CHAPTER 51
REVIEW OF THE 1989 EXTERNAL AUDIT OF THE STATE BANK
TABLE OF CONTENTS
51.1 PURPOSE OF CHAPTER
51.2 PLAN OF CHAPTER
51.3 BUSINESS OF BANK AND BANK GROUP
51.3.1 THE BANK
51.3.2 SUBSIDIARIES
51.4 ACCOUNTS OF BANK AND BANK GROUP
51.5 INVESTIGATION OF THE AUDIT PROCESS
51.5.1 PLANNING THE AUDIT
51.5.1.1 Matters Noted
51.5.1.2 Conclusion
51.5.2 EXECUTION OF THE AUDIT
51.5.2.1 Preamble
51.5.2.2 Matters Noted - Investments
51.5.2.3 Matters Noted - Treasury and International
51.5.2.4 Matters Noted - Provision for Doubtful Debts
51.5.2.5 Matters Noted - Provision for Taxation
51.5.2.6 Matters Noted - Provision for Self Insurance
51.5.2.7 Matters Noted - Superannuation Provision
51.5.2.8 Matters Noted - Sub-ordinated Debt
51.5.2.9 Matters Noted - Interest Income and Expense
51.5.2.10 Matters Noted - Other Inadequate Audit Procedures
51.5.3 CONCLUDING PROCEDURES
51.5.3.1 Preamble
51.5.3.2 Matters Noted - Subsequent Events Review
51.7 CONCLUSION 51-61
51.1 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 1988-89 and significant features of the statutory accounts in respect of the 1988-89 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 1989. The Chapter also concludes as to the appropriateness and adequacy or otherwise of the audit process undertaken.
51.2 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.
51.3 BUSINESS OF BANK AND BANK GROUP
51.3.1 THE BANK
The Bank expanded its network of branches with the opening of a branch in New York and the establishment of banking operations in New Zealand.
51.3.2 SUBSIDIARIES
The State Bank Group expanded during the year with the establishment of Day Cutten Ltd on 1 July 1988. The Bank's establishment of Day Cutten Ltd resulted from the merger of SVB Day Porter Pty Ltd and Cutten Pentelow Pty Ltd to form a sharebroking and investment and advisory organisation. In addition, licensed banking operations were established in New Zealand with the acquisition of Security Pacific Bank New Zealand Limited. This latter company was subsequently renamed SBSA (NZ) Limited and operated as the State Bank of South Australia Auckland branch.
The Beneficial Finance Group increased its profit by $11.0M (57.9 per cent) over the previous year to $30.0M while total reported assets increased by $595.2M (36.0 per cent) to $2,250.4M.
51.4 ACCOUNTS OF BANK AND BANK GROUP
On 24 August 1989 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 1989. The accounts presented comprised a Profit and Loss Statement, Balance Sheet and Notes to the Accounts, for both the Bank and consolidated Bank Group, and a Source and Application of Funds Statement for the 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 |
|
||||||||||||
|
1988 |
1989 |
1988 |
1989 |
Per Cent |
||||||||||
| Profit and Loss Statement | ||||||||||||||
|
Income |
||||||||||||||
|
Operating Profit |
872.6 |
1,364.0 |
1,091.0 |
1,727.1 |
58 |
|||||||||
|
Before Tax |
55.5 |
78.5 |
69.5 |
97.0 |
40 |
|||||||||
|
After Tax and Extraordinary Items |
55.5 |
78.5 |
64.4 |
90.8 |
41 |
|||||||||
| Balance Sheet | ||||||||||||||
|
Assets |
||||||||||||||
|
Loans, Advances, Receivables |
6,126.9 |
7,959.8 |
7,467.7 |
10,269.2 |
38 |
|||||||||
|
Other |
3,405.2 |
4,728.4 |
3,535.6 |
4,759.8 |
||||||||||
|
9,532.1 |
12,688.2 |
11,003.6 |
15,029.0 |
37 |
||||||||||
|
Liabilities |
||||||||||||||
|
Deposits and Borrowings |
6,608.7 |
8,833.8 |
8,070.9 |
10,888.4 |
35 |
|||||||||
|
Other |
1,951.3 |
2,541.7 |
1,922.0 |
2,784.3 |
||||||||||
|
8,560.0 |
11,375.5 |
9,992.9 |
13,672.7 |
37 |
||||||||||
|
Net Assets |
972.1 |
1,312.7 |
1,010.4 |
1,356.3 |
34 |
|||||||||
|
Capital, Subordinated Debt, Reserves |
972.1 |
1,312.7 |
1,010.4 |
1,356.3 |
34 |
|||||||||
| Doubtful Debts | ||||||||||||||
|
Expenses for the Year |
14.5 |
56.6 |
26.3 |
71.3 |
171 |
|||||||||
|
Provision at Balance Date |
28.5 |
77.2 |
51.9 |
108.3 |
109 |
|||||||||
51.5 INVESTIGATION OF THE AUDIT PROCESS
51.5.1 PLANNING THE AUDIT
51.5.1.1 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 and the system of internal controls of the Bank.
The following comments were made in the Peat Marwick Hungerfords Audit Approach Memorandum:()
"We intend to assess the overall quality and effectiveness of the internal audit function to determine the extent of reliance and thus the nature, timing and extent of external auditing procedures.
A satisfactory conclusion will imply that our sample sizes and level of testing can be reduced due to reliance on an enhanced system of internal control."
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 |
Low |
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" 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.
This approach is well documented in the audit files ..."
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.
51.5.1.2 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.
51.5.2 EXECUTION OF THE AUDIT
51.5.2.1 Preamble
Chapter 46 - "The External Audits of the State Bank: Background Information" sets out background information on appropriate audit procedures in this area.
51.5.2.2 Matters Noted - Investments
There is no evidence in the audit working papers that the joint auditors tested purchases and disposals of treasury investments to achieve the objectives listed in Chapter 46 - "External Audits of the State Bank: Background Information".
