of their choice.
The concessional housing reserve relates to the difference between the interest received by the Bank from advances under the scheme and the interest paid on funds provided by the State Government, less administration and commission at a rate agreed with the State Government.
A comment in the audit working papers noted that:
"... a surplus [ie the current year reserve allocation] should be returned to Govt. Treasury." ()
The audit working papers contain no evidence of the reason for the treatment of this item as a reserve rather than a liability to the government.
In their submission on this matter() the joint auditors stated that arrangements confirmed with the Treasurer of South Australia meant that the surplus would not be taken into the Bank's revenues but would be set aside as a special surplus in trust for housing purposes.
A review of the document attached to Exhibit JHR6 shows that it is not in fact a confirmation of arrangements but an unsigned memorandum from the Chairman of the then State Bank, probably addressed to the State Treasurer (the addressee is unclear). The "arrangements confirmed" are actually recommendations by the Chairman, and there is no evidence available to the Investigation as to whether these recommendations were ever officially accepted in the form recommended in the memorandum.
The exact nature of the surplus remains unclear. However, if it is accepted that the Chairman's recommendations were carried through, the mention of a trust, together with the fact that the Bank was paid a commission for administering the related concessional housing portfolio, suggests that the accumulated surplus was a liability due eventually to the State Government. This view is reinforced by the comment in the audit working paper quoted above. The joint auditors maintain in their submission that the later capitalisation of the surplus indicates that it was capital in nature. This does not necessarily follow as the surplus would be capable of being capitalised by decision of the State Government irrespective of whether the surplus was a reserve or a liability.
The matter has significance as it affects the calculation of the Bank's capital for the Reserve Bank of Australia's capital adequacy purposes, and the auditors should have given due consideration to the matter and its impact on the accounts.
Total Capital and Reserves at 30 June 1988 were $972.1M for the Bank and $1,004.0M 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 procedures concerning the Concessional Housing Reserve and its presentation in the Bank's accounts, and it was inappropriate for the joint auditors to accept management 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 1988 were as a result materially mis-stated is considered in the Section headed "Conclusion" at the end of this Chapter.
50.5.2.6 Matters Noted - Provision for Taxation
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.
In accordance with the Act, the Bank is required to pay a sum to the State Government, equal to the income tax which the Bank would have been liable for under the law of the Commonwealth, assuming it was a public company(), and a bona fide dividend determined by the Treasurer having regard to the Board's recommendation and the profitability of the Bank.()
In the Bank's 1988 accounts the State income tax is shown as an appropriation of the profit in the manner of a dividend rather than as a charge against operating profit before income tax.
In 1988 this treatment of the State income tax as a distribution akin to a dividend resulted in an overstatement of the operating profit after extraordinary items and tax by $13.8M. In the notes describing the principal accounting policies the obligation to pay the State income tax was described under the heading of "Taxation". No indication is given in the taxation accounting policy that the amount payable is in fact included in the amount shown in the accounts as a distribution rather than as a charge against profits. No evidence in the audit working papers was noted where the treatment and its implications were considered.()
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 1988 Profit and Loss Statement of the Bank;
(b) the presentation in the Profit and Loss Statement of the amount payable under Section 22(1)(a) of the State Bank Act was inappropriate.
The question of whether the accounts of the Bank at 30 June 1988 were as a result materially mis-stated is considered under the section headed "Conclusion" at the end of this Chapter.
50.5.2.7 Matters Noted - Provision for Self Insurance
Chapter 46 - "The External Audits of the State Bank: Background Information" provides a discussion of this provision and consideration of the joint auditors' submissions on the subject. The conclusion which follows draws on that discussion.
The Provision for Self Insurance contained in the Bank's 1988 accounts amounted to $6.285M. 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 1988 were as a result materially mis-stated is considered in the section headed "Conclusion" at the end of this Chapter.
50.5.2.8 Matters Noted - Superannuation Provision
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 conclusions which follow draw on that discussion.
(a) Note 1(k) of the Bank's 1988 financial statements states inter alia:
"... certain properties have been specifically identified and set aside as income earning assets for funding the staff superannuation funds ... A surplus of $4,119,000 arising from revaluation of these properties has been credited against staff superannuation fund liabilities."
As noted in Chapter 46 - "The External Audits of State Bank: Background Information" Accounting Standard AAS10 "Accounting for the Revaluation of Non-Current Assets", and the approved Accounting Standard ASRB1010 of the same name, require that the increment resulting from the revaluation of a class of non-current assets be accounted for by crediting the increment directly to an asset revaluation reserve.