Total treasury investments at 30 June 1989 amounted to $914.5M.
In their submission() the joint auditors state that their audit procedures were directed towards testing the year end balance of investments, and in particular confirmations from relevant registrars was obtained. They believe that specific testing of purchases and disposals was not necessary to support the audit conclusion. In my opinion the procedures carried out were not adequate to address the audit objectives referred to in Chapter 46.
In addition the joint auditors state that purchases and disposals of investments were tested by Internal Audit and provide work paper references in support. There is, however, 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.
51.5.2.3 Matters Noted - Treasury and International
(a) Negotiable Certificates of Deposit
There is no evidence in the audit work papers that the investment of $156.0M in negotiable certificates of deposit was audited so as to confirm its existence, that the negotiable certificates of deposit were owned by the Bank, and that their carrying value was not materially mis-stated.
The audit work paper which supports the negotiable certificates of deposit balance of $156.0M includes a comment dated 24 August 1989 that:
"Only a limited amount of work had been performed on this account as at 30/6/89." ()
The `work performed' comprised adding a list of negotiable certificates of deposit and agreeing the total to the trial balance. The joint auditors should have recognised that negotiable certificates of deposit are risk assets, being negotiable bearer securities susceptible to misappropriation, and consequently should have performed substantially more audit work on this balance. The prime audit procedure should have been either a physical examination of the securities on balance date if held on the Bank's premises or, obtaining a certificate from independent custodians as to their holding on behalf of the Bank at balance date.
In their submission() the joint auditors assert that negotiable certificates of deposit are low risk in nature and a rotational audit approach was adopted in respect of them. I do not accept that the audit risk associated with negotiable certificates of deposit is low, and I note that the joint auditors rated the Treasury audit risk() as generally "High". The Investigation found no reference to the rotational audit approach claimed to have been adopted in the audit planning work papers.
In their review of the issue of negotiable certificates of deposit by the bank to investors, the joint auditors noted that in some circumstances Bank procedures were not being followed in that certificates were not always issued. I also note, that in 1990, 100 per cent of the negotiable certificates of deposit were examined by the joint auditors in one way or another, including confirmation from independent holders.
The joint auditors sought to test the Bank's records for negotiable certificates of deposit issued which they had tested for `existence' in their 31 December 1988 audit work, and which were due to mature prior to 30 June 1989, by sighting the redeemed Negotiable Certificates of Deposit.
In two of the six selections made the joint auditors were unable to locate the redeemed certificate. The explanation provided to the joint auditors' staff by Bank employees was:
"During discussion with [a Bank employee] she mentioned that when they are very busy, State Bank Paper may not be issued for small value NCDs." ()
There is no evidence that the joint auditors sought to substantiate the Bank employee's comment. If true it was a matter which should have been brought to the attention of the Bank's management. There was no mention of the subject in the joint auditors' letters to Management dealing with matters arising from the 1989 audit.
In their submission() the joint auditors acknowledge that the matter was not brought specifically to the attention of the Bank's management, but that they recommended a strengthening of the number and experience of staff in a report to the Bank on Treasury shortly after the completion of the audit.
I believe the matter should have received prompt investigation and reporting to the management, and the relatively high "failure rate" of the test of redemptions may have indicated that the failure to issue paper was more extensive than the recorded comment suggested.
(b) Euronotes
In my opinion the audit work papers produced to support the following balances did not contain sufficient documentation of audit procedures performed to enable the joint auditors to conclude that the balances were fairly stated in the Bank's 1989 accounts.
|
|
General |
Amount $ |
|
BNK 008009 |
Euronotes purchased |
177.7M DR |
|
BNK 006197 |
Euronotes - F/currency funding |
74.6M CR |
Samples were selected from these balances and noted as "vouched" to supporting documentation. However, there is no note as to what this documentation or other evidence comprised.
The appropriate audit verification technique for these items is either examining the relevant investment scrip or obtaining confirmation of its being held on behalf of the Bank by custodians as regards the Euronotes, and obtaining third party confirmation of the balance outstanding in respect of the funding.
The joint auditors state in their submission() that the Euronotes were vouched to supporting documentation contained in the individual deal files. Each deal transaction had a separate file which included, inter alia, the Offering Circular, deal settlement documents, confirming telexes/faxes with the counterparty in respect to settlement and various legal documentation supporting the offering Circular. The Offering Circulars were subject to review prior to settlement as they usually required a letter to be issued by the external auditor.
The joint auditors failed to recognise that the procedures adopted were not sufficient to give assurance as to the balances at year end, particularly as Euronotes are negotiable assets and notes held may have been sold subsequent to audit review and prior to year end.
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 above mentioned account 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.
51.5.2.4 Matters Noted - Provision for Doubtful Debts
The provision for doubtful debts of $77.3M appearing in the Bank's 30 June 1989 accounts comprised the following:
(a) A specific provision of $48.5M, relating to assessment of recoverability of individual loans;
(b) A general provision of $28.8M, relating to the perceived credit risk inherent in the Bank's corporate, treasury and retail operations, and calculated by applying risk percentages to outstanding balances and commitments for different categories of exposure.
The Investigation noted a number of matters concerning the procedures carried out by the joint auditors with regard to the provision for doubtful debts. In this section of the Chapter, after a brief introduction, matters concerning specific provisions will be discussed, then matters concerning the general provision, then a number of other matters concerning audit procedures and reporting 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) Introduction
Mr B H Edwards of Touche Ross & Co was primarily responsible for the audit of the provision for doubtful debts in 1989, subject to the usual liaison with the other joint auditor, Mr T J Whimpress of Peat Marwick Hungerfords.
In 1989, the National Chairman of the Peat Marwick Hungerfords Banking Practice was Mr N P Craig of Sydney. In about June 1989 rumours came to the attention of Mr Craig concerning the exposures of certain financial institutions including the Bank and, after consultation with the National Chairman of Peat Marwick Hungerfords, it was decided that Mr Craig would assist Mr Whimpress in connection with the audit of the provision for doubtful debts.() Mr Craig spent some time in July 1989 reviewing work papers of the joint auditors in relation to accounts to be considered for possible provisioning.() Mr Craig said that the audit timetable required clearance on receivables by around 24 July 1989.()
The joint auditors considered it desirable to address the Bank Board with regard to the level of provisions, having regard to the significant disparity between the Bank's minimum level and what might have been regarded as a more conservative position, and did so at the meeting of the Board on 27 July 1989.() The minutes of that Board meeting record:()
"The General Manager, Group Finance reviewed provisions for doubtful debts. Having consulted with the Bank's external auditors, it was considered that adequate provisioning had been incorporated in the end of year accounts. A need for further provisioning would be required next year.
The Bank's external auditors, Messrs B H Edwards and T J Whimpress, joined the meeting to discuss provisioning for doubtful debts.
The auditors highlighted the following in relation to provisioning for doubtful debts -
. National Safety Council of Australia (Victorian Branch) - the auditors considered that adequate provisioning had been allowed in relation to this debt, given the Bank's legal position in regard to Rothschild Australia Limited.
. Equiticorp - estimates of recovery ranged between 2 cents and 60 cents. The auditors considered that the Bank had provided the minimum level of provisioning required for this debt.
. The general provisioning level should be increased to reflect the foreseeable economic conditions.
. The formula for the calculation of the general provision may require further review in the next 12 months.
The formation of a Board audit sub-committee was suggested by a director, however, it was considered that management should further review the matter and prepare a report for a later Board meeting."
Mr Edwards said in evidence that the above minute did not reflect the representations made by the joint auditors to the Board that the Bank's provisioning was at the minimum end of the scale and a more conservative approach to provisioning would be desirable.() Certain former Non-Executive Directors of the Bank have submitted that the auditors did not suggest that the Bank's provisions were inadequate.()
Mr Edwards said that the auditors were not present when Mr K L Copley, the General Manager, Group Finance, addressed the Board on the subject of provisioning.() Mr Edwards also said that the auditors did not receive a copy, either before or after the meeting, of Mr Copley's Board paper dated 24 July 1989.() Mr Copley's paper addressed the specific provisions in relation to Equiticorp and the National Safety Council, which I will discuss in more detail below, and went on to discuss the level of the general provision and the impact of both specific and general provisions on the profit for the year:()
"General Provision
The calculations for the quantum of the general provision using the approved formula disclose that the figure at June 30, 1989 should be $30.0M.
However, fully providing for specific debts as outlined above and maintaining the group profit at the budgeted level results in the general provision being $27.0M, a shortfall of $3M but, an increase over June 1988 of $9M (52%).
Given the size of the increase, the substantial amount allocated, and the desirability of achieving budget, this is considered to be satisfactory and is recommended to Directors for approval ...
Profit Year 1989/90
In establishing the profit after provisioning and Federal Tax for the coming year at $130M, an amount of $70M has been included for doubtful debts. This amount is made up of:
Bank $57M
Beneficial Finance $13M
At this time, we are unable to estimate the amount of specific provisioning which will be required, but given that Equiticorp is provided to the level known at this stage, a further $12M may be required for N.S.C.A., and assuming write-offs of around $10M in the normal course of business, a net $55M can be expected to be added to the total provision by June 30, 1990.
This would result in the group total provision becoming around $160M, and would mean that the Group would be well positioned to protect itself against additional requirements for Equiticorp should they eventuate and other unknown factors in uncertain times ahead.
The matters outlined about have been discussed in detail with the External Auditors, who have indicated their agreement to the plans outlined. They have however, indicated a desire to discuss the matter with Directors."
The joint auditors have submitted that the above paper did not accurately record their views.() In my opinion, once the joint auditors determined that it was desirable for them to address the Board on the matter of provisioning, it was inappropriate that they did not acquaint themselves with the views of management which were put to the Board, in the form of the Board paper, prior to the joint auditors stating their own position.
(b) National Safety Council of Australia - Exposure $25.3M
A provision of $12.0M was made against this exposure by the Bank. Approximately $12.0M of the unprovided portion was unsecured and the only chance of recovery of that unsecured amount was through legal action against a third party for alleged misrepresentation. Legal opinion obtained by the Bank gave an "arguable case" () against the third party but not a "strong case". Counsel retained by the Bank said that they could not give a better estimate of the Bank's prospects of success since the case turned upon the evidence of witnesses, and the evidence of the other party's witnesses would not be known until the trial.() There is evidence that Mr Whimpress followed up this matter on a number of occasions up to 23 August, to check whether a stronger opinion could be obtained prior to the signing of the audit report. The audit files contain no evidence that anything more than an "arguable case" was ever expressed by the lawyers.
Mr Copley, in his paper to the Board dated 24 July, 1989, said "we are unable to establish as to whether the action is likely to be successful, but we believe we have a strong case."
Mr Edwards said the joint auditors informed the Board on 27 July 1989 that the auditors could accept the Bank's provision on the understanding that the strength of the Bank's position could be re-inforced by legal opinion.()
Mr Craig stated in his letter of 14 August to Mr Whimpress:
"We cannot sign the audit report unless the legal opinion on NSC is available and is sufficiently strong to support the exposure of $14 million."
Mr Craig said that his own view, as a non lawyer, when he reviewed the matter in July 1989 was that the Bank's prospects of success were around the 50-50 mark but he was looking for something stronger.()
The provision of $12.0M had been determined by the Bank simply by taking one half of the Bank's total unsecured exposure of $24.0M.() There is no logic in that calculation. Having regard to the amount of the claim against the third party, of $17.5M, it can be seen that the carrying value adopted by the Bank implicitly assumed a 67 per cent probability of recovery:
|
$M |
||
|
Secured exposure |
1.5 |
|
|
Recovery from Rothschild |
17.5 x 67 per cent |
11.8 |
|
Actual carrying value |
13.3 |
It can easily be calculated that if the action against Rothschild was given a 50 per cent chance of success, one could conclude that the exposure was under-provided by $3.0M.