(b) Note 19 of the Bank's 1988 financial statements states inter alia that:
"There are numerous superannuation and retirement benefit plans within the Bank and the Bank Group ... All plans are subject to actuarial review with funds available being adequate to satisfy all benefits that may arise or all vesting under the plans."
The largest component of the employee entitlements at 30 June 1988 relates to the Superannuation Provision of $64.0M.
Actuarial review of superannuation obligations was last performed as at 30 June 1984.
The joint auditors have submitted:()
"... The joint auditors' management letter (Executive Summary) of 15 November 1988 they again referred to the requirement for review which was not undertaken in 1987 and deferred again in 1988. The review by the Public Actuary was deferred until 30 June 1989. Nevertheless, the Bank was advised by letter 5 July 1988 from the Public Actuary that it was "anticipated that the current contribution rates are considered adequate".
I am not satisfied that the joint auditors gained reasonable assurance that the Provision for Superannuation was free of material mis-statement. In order to rely on the conclusion of the Public Actuary referred to above, it would, in my opinion, be appropriate to reconcile the Provision for Superannuation in the accounts at 30 June 1989 to those liabilities on which the Public Actuary based his review. It would also be appropriate to ensure that "contributions" to the notional fund in the year ended 30 June 1988 were in accordance with the recommendations of the Public Actuary or that the amount of the provision was consistent with his recommendations.
(c) Note 1(b) of the Bank's financial statements states, inter alia:
"Where practicable, accounts have been drawn up generally in accordance with the requirements of the Companies (South Australia) code and Schedule 7 Regulations, and with Accounting Standards so far as they are considered appropriate to the Bank."
Clause 32(2) (e) of Schedule 7 of the Companies Regulations required disclosure of:
"... the date of the last actuarial assessment (if any) of the plan and the name and qualifications of the actuary who made that assessment."
The minutes of the Board meeting held on 23 June, 1988 note, inter alia, that;
"... it has been agreed with the External Auditors that the Bank does not comply with the Schedule 7 of the Companies Code which requires the ... disclosure of contributions to superannuation funds."
The Board paper supporting this minute discusses the issue of disclosing information on superannuation contributions, as such;
"... because of the complexity and the way in which Superannuation is evaluated in State Bank, it should not be available for public scrutiny."
No evidence that this was considered by the joint auditors was noted in the audit working papers.
The joint auditors have submitted:()
"The date of the last actuarial assessment and the name and qualifications of the actuary who made that assessment were not disclosed in the 1988 accounts. The joint auditors do not see this non-disclosure as material to users of the financial statements nor do the joint auditors see it as giving rise to an inappropriate audit opinion being given in relation to the financial statements of the Bank for the year ended 30 June 1988."
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 wrongly accepted management's taking the asset revaluation surplus of $4.1M to the credit of the "Superannuation Provision" rather than to the "Asset Revaluation Reserve"; and
(b) the joint auditors did not have sufficient appropriate audit evidence to support a conclusion that the Superannuation Provision was not materially misstated.
(c) On the assumption that the reported Provision for Superannuation was not materially mis-stated then, as a result of adjusting for the error noted in paragraph (a), the profit for the year would have been overstated by $4.1M
The question of whether the accounts of the Bank at 30 June 1988 were as a result materially mis-stated is considered in the Section headed "Conclusion" at the end of this Chapter.
50.5.2.9 Matters Noted - Contingent Liabilities
Note 1(b) to the 30 June 1988 accounts of the Bank states that the accounts comply with Schedule 7 of the Companies (South Australia) Code, where practicable and appropriate. Clauses 22 of Schedule 7 required certain disclosures in relation to contingent liabilities.
Note 17 of the 30 June, 1988 accounts of the Bank disclosed contingent liabilities totalling more than $5.68B, and $7.23B for the Group. The Investigation found no evidence on file of any substantive audit work performed on contingent liabilities to ensure completeness and accuracy.
In their submission() the joint auditors refer to a number of their work papers which they claim show sufficient work was performed to verify the completeness, accuracy and validity of the contingent liabilities as disclosed. The Investigation has re-examined the work papers referred to but has found that they do not provide sufficient audit evidence of appropriate substantive audit procedures having been performed.