Much time of the Investigation was taken up in attempting to determine the interpretation that an auditor should place upon the words "arguable case". Mr Whimpress said he thought it meant that the case was likely to succeed.() Mr B Lander QC, on behalf of the joint auditors, submitted that such was the meaning of the expression.() Mr P Wenham, an independent expert retained by the joint auditors who submitted a report, said he thought the expression meant, at best, that the Bank was as likely to win as it was to lose.() Mr Wenham carried out a calculation which implicitly assumed a 50 per cent chance of recovery, and concluded that the Bank's exposure was underprovided by $3.0M.()
The joint auditors submitted that Mr Whimpress undertook a detailed review of the circumstances surrounding the Bank's claim against Rothschilds, apparently in an endeavour to comply with Mr Craig's advice, and concluded on 23 August 1989 that he could be satisfied that the Bank had a strong case.() Mr Edwards gave evidence that he always thought that the Bank had a strong case.()
Mr Whimpress made a statutory declaration dated 3 March 1993 in which he said that he and Mr Edwards formed the view at the time of the 1989 audit that the Bank had a high probability of recovering the amount of $17.5M from Rothschild, and hence the Bank's provision was appropriate.
In my opinion, the proper approach to provisioning this exposure is that, unless full recovery is reasonably likely a provision is required for the estimated shortfall. In my opinion, the joint auditors did not have sufficient appropriate audit evidence to support a conclusion that it was reasonable to accept a provision implicitly based on a 67 per cent chance of recovery. The lawyers retained by the Bank were unable to conclude, on the same facts which Mr Whimpress reviewed in forming his conclusion, that the Bank had better than an arguable case. In my opinion, it was inappropriate for Mr Whimpress, as a layman, to attempt to take the matter further than the lawyers were prepared to go.
While it is not relevant to the consideration of the matter in 1989, the Bank effectively increased the provision by a further $6.0M at 30 June 1990, and by 30 June 1991 had fully provided for loss of the whole of its unsecured exposure.()
Based on the evidence examined by the Investigation, and for the reasons set out above, I have formed the opinion that:
(a) the provision against the National Safety Council exposure should have been approximately $12.0M higher than that carried by the Bank in its 1989 accounts; and
(b) the amount of this under-provision, and the consequent overstatement of the Bank's operating profit,was material.
(c) Equiticorp Australia Ltd - Exposure $54.0M
In the 18 August letter to Mr T M Clark, the joint auditors noted:
"... the specific provision [of $13.62M] in relation to Equiticorp has been accepted in the expectation that the first $10 million of any loss will be recovered from Beneficial Finance Corporation Ltd and that the provisions for loss in their accounts are adequate for this purpose."
However, the joint auditors had known for some time that the first $10.0M of loss to be recovered from Beneficial Finance pursuant to the "underpin agreement" dated 13 January 1989 was not being specifically by Beneficial Finance. I discuss the circumstances surrounding this agreement in detail in Chapter 58 - "Review of the 1989 External Audit of Beneficial Finance". In a file note dated 23 August 1989, based on a meeting held on 19 July 1989 with Mr A H Giles, the auditor of Beneficial Finance, Mr Whimpress noted that:
"Equiticorp was discussed in detail and it became clear that BFC's loss was only being treated as contingent as this stage, with PW [the audit firm of which Mr Giles was a partner] being under the impression that full provisioning would be made in the bank.
NB. Numerous discussions were held with Alan Giles of PW over this matter. In the end he had to be satisfied with the quantum of BFC's general provision ($21M) and the existence of surplus accruals and provisions." ()
Reference should be made to Chapter 58 - "Review of the 1989 External Audit of Beneficial Finance" where provisioning of that company's exposure to Equiticorp is discussed. The "numerous discussions" held with Mr Giles made the joint auditors aware that Beneficial Finance had made no specific provision for its Equiticorp exposure.
As noted in Chapter 46 - "The External Audits of the State Bank: Background Information" under 'Provision for Doubtful Debts', general provisions are maintained to cover the risk of loss inherent in any loan portfolio which has not, at balance date, been specifically identified. The Equiticorp risk had been identified by the Bank which had raised a substantial specific provision in respect of part of it, so it was not appropriate at the group level to regard a portion of the Equiticorp exposure as being covered by the general provision for doubtful debts, either in the Bank's books or in those of Beneficial Finance.
Such treatment of the Beneficial Finance exposure clearly did not meet with the approval of Mr Craig who, in a memorandum to Mr Whimpress dated 28 July 1989, stated:
"Highlight to directors that the loss under this deal [referring to the $10.0M underpin by Beneficial Finance] should be provided for specifically in Beneficial and that the Beneficial general provision should not be used for this purpose."()
Mr Craig gave evidence that his memorandum dated 28 July 1989 was written to record the more significant matters discussed between him and Mr Whimpress on 27 July 1989 after Mr Whimpress and Mr Edwards had attended a meeting of the Bank Board on that day to discuss provisioning.() As I have noted in Chapter 58 - "Review of the 1989 External Audit of Beneficial Finance", Mr Copley, the General Manager, Group Finance of the Bank had prepared a paper dated 24 July 1989 which was presented to the Board at the meeting on 27 July 1989. This paper informed the Board that the Bank would not be providing in respect of the $10.0M underpin amount and neither would Beneficial Finance, on the basis that Beneficial Finance's general provision would be adequate to cover any loss. The paper mentioned that Beneficial Finance's auditors had accepted the proposed treatment. As is noted above, the joint auditors did not receive a copy of that paper. Nevertheless, it is clear from Mr Craig's memorandum and his evidence that the joint auditors were aware of the Bank's intentions regarding provisioning of the account by the Bank and by Beneficial Finance.
Accordingly, in my opinion, the joint auditors should have raised with the Bank the necessity for increasing the Bank's specific provision by $10.0M. The lack of such an adjustment would have resulted in the 1989 group operating profit being overstated by $10.0M.
The joint auditors did not follow the above course of action. Instead, they attempted to place responsibility upon the auditors of Beneficial Finance, Price Waterhouse, by writing a letter, which was not dated, advising Price Waterhouse that the Bank had allowed in its provision for loss on Equiticorp for a full recovery of $10.0M from Beneficial Finance for the portion of the debt assumed by it.()
Much time of the Investigation was taken up hearing evidence and submissions on behalf of the joint auditors and Price Waterhouse attempting to ascertain when the undated letter was provided by the joint auditors to Price Waterhouse. Mr Whimpress gave evidence that he was unable to recall when the letter was provided.() Mr Giles and Mr D Clark of Price Waterhouse gave evidence that Mr Whimpress handed the letter to Mr Giles at a meeting on 15 August 1989, convened, after Price Waterhouse signed their audit report on 11 August, 1989, for the purpose of the joint auditors reviewing Price Waterhouse's audit files.() Mr M G H Burgess, at the time a partner in Touche Ross & Co, one of the joint auditors of the Bank, gave evidence that he attended the meeting of 15 August 1989 with Mr Whimpress and does not believe that Mr Whimpress handed the undated letter to Mr Giles at any time on that day.() Each of the parties gave evidence knowing that their evidence directly conflicts with the evidence of the opposite party.
Mr Burgess gave evidence that his involvement in the audit was minor, and he was in fact representing the other joint auditor, Mr Edwards of Touche Ross & Co.() Mr Burgess gave evidence that the matter of the Equiticorp underpin was not a matter with which he concerned himself in the course of the review of Price Waterhouse's work papers on 15 August 1989, although he was aware of the issue.() Mr Giles and Mr D Clark gave evidence that the receipt of the letter caused them some consternation which they expressed to Mr Whimpress, and that they re-stated their position that Beneficial Finance was not going to provide for the loss on the basis of the instructions that had been received from the Bank.()
In my opinion, nothing turns upon the date the letter was provided to Price Waterhouse because at all times before and after Price Waterhouse signed their Audit Report on the Beneficial Finance accounts, the joint auditors of the Bank were aware that Beneficial Finance would not and did not make a specific provision for the $10.0M underpin amount. That is clear from Mr Whimpress' work paper dated 23 August 1989 recording numerous discussions with Mr Giles in the period 19 July to that date.() For this reason I will accept the submission by Mr Lander QC on behalf of KPMG Peat Marwick() that I should not make a finding on which account of events surrounding the receipt of the undated letter I would regard as the more reliable.
Nevertheless, I believe I should make a finding on this matter in case it might be said that, if Price Waterhouse had received the letter prior to signing their Audit Report, Price Waterhouse should have conducted themselves differently. In my opinion, for the reasons set out in Chapter 58 - "Review of the 1989 External Audit of Beneficial Finance" this would not have been the case.
As noted in Chapter 58 - "Review of the 1989 External Audit of Beneficial Finance" it must have been clear to the joint auditors of the Bank when they reviewed Price Waterhouse's work papers on 15 August 1989 that Beneficial Finance had not provided for the $10.0M underpin amount, and the stated reason for not providing. In my opinion, the joint auditors should then have raised with the Bank the necessity for increasing the Bank's specific provision by $10.0M. The joint auditors failed to take that step. Instead, the joint auditors claim to have obtained assurance from Price Waterhouse that the apparent $10.0M under provision was offset by unadjusted differences in the Beneficial Finance accounts.
Mr Whimpress' work paper of 23 August 1989, quoted above, refers to numerous discussions held with Mr Giles. It was suggested to Mr Whimpress during his oral evidence that the notation in his work paper "in the end [Mr Giles] had to be satisfied with the quantum of BFC's general provision ($21.0M) and the existence of surplus accruals and provisions" recorded a proposition that Mr Whimpress may have put to Mr Giles, but did not record an assurance by Mr Giles that the proposition was correct. It was also put to Mr Whimpress that the evidence of Mr Giles was that no such assurance had been given by Mr Giles.() Mr Whimpress said in evidence that he believed that Mr Giles had given an assurance, in a telephone conversation on a date prior to 23 August 1989 which Mr Whimpress could not recall, that Beneficial Finance had surplus accruals and provisions sufficient to cover the apparent $10.0M under provision relating to the underpin agreement.() Mr Whimpress said that he believed that assurance had been recorded by him in the passage from work paper 24479 quoted above.
Mr Whimpress referred in evidence to a work paper of his dated 16 August 1989, recording the results of his review of the Price Waterhouse work papers on 15 August 1989.() This work paper records under the heading "Income" unrecognised income and excess provisions amounting to $6.7M. Mr Whimpress gave evidence that this matter was noted by him from the Price Waterhouse work papers, and that it was not related to the Equiticorp underpin amount.()
The Investigation reviewed the Price Waterhouse work papers and, while there is no single figure corresponding to the $6.7M noted by Mr Whimpress, the work papers support a conclusion that there were indeed recorded surplus accruals in the order of $6.7M comprising fee income not recognised and other accruals.()
It is usual practice for auditors to keep a record of unadjusted differences on a work paper called an unders and overs schedule or unadjusted differences work paper. Price Waterhouse kept such a record, which appeared at Schedule IV of their work papers. The amounts of unrecognised income and surplus accruals identified on Price Waterhouse work paper Schedule II-1 were not transferred to their unders and overs schedule. One could infer from the work papers that Price Waterhouse did not regard those amounts as unadjusted differences available to be taken up either in Beneficial Finance's unders and overs or to be transferred to Bank Group unders and overs.