In an exhibit() accompanying Mr J H Richardson's oral evidence on behalf of KPMG Peat Marwick, the joint auditors describe the procedures adopted. 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.
Mention is made in the exhibit of reliance placed on the work of Internal Audit in this area, but there is no evidence of the assessment of this work.
In the same exhibit the joint auditors state 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.
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.
50.5.2.10 Matters Noted - Interest Income
(a) Fully Drawn Advances - Interest Income $122.0M
The analytical review procedures performed by the joint auditors involved the calculation of the average yields (ie interest income divided by the Fully Drawn Advance balance) on different categories of Fully Drawn Advances including personal, business, corporate fixed interest and society, for the year to 30 June 1987, the half year to 31 December 1987 and the year to 30 June 1988.
The fluctuations in the average yields were then examined by the joint auditors.
The joint auditors did not document the reason why the average yields on personal, business, corporate, and corporate fixed rate Fully Drawn Advances had decreased between 19 per cent and 33 per cent during the year whilst the average yield on society Fully Drawn Advances had decreased 8.6 per cent.
The joint auditors did not adequately explain why their calculated average yield on corporate fixed rate Fully Drawn Advances had decreased from 13.08 per cent at 30 June 1987 to 9.33 per cent at 30 June 1988.
This significant decrease in the average yield should have also been compared to the average yields on other categories of Fully Drawn Advances which ranged from 8.11 per cent to 15.1 per cent at 30 June 1988.
The following explanation was provided by the joint auditors for the entire decrease in the average yield of Fully Drawn Advances between 30 June, 1987 and 30 June, 1988:()
"... interest rates have decreased due to market forces"
(This was an explanation frequently provided for fluctuations in the average yields);
"... the corporate loans dept structure some of its loans with interest rates & high establishment fees, to give favourable tax advantages, to its clients this is one of the main reasons why the interest rate appears low, in comparison to others:" ()
There is no evidence of the joint auditors comparing the calculated average yield to an appropriate "bank indicator rate" or analysing margins which the Bank typically earned on its Fully Drawn Advances above such an indicator rate.
Furthermore, given the material size of interest income on Fully Drawn Advances and the potential for interest rates to fluctuate significantly and for the rates charged on floating rate Fully Drawn Advances to change a number of times during the year, (as evidenced by a 31 December 1987 rate of 25.8 per cent and 30 June 1988 rate of 15.11 per cent - unexplained by the joint auditors) an effective analytical review of interest income of Fully Drawn Advances should have included calculations and review of average yields on a monthly basis rather than on a yearly and half yearly basis.
(b) Fluctuating Overdrafts - Interest Income $26.3M
The joint auditors performed an analytical review of the interest income received for fluctuating overdrafts. This consisted of a comparison of the average interest yields for different categories of fluctuating overdrafts on the same basis as Fully Drawn Advances.
The comment by the joint auditors' staff with regards to these fluctuations was:
"... interest rates have decreased due to market forces" ()
A significant shortcoming in the analysis performed by the joint auditors was the failure to explain conflicting yield trends and the significantly different yields for different categories of overdrafts. For example the following extracts from the audit work papers() indicate significant differences:
|
" |
||||
|
Overdraft Category |
||||
|
Average |
Personal |
Business |
Corporate |
Society |
|
June 1988 |
12.7 |
12.8 |
9.4 |
9.2 |
|
Dec 1987 |
13.0 |
16.3 |
16.2 |
12.4 |
|
June 1987 |
14.4 |
15.8 |
3.1 |
11.4" |
In their submission() dealing with these matters, the joint auditors acknowledged that the monthly analysis rather than an annual analysis would have provided additional assurance but such analysis was not critical to the audit approach. The variations in the yields were assessed against the joint auditors general knowledge of prevailing interest rates. Further the procedures were not designed to give a high level of accuracy.
The fluctuations in interest rates were sufficiently large in my view to warrant the recording in the audit work papers of detailed reasons why they were acceptable. Without a proper explanation there remained the possibility of a material mis-statement to the Bank's accounts.
Based on the evidence examined by the Investigation, and for the reasons set out above, I am not satisfied that the audit procedures performed by the joint auditors in respect of the categories of interest income referred to above were appropriate and adequate to provide the joint auditors with reasonable assurance that the categories of interest income examined were free to material mis-statement, 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.