Price Waterhouse have submitted to the Investigation that the fee income not recognised and other accruals were in fact proper accruals and did not represent unadjusted differences.() I discuss the subject of prudent accruals, or "shockproofing" in Chapter 58 -"Review of the 1989 External Audit of Beneficial Finance". In my opinion, there was in fact no significant net unadjusted credit in Beneficial Finance to offset the under-provision of the $10.0M Equiticorp underpin amount in the Bank Group accounts.
In my opinion, if the joint auditors intended to treat the amount of $6.7M noted by them at the time of their review of the Price Waterhouse working papers on 15 August 1989 as an unadjusted credit available for the purposes of the Bank Group accounts, they should have verified, either from the Price Waterhouse audit file unders and overs schedule or in some other appropriate and adequate manner with Price Waterhouse, the amount of unadjusted credits and debits to be taken to a work paper of Bank Group overs and unders. In my opinion the joint auditors failed to do this.
Based on the evidence examined by the Investigation, and for the reasons set out above, I have formed the opinion that:
(i) the joint auditors did not have sufficient appropriate audit evidence to conclude that the unprovided $10.0M Equiticorp underpin amount was offset by unadjusted differences in the Beneficial Finance accounts;
(ii) on the contrary, there was in fact no significant net unadjusted credit available for that purpose; and
(iii) consequently the doubtful debt provision in the accounts of the Bank and the Bank Group was under-stated by $10.0M.
(d) Hooker Corporation Exposure $78.11M (Secured $27.375M)
Blanche Pty Ltd Exposure $32.09M
The joint auditors performed detailed credit reviews() of each component of the abovementioned exposures. Blanche Pty Ltd was a company related to Hooker Corporation.
In respect of Hooker Corporation, the audit working papers noted that the corporation was experiencing "major cashflow difficulties"; that a moratorium was in place to prevent further credit line withdrawals by financiers and that eventually the moratorium was terminated and a provisional liquidator appointed. In view of those adverse conditions, the audit manager's preliminary conclusion was that a provision of 20 per cent, or approximately $10.5M () was required against the $52.735M unsecured debt. The twenty per cent provision was proposed in view of an identified shortfall when comparing estimated realisable values of tangible assets with the company's debt levels. The work papers stated that this provision was:
"... to be revised as more info is available." ()
In respect of Blanche Pty Ltd, estimates were obtained from the receivers and managers indicating an `unavoidable' loss of at least $10.0M on the project.() As this loss was guaranteed by Hooker Corporation, and a claim under the guarantee would rank equally with the Bank's unsecured exposure, a further provision of at least $2.0M, being 20 per cent of the estimated loss, was indicated. The work papers contained a preliminary conclusion by a manager that only $1.0M additional provision was required() at 30 June 1989, but this conclusion was not updated to take account of the receivers' and managers' estimate.
Ultimately, no provision was raised against the Hooker or Blanche exposures. The 18 August letter to Mr T M Clark from the joint auditors noted:
"We realise that it is not possible at this time to estimate the likely outcome of the liquidation of this Group and that preliminary indications are that all creditors will be paid in full; we have therefore accepted the Bank's decision to make no provision. However, in view of the fine margin of net tangible assets available on stated book figures before adjustment to liquidation conditions, we believe that some provision could have been contemplated in order to take a conservative position."
The joint auditors' statement that "indications are that all creditors will be paid in full" is contrary to the preliminary conclusions reached in the work papers as described above, and there is no explanation documented as to how they satisfied themselves that full recovery was likely.
In his letter of 14 August to Mr Whimpress, Mr Craig was critical of the joint auditors' decision to accept a non-provision against the Hooker group exposure and regarded the exposure as one of the "three major problems" facing the auditors as a result of their work on adequacy of provisions (the others being the National Safety Council exposure, and the level of the general provision), stating:
"I am very disappointed that ... `we have now been satisfied as to the level of provisioning'. I thought you had stated that you would be still pushing the Board to increase provisions in respect of ... Hooker Corporation and Blanche ..."
Despite the preliminary conclusions of managers in their audit working papers that a provision of $11.5M was required in respect of the Hooker corporation/Blanche exposure, the joint auditors accepted, without recorded explanation in the audit files, the Bank's view that no provisions were required. .
Mr Whimpress provided a statutory declaration dated 3 March 1993 in which he said that he had a conversation on or about 8 August 1989 with Mr R Grellman, a partner in Peat Marwick Hungerfords who was assisting in the liquidation of Hooker, and who subsequently became a joint provisional liquidator of the Hooker Group. Mr Grellman provided a statutory declaration dated 23 February 1993 in which he confirmed that he spoke with Mr Whimpress on about 8 August 1989 and that he advised Mr Whimpress that, on then current indications (that is, an excess of book values of assets over liabilities) it was Mr Grellman's view that creditors would not suffer any real shortfall. Mr Grellman gave evidence to the Investigation on 4 May 1993, and I am satisfied that Mr Grellman had reasonable grounds to hold that view at that time, and that he advised Mr Whimpress of his view on about 8 August 1989.
In my opinion, having regard to the applicable professional standards() it was inappropriate that Mr Whimpress did not record the details of that conversation in his working papers, and the reversal of the manager's preliminary conclusion. Consequently the appropriateness and adequacy of the audit procedures has had to be assessed by reference to evidence relying on witnesses' memory of events taking place nearly 4 years ago.
(e) Chase Corporation: Exposure $37.0M
The exposure to Chase Corporation in Australia, of $25.0M, was reviewed by the joint auditors, who concluded that the exposure was sub-standard following defaults in interest payments and doubts over recoverability in full of the collateral provided to the Bank. No specific provision was deemed necessary, but the $25.0M exposure was noted as `high risk' in the 18 August letter to Mr T M Clark.()
There is no mention made in the 18 August letter of the related New Zealand exposure of $NZ 16.3M (approx. $12.0M), which was unsecured, and whether that exposure was considered high risk. The major part of the Chase Group in New Zealand had been placed under statutory management, a form of Government initiated administration, on 3 July 1989. There is nothing in correspondence received prior to 18 August from the auditors of the Bank's New Zealand branch and subsidiaries to indicate that this exposure should have been provisioned.
In a memorandum() from a Peat Marwick New Zealand audit partner, Ms J A Dawson to Mr Whimpress, also on 18 August, attention was drawn to a newspaper article which stated that, based on the latest Chase Corporation business plan drawn up for creditors, unsecured lenders to Chase Corporation could hope for only 14-24 cents in the dollar in the next year. Ms Dawson commented that it was not known whether this was the total expected payout or merely that expected for the next year. The article mentioned a projected deficiency of assets over liabilities after the 14-24 cents payout, but there was insufficient information provided to assess the full effect of this shortfall. The article also stated that even some secured creditors would not be paid in full.
Ms Dawson had discussed the Bank's options for recovery of this exposure with the local management of the Bank and had been informed that:
"... there is no need to provide at this point ..."
Nevertheless, Ms Dawson noted that the provision level suggested by the article as applied to the branch's unsecured exposure:
"... would be in the order of (NZ) $12-$13m [approximately $9.1-$9.8M]"
and concluded:
"I consider that a provision would certainly be conservative and desirable, but it would not necessarily be at this level."
There is no evidence in the audit files that further consideration was given by the joint auditors to the need to treat this exposure as potentially doubtful in the 1989 accounts, and no provision was raised. Indeed, in a memorandum from Mr G Edgar (Touche Ross audit partner, Auckland, responsible for a `peer review' of the KPMG New Zealand audit files) to Mr Burgess (Touche Ross audit partner, Adelaide) dated 29 August 1989, five days after the joint auditors signed their report on the Bank's 1989 financial statements, Mr Edgar noted:
"I was informed you participated in the decision that the CHASE matter was to be treated as a post-balance date matter."
In my view it was inappropriate for the joint auditors to conclude that identification on 18 August 1989, six days prior to signing the Bank's audit report, of foreseeable losses arising in respect of the Bank's Chase Corporation exposures at 30 June 1989 constituted a post-balance date matter which required no further action on their part. In my opinion, the joint auditors should have performed a detailed review of the Chase Corporation business plan noted in the newspaper article to ascertain the extent, if any, of provisions required against the secured Australian exposure, and to prudently assess an adequate provision for the unsecured New Zealand exposure.
Mr Whimpress provided the investigation with a statutory declaration dated 3 March 1993 with regard to Chase. In that declaration, Mr Whimpress said that on 21 August 1989 he spoke to Mr Copley at the Bank, who had no further information about this account, but who informed Mr Whimpress that as the financial statements had been sent to the Directors, it would be too late to make any changes unless there was a very good reason for doing so. Mr Whimpress said that he then spoke by telephone with Ms Dawson, who suggested that he speak to the administrator of Chase. Mr Whimpress said that he was unable to contact the administrator of Chase until after the Bank's 1989 accounts were signed.
I have requested information from Ms Dawson as to the steps, if any, she took to follow up the press report, for example, by obtaining a copy of the administrator's report to creditors or in probing the Bank's New Zealand management on whether management's proposed workout strategy had a reasonable prospect of success.
Peat Marwick Hungerfords, New Zealand, was the auditor of the Bank's subsidiary, SBSA (New Zealand) Limited and Ms Dawson was the signing partner. The Investigation has been informed by Ms Dawson's solicitors that she had taken legal advice and has declined to provide the Investigation with the information requested.
I consider that I am unable to carry out my Terms of Appointment with regard to the investigation of the appropriateness and adequacy of the external audit of the Bank Group with regard to its exposure to Chase. I am not satisfied, on the basis of the evidence before the Investigation, that the audit was appropriate and adequate in that respect.
(f) New York and Grand Cayman Branches
No credit review was conducted by the joint auditors of the loan portfolio of the Grand Cayman branch to assess the adequacy of loan loss provisions. At 30 June 1989 the branch's loan balance was approximately $345.0M.
Correspondence between Mr Edwards and Mr T G Hallion of Touche Ross Adelaide, and the engagement partner and manager from Touche Ross New York, indicates that it was the intention of both offices that Touche Ross New York were to undertake a credit review of the New York and Grand Cayman branches' loan portfolios, both of which were managed from the New York office, to assess the adequacy of the provisions for loan losses. Pressure from the Bank's New York management regarding time restraints and audit costs was later highlighted in correspondence between Mr Edwards and the Touche Ross New York audit partner, including a statement from Mr Edwards that:
"... they [State Bank New York branch management] are very concerned that we are over-auditing the New York Branch." ()
This eventually led the joint auditors to amend their instructions, stating:
"... it has been decided that the loans loss assessment review can be dispensed with for this 30 June." ()
In lieu of an independent audit assessment of provisions the joint auditors relied on an assessment of the branches' lending activities and procedures produced by a newly appointed vice-president of the New York office. This assessment did not extend to a review of individual exposures, but reached the overall conclusion that no credit problems were evident. This conclusion was supported by an Internal Audit report on the activities of the New York office dated June 1989 which stated that management controls within the Corporate Banking area were of a high standard. Furthermore, Touche Ross New York had informed Mr Edwards of the branch management's comment that all credits in the loan portfolio had been recently extended and had, therefore, recently been through extensive credit approval procedures.()
The joint auditors have submitted that it is generally accepted bank auditing practice worldwide not to conduct credit reviews of all offshore branches every year.() I accept that this practice may be appropriate in certain circumstances. The New York and Grand Cayman portfolios were less than 5 per cent of the Bank's receivables, and had recently been through credit approval procedures.
Accordingly, I accept that, the procedures carried out by the joint auditors with regard to provisioning of the New York and Grand Cayman branch portfolios were in the circumstances appropriate and adequate.