50.5.2.11 Matters Noted - Other Accounts Inadequately Audited
There is no evidence in the audit working papers that the following liability and reserve account balances as at 30 June 1988 were subject to examination by the joint auditors:
|
General Ledger |
|
|
|
0 BNK 00 6170 |
Christmas Club (liability) |
7,212,618 Cr |
|
0 BNK 00 6139 |
Money Market Accounts (liability) |
9,294,671 Cr |
|
0 BNK 00 6841 |
Int received in advance (liability) |
13,457,539 Cr |
|
0 BNK 00 6917 |
Amortised discount paid (liability) |
26,653,398 Cr |
|
56,618,226 Cr |
The Investigation has been unable to determine from the audit working papers further details regarding the nature of the liability and asset accounts.
In their submission() the joint auditors refer to CAATs [computer assisted audit techniques] which were used to extract samples of accounts which were then tested via confirmation procedures. The joint auditors state that the Christmas Club and Money Market accounts were included in the population sampled, but from a re-examination of the work papers, the Investigation holds doubts over their inclusion.
When reconciling the totals of the sub-systems sampled, with the general ledger, the joint auditors relied upon reports generated by Internal Audit. There is no evidence noted in the audit working papers of work done to support the use of these Internal Audit reports.
As regards the Interest Received in Advance and the Amortised Discount Paid accounts, the joint auditors acknowledge() that no detailed audit work was conducted, and submitted that these amounts were not material in relation to the total of cheque accounts. However, these two accounts represent accrued interest payable and it is likely that any errors in the balances will be reflected in the operating result where a different and lower level of materiality applies.
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 the balances listed above, 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.
50.5.2.12 Matters Noted - Other Inadequate Audit Procedures
(a) Failure to confirm certain balances
Third party confirmations were not sought by the joint auditors to verify certain balances nor is there any evidence that suitable alternative procedures were adopted to verify the existence, completeness and valuation of those balances. Examples are:
(i) The joint auditors did not seek third party confirmation of any of the Bank's international nostro or vostro balances. In my opinion it was inappropriate that the joint auditors failed to do so.
Nostros are bank accounts that the Bank has with other banks. Vostros are bank accounts that other banks have with the Bank. It is usual for an auditor to seek direct third party confirmation of such balances.
While the net amount of nostros was $2,765,435.21(debit) and vostros was $1,468,172.58 (credit) they were supported by a detailed general ledger listing which shows that the balance was actually a combination of asset and liability balances with different banks.
In their submission() the joint auditors refer to work done by Internal Audit on nostro and vostro accounts, but do not provide details of the work or how the joint auditors established that the work met their audit objectives. From a further review of the work papers by the Investigation it appears that the joint auditors were in effect relying on the Bank's internal controls in this area despite the joint auditors' assertion that the overall audit approach was substantive(). In banks generally, nostro and vostro accounts usually have a higher risk factor than other areas, and thus usually calls for a greater emphasis on substantive tests, is usually required.
(ii) There is no evidence in the audit working papers that confirmation requests were despatched to confirm foreign currency advances made by the Bank totalling $149,743,377.57 (asset). A foreign currency advance is simply a loan made in a foreign currency. In relation to a sample of foreign currency advances the audit working papers state:
"Agreed to client generated foreign currency advance confirmation"
or :
"Agreed to correspondence from client x held by corporate confirming advance".
The joint auditors did not seek third party confirmation of any of the Bank's foreign currency advances. The alternative procedures noted above, in my opinion, were not sufficient, appropriate audit evidence to verify the balances outstanding at 30 June 1988. No evidence was noted to support the reliance on the client's foreign currency advance confirmation or the timeliness of the client correspondence.
In their submission() the joint auditors state that the existence of foreign currency advances was considered to be a low risk area, and that the procedures adopted were sufficient. The joint auditors did not mention in their submission as to why they regarded these advances as having lower risk than other areas where third party confirmation procedures were adopted. Moreover, the Investigation noted in respect of the 1989 audit, 77 per cent by value of the foreign currency advances were initially selected by the joint auditors for direct confirmation with the borrowers. It is noted() that at that time the Bank had considerable difficulty in locating documentation in relation to these advances, and because of this the high level of confirmation intended by the joint auditors had to be abandoned. It is not known if this difficulty also existed at the time of the 1988 audit.
(b) Verification by Reference to Internal Bank Documents
The joint auditors agreed numerous account balances which they had selected for testing by reference to internally prepared Bank documents. There is no evidence in the audit working papers that these documents were prepared independently of the accounting process or persons responsible for producing the information being audited. The audit working papers provide no evidence that the internally prepared Bank documents were tested (or that similar documents prepared by the Bank were subject to testing) and so there is insufficient audit evidence to verify the balances selected for testing.
For example, the following asset account balances were merely agreed to computer prepared Internal Audit working papers, which bear no evidence of testing by the joint auditors:
|
General Ledger |
|
|
|
|
0 BNK 00 8120 |
Fluctuating O/D’s Personal |
25,387,954 |
|
|
0 BNK 00 8125 |
Fluctuating O/D’s Business |
118,948,326 |
|
|
0 BNK 00 8140 |
Fluctuating O/D’s Society |
4,391,001 |
|
|
0 BNK 00 8165 |
Fluctuating O/D’s Local Govt. |
897,426 |
|
|
0 BNK 00 8145 |
Fully Drawn Advances Personal |
23,961,559 |
|
|
0 BNK 00 8150 |
Fully Drawn Advances Business |
266,736,531 |
|
|
0 BNK 00 8160 |
Fully Drawn Advances Society |
8,122,576 |
|
|
$448,445,373 |
|||
The joint auditors should have performed additional audit work to verify these amounts. This may have included third party confirmation.
In their submission() the joint auditors summarise the work done in support of these balances, a significant portion of which depended upon work performed by Internal Audit. The Investigation has seen no evidence that this Internal Audit work was assessed in any way to support the joint auditors' reliance upon it.
(c) Disclosure Issues
There is no evidence in the audit working papers that the joint auditors confirmed (either by direct confirmation with South Australian Government Treasury or examination of relevant agreements) the terms of:
(i) Sub-ordinated Perpetual Debt
In June 1988, the Bank issued what is called sub-ordinated perpetual debt (Floating Rate Notes) with a face value of $US 150.0M. The Bank classified the discounted value of the debt, totalling $134.5M as equity in the 30 June 1988 Balance Sheet.
A letter dated 6 May 1988 from the joint auditors to Mr K S Matthews, Chief General Manager of the Bank, regarding what was then the 'Proposed Issue of Perpetual Floating Rate Notes' contained the following details:
"Proposed Issue of Perpetual Floating Rate Notes
We refer to our recent meeting with yourself and Mr Trevor Mallet and your request for our views on the accounting treatment appropriate to the proposed note issue.
The opinion we offer is based on the facts given to us, which we would expect to be supported by formal documentation if the issue proceeds. We understand the proposed arrangements to involve:
1. The issue by the Bank of floating rate notes having a face value of $US 150m.
2. The notes to be issued at a discount of $US 45m.
3. Interest to be payable for 15 years at the rate of six months Libor + 0.65 per cent.
4. The funding to take up the notes to be found by a special purpose company which will borrow $US 150m. from a syndicate of international investors. We have been advised that this company will not be controlled, directly or indirectly, by the Bank.
The special purpose company will enter into a separate arrangement whereby for payment of $US 45m. (an amount equivalent to the discount on the notes) its liabilities to investors will be defeased at the end of 15 years.
5. At the end of 15 years the notes issued by the Bank will have no further interest entitlement and accordingly, will themselves have no value. The Bank will be in a position to buy back the notes, either itself or through a nominee, for a minimal amount.
In our view, the correct account is as follows:
1. The note issue should be recorded and appear in the Balance Sheet of the Bank as follows:
|
$A Equivalent |
||
|
Perpetual Floating Rate Notes |
150.0M |
|
|
Less Discount on Issue |
45.0M |
|
|
105.0M |
||
2. The Profit and Loss Account should be charged each year with:
- interest expense in relation to $US 150m., and
- amortisation (over 15 years) of the discount of $US 45m.
After year one the remaining discount on issue should be shown as (Net of Amortisation).
At the end of 15 years the discount will have been extinguished.
3. There should be a note to the accounts setting out, in brief, the nature of the transactions.
If you should have any further questions regarding the foregoing, we will be pleased to further discuss the matter with you."
Despite the above noted recommendations, no details of the perpetual Floating Rate Note issue were disclosed in the 1988 financial statements apart from the fact in 1988 that the Bank had issued perpetual sub-ordinated debt of $134.5M (ie the $US 150.0M issue less $US 43.0M discount converted to Australian dollars).
As regards the non-disclosure of the details of the new issue of perpetual debt, the joint auditors in their submission() state that the auditors are unable to force disclosure and if requested changes or disclosures are not made, then the auditors' only recourse is to qualify the audit report.
The Investigation was unable to find evidence in the audit files where the matter of non-disclosure had been considered when approving the Bank's accounts.
In addition, the audit working papers include comment on why perpetual floating rate notes are debt. This emphasises the opposite view of disclosure to that used by the Bank and highlights the significance of the matter and, in my opinion, the requirement for the auditors to examine the issue.
The Bank intended to comply with Schedule 7 unless it felt it was inappropriate for the Bank to do so. As the joint auditors issued an opinion on the basis of compliance with, in part, Schedule 7 it was critical that they evaluate the impact of any non-compliance. This risk was identified and documented in minutes of the First Quarterly Meeting held between the "External Auditors/Bank Senior Management" on 12 January 1988. The minutes note:
"The Bank will supply us with information on those areas of Schedule 7 with which they do not intend to comply, in order for us to decide any impact on our audit report." ()
No evidence was noted in the audit working papers where this occurred or where non-compliance with Schedule 7 was given any other consideration for the year ending 30 June 1988.
The following comments are made with regard to the accounting treatment proposed by the joint auditors in their letter dated 6 May 1988. Extracts of the letter have been quoted above.
. AAS23 "Set-off and Extinguishment of Debt" does not permit "principal only" defeasance and consequently it is correct to net the discount from the face value of the Floating Rate Note, as the joint auditors proposed.
. The substance of the transaction will result in the "perpetual debt" being repaid in 15 years, and therefore the payments made by the Bank, for the coupon interest payable on the full $US 150.0M Floating Rate Note, comprises two elements:
- interest expense on $US 107M; and
- repayment of the principal of $US 107M.
. The accounting treatment proposed by the joint auditors in their letter of advice dated 6 May 1988 would result in:
- the profit being understated (ie interest expense being overstated) each year by the difference between the interest calculated on the face value of the $US 150.0M Floating Rate Note, and the interest calculated on the outstanding balance of the Floating Rate Note;
- the profit being understated each year (for a period of 15 years) due to the amortisation of the $US 45.0M discount (for a period of fifteen years); and
- the balance of "perpetual debt" will be overstated by the amount of principal which has been repaid (ie the cumulative amount of interest expense overstatement noted above.
I have considered the joint auditors' submissions() in respect of the sub-ordinated "perpetual" debt which described the advice given by the joint auditors to the Bank when the debt issue was first proposed and the eventual accounting treatment adopted by the Bank.
It is of concern to me that the true nature of the transaction was not recognised by the joint auditors at the outset. Despite the words used to describe the arrangement, "sub-ordinated perpetual debt", in reality it was, from the Bank's viewpoint, a $US 107.0M loan repayable over fifteen years. This was acknowledged by Mr Richardson in his oral evidence for the joint auditors, who also agreed that the treatment adopted by the Bank led to some understatement of profit to the extent that the interest paid and charged against profit contained an element which was in fact an amortisation of the $US 107.0M actually borrowed.
The joint auditors have submitted that the arrangement was novel at the time, and the treatment adopted was acceptable at the time. Again I cannot accept this proposition.
It is clear from a review of the elements of the scheme that after fifteen years the original investors would have been fully repaid, that the Bank would have no further liability for interest, and that the notes would have no value. Accordingly, in my opinion it was misleading to describe the borrowing as "perpetual' and to classify it within capital and reserves.
In my opinion, the debt was not in substance "sub-ordinated", because the debt, along with other liabilities of the Bank, was guaranteed by the State Government, and because other security was provided under the scheme for the repayment of the ultimate lenders' principal.
The accounting treatment of this transaction implemented by the Bank is fully discussed in Section 6.6.6 of Chapter 6 "The Funding of the State Bank" of my First Report.
(ii) Capital
During 1988, the Bank received a $250.0M capital injection. This was described by SAFA as a transaction which would:
"... provide a return (to SAFA) ... of bank bill + 0.65 per cent p.a. in perpetuity."
This was in the context of:
"... terms and conditions to apply to State Bank loans from SAFA converted to capital".
The only audit testing noted was a confirmation of the capital as "non-repayable" signed by Ms J Campbell Accounts Clerk, South Australian Government Financing Authority. In my opinion, the joint auditors should have verified the nature, terms and conditions of the capital injections in order to ascertain what was the appropriate classification and disclosure of the capital injection.
The terms and conditions attaching to the capital were not disclosed in the notes to the accounts. The joint auditors submitted that disclosure was not material to a user of the accounts.()
In my opinion, non-disclosure of these matters was inappropriate.
(iii) Directors Remuneration
Transactions concerning directors of the Bank were noted in the joint auditors working papers however, no evidence of testing, discussions, or disclosure were noted.
Mr Whimpress reviewed the Executive Committee Minutes and noted that the minutes of 30 October 1987 made:
"... reference to the use of C.E.O. Development Fund ... should be subjected to audit along with the M.D's salary."
No evidence of audit testing, discussions or disclosure were noted.
The cheque accounts lead schedule notes that:
"... $200,000 advances to Managing Director - not on CIRF system"
No evidence of audit testing, discussions or disclosure were noted.
There is no evidence that the joint auditors addressed the implication of these transactions or the issue of disclosure of directors remuneration, in general. In the opinion of the Investigation the joint auditors should have considered the directors remuneration issue in the light of the disclosure requirements outlined in clause 24 of Schedule 7.
The minutes of the Board meeting held on 23 June, 1988 note, inter alia, that;
"... it has been agreed with the External Auditors that the Bank does not comply with the Schedule 7 of the Companies Code which requires disclosure of Directors' remuneration ...".
The Board paper supporting this minute discusses the issue of disclosing information on Directors remuneration, as such;
"... it [ie disclosure of directors remuneration] would require disclosure of the remuneration package paid to the Managing Director, Mr T M Clark, and it is felt that there is little benefit to be gained by such disclosure, in that it is likely that there would be difficulty and misunderstanding as to the value of the package paid to Mr Clark."
I do not accept the validity of the reasoning contained in the above Board Paper.
In their submission() dealing with non-disclosure of director remuneration the joint auditors state that to the extent that a disclosure requirement of the Companies Code is not complied with, this non-compliance is evident to any users of the financial statements. In their view the non-disclosure would not be a breach of any statutory requirement unless the non-disclosure would affect decisions by users of the accounts.
While the immateriality argument might apply to some non-disclosures I do not believe it is available to the non-disclosure of directors' remuneration which according to the Companies Code is required to be disclosed irrespective of materiality to the rest of the accounts. If it were otherwise, very few companies would disclosure directors' remuneration as it is an item which in monetary terms, is generally immaterial to the content of published financial statements.
As regards the argument that the Bank's shareholder had access to the information if it so desired, in oral evidence to the Inquiry() Mr Richardson of KPMG Peat Marwick acknowledged that "the accounts should stand on their own" without the inference that the shareholder could use some other knowledge in its interpretation of the accounts of the Bank.
In their submission() dealing with the absence of audit work on the Chief Executive Officer Development Fund and the $0.2M loan to the Managing Director, the joint auditors state the Fund was not examined as it was immaterial to the accounts of the Bank. In my opinion, it was inappropriate that the joint auditors did not examine these accounts and in relation to the loan to the Managing Director, ensure appropriate disclosure in the notes to the accounts in accordance with Schedule 7.
In their submission() the joint auditors stated that the Managing Director's remuneration was reviewed periodically by the joint auditors. The Investigation could find no evidence in the audit files that this review had been carried out, and no reference to work papers was supplied by the joint auditors in their submission.
Based on the evidence examined by the Investigation, and for the reasons set out above:
(a) I am not satisfied that the joint auditors performed adequate and appropriate audit procedures in relation to the items listed below, to provide the joint auditors with reasonable assurance that these balances did not contain material mis-statements:
(i) nostro and vostro balances;
(ii) foreign currency advances;
(iii) fluctuating overdrafts; and
(iv) fully drawn advances.
However, I have no reason to believe any such failures to perform appropriate and adequate audit procedures resulted in a material mis-statement in the Bank's accounts.
(b) I have formed the opinion that:
(i) The joint auditors failed to ascertain the true nature of the Bank's "sub-ordinated perpetual debt" and accepted an inappropriate treatment of the debt in the Bank's accounts as part of capital and reserves rather than as a liability to a third party, which also would lead to the understatement of the operating profit before tax each year until the eventual extinguishment of liability after fifteen years.
(ii) Consequently the Bank's capital and reserves were materially overstated.
(iii) The joint auditors wrongly accepted the non-disclosure by the Bank in its accounts of:
. the terms of issue of the increase in the Bank's capital; and
. the remuneration and loans to directors.
However, apart from the incorrect disclosure of the Bank's "Sub-ordinated Perpetual Debt" I have no reason to believe that these failures to perform appropriate and adequate audit procedures resulted in a material mis-statement in the Bank's accounts.
In the case of the incorrect disclosure of the Bank's "Sub-ordinated Perpetual Debt" the question of whether the accounts of the Bank at 30 June 1988 were, as a result, materially mis-stated is considered under the heading "Conclusion" at the end of this Chapter.
50.5.3 CONCLUDING PROCEDURES
50.5.3.1 Preamble
Chapter 46 - "The External Audit of the State Bank: Background Information" sets out background information on appropriate audit procedures in this area.
50.5.3.2 Matters Noted - Settlement of Audit Issues
There is no evidence in the audit working papers of how and with whom the undermentioned relevant important matters, were considered, and hence the reasons for the joint auditors accepting the Bank's treatment of them in its 1988 accounts:
(a) The level of the provision for specific and general doubtful debts.
(b) Disclosure and treatment of the additional capital obtained by the Bank.
(c) Disclosure of details of directors' remuneration.
(d) Treatment of State income tax (ie distribution to the State Government).
(e) Basis of the Provision for Self Insurance.
(f) Disclosure of the details of the "perpetual sub-ordinated debt" treated by the Bank as capital.
Each of these matters has been discussed in more detail earlier in this section.
Based on the evidence examined by the Investigation, and for the reasons set out above, I am not satisfied that all issues were brought to the attention of the joint auditors by their staff, and that they dealt adequately with issues that were brought to their attention.
50.5.3.3 Matters Noted - Management Representations
The only evidence noted in the audit working papers evidencing that the joint auditors had considered representations from management was a memorandum which commented:
"... that the Board of Directors approve the Annual Accounts ... and that the Chairman and Managing Director be authorised, on behalf of the Board to sign the Directors Statement attached to those accounts".()
The memorandum included matters which had been taken into consideration in the preparation of the accounts and was from the Managing Director and the Chief Manager, Group Finance of the Bank to the Board of Directors. The letter made comment on the profit and loss statement, certain balance sheet categories, certain notes to the accounts, insurance, events subsequent to balance date and statutory records.
There was no letter of representation from management to the joint auditors.
In their submission() the joint auditors quoted from the KPMG Peat Marwick audit manual "The auditor should try to corroborate significant management representations on which he intends to rely." Also, a KPMG Peat Marwick Accounting and Audit Bulletin issued in 1987 stated that written representation should be received from management in support of oral representations made in relation to matters which may impact upon the financial statements.
The joint auditors state they were able to satisfy the requirements of this guidance by reviewing the Board papers. In my view the review of Board papers is an inadequate substitute for written representations on matters 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 obtaining management representations on significant matters were inappropriate and inadequate, however, I have no reason to believe that this failure to perform appropriate and adequate audit procedures resulted in a material mis-statement of the Bank's accounts.
50.7 CONCLUSION
In my opinion, the audit opinion expressed by the joint auditors on the accounts for the year ended 30 June 1988 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, capital and liabilities as noted in the Section on "Execution" above were not materially mis-stated.
(c) The Provision for Self Insurance of $6.285M was materially mis-stated.
(d) The joint auditors wrongly accepted management treating the balance of the "Concessional Housing Reserve" of $57.7M as part of the Bank's capital and reserves.
(e) The Bank's operating profit and extraordinary items after tax was overstated by $13.8M 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.
(f) As a consequence of asset revaluation surpluses of $4.1M wrongly being credited to the "Superannuation Provision", the "Asset Revaluation Reserve" was materially understated and it is likely the Bank's profit for the year was materially overstated.
(g) The Bank's capital and reserves were materially overstated by the inclusion of "Sub-ordinated Perpetual Debt" of $134.5M.
By reason of the foregoing, the joint auditors' opinion that the accounts and group accounts for the year ended 30 June 1988 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) to (g). First, item (c) was, in my opinion, material in relation to the reported profit of the Bank for the year of $55.5M 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 $972.1M. Third, item (e) was material in relation to the Bank's reported after tax profit of $55.5M. Fourth, item (f) was material by its nature and in relation to the Bank's reported profit. Fifth item (g) was material by its nature, and in relation to the Bank's reported total capital and reserves of $972.1M.