(g) General Provision
Risk percentages were set by reference to a formula which was approved by the Board of Directors in 1987. This formula fixed risk percentages for certain categories of exposure, and provided for other risk percentages to increase over a number of years, to allow the general provision for those applicable categories of exposure to gradually become larger.
The risk percentages give a rough indication of relative levels of risk perceived between different exposure types. For example, housing loans are viewed as low risk and were assigned a risk factor of 0.025 per cent at 30 June 1989 whereas higher risk credit card loans were provisioned using a factor of 1.0 per cent. The largest categories of corporate exposures, excluding bill acceptances, were weighted at 0.5 per cent. No risk factors at 30 June 1989 exceeded 1.0 per cent.
The joint auditors submitted that it is not the auditor's responsibility to calculate the amount required to be recorded to provide for loan losses, and that the auditor's responsibility was to obtain reasonable assurance, by the use of appropriate auditing techniques, that management's estimate of the provision was not materially mis-stated in the context of the accounts as whole.() The joint auditors submitted that there was no norm in the banking and finance industry, concerning the desirable general provision as a percentage of gross receivables, to assist auditors when assessing the adequacy of general provisions for doubtful debts, and in fact there was not universal acceptance of a need to provide for unidentified losses.() The joint auditors submitted that the lack of precision in assessing the adequacy of a general provision meant that, although the joint auditors strongly advocated to the Bank Board that a more conservative approach should be adopted to general provisioning, they did not believe that they could have sustained their views that their own assessment would be more appropriate than management's assessment, and hence they would not have had grounds to qualify their audit report in the event of such a difference.() In my opinion, the joint auditors should have satisfied themselves that the policy and formula adopted by the Board of Directors was appropriate and had been adequately implemented by management.
Submissions were made to me on behalf of certain former Non-Executive Directors of the Bank, that it was never made clear to the Board that the risk factor of 1 per cent adopted by the Board in 1985 for Corporate Banking had not been implemented,() nor was the Board given any cause to believe that the formula for general provisions adopted by the Bank was inappropriate.() The Investigation has not sought comment from the joint auditors with respect to the knowledge of the Board, and no finding is made concerning that matter.
In my opinion, the audit of the Bank's general provision was deficient in a number of respects, as detailed below:
(i) There is no evidence that the joint auditors performed a critical review of risk factors during the audit. Instead, they accepted the Bank's calculations based on a formula constructed in 1987. This formula, which at least halved the risk factors applicable to categories of corporate exposure in the previous year (1986) was, according to a comment by the joint auditors during the 1987 audit, a copy of which was located in the 1989 audit files:
"... acceptable given low levels of write offs in the last 2 years [to 30/6/1987]." ()
The joint auditors have submitted that the matter of general provisioning was given very full consideration in 1989 and that a critical review of the risk factors was carried out by the specialist banking audit manager seconded to participate in the loans review.() No evidence of such a review was found in the work papers, nor, in my opinion, was it appropriate and adequate for the joint auditors to fail to document their procedures in relation to this important matter.
The appropriateness of the general provision as a whole is further questioned by the inclusion in the audit files() of a comparison over four years to 1988 of the general provision levels of the Bank and Group against those for the State Bank of Victoria and the four major trading banks. The comparison clearly shows that the Bank's general provision is significantly lower than the average of the other five banks in 1988 (0.32 per cent of total loans excluding acceptances for the Bank, compared to an average of 0.90 per cent for the other five banks). The Bank's general provision percentage of 0.32 per cent was also significantly below the range of general provisions carried by these other banks which ranged from 0.49 per cent to 1.38 per cent. 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 banks 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 having regard to the factors referred to 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 during the year. As is noted above and in 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 general 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.
(ii) One risk percentage used in the calculation of the 1989 general provision was reduced as compared to those used to establish the 1988 general provision. Had this risk percentage remained unchanged at 1989, an additional general provision of $0.7M would have been required. No justification for this reduction in risk percentage was recorded by the joint auditors in their work papers. The joint auditors submitted() that this was of no consequence because other risk percentages were increased.
(iii) The joint auditors' letter of 18 August to Mr T M Clark included a list of fourteen `potential risk accounts' exposures totalling $426.8M preceded by the following comments:
"... our review highlighted several other loans which we believe require special mention as they have a greater degree of risk associated with them and warrant the careful attention of management. At this stage, current circumstances do not require a specific provision; however, special consideration could have been given to these loans in terms of the level of General Provision."
The `special consideration' referred to above relates to the joint auditors' assessment that the loans listed for special mention in their letter should have attracted a general provision of between 2.5 per cent and 5 per cent. For example, Mr Edwards noted in his review of selected credit reviews performed by his staff() that exposures to Chase Corporation (Australia), Hooker Corporation (secured debt) and Pro Image Studios/exposure $15.0M) should have attracted at least a 2.5 per cent general provision. In Mr Craig's internal memorandum dated 28 July 1989 to Mr Whimpress, a more general comment is made:
"... we should be insisting on at least an additional 2% provision on the $374 million [later revised to $426.8M] higher risk loans." ()
This additional 2 per cent provision on top of the 0.5 per cent already provided by the Bank for most loans and advances gives the abovementioned 2.5 per cent minimum general provision requirement. Applying the additional 2 per cent against the $426.8M high risk loans identified by the joint auditors gives an additional general provision of $8.536M.
In response to the joint auditors' comments to the effect that a general provision increase of this order was warranted, Mr Copley, General Manager, Group Finance stated:()
"We refute the need for such an increase in the position."
but went on to comment:
"However, given the anticipated position in the immediate future, we are prepared to increase the amount required by the formula by $2.5M as an extraordinary increase."
This $2.5M increase was subsequently reduced to $2.15M in determining the general provision which was included in the 1989 financial statements. As a result the level of general provision was approximately $6.4M below the minimum level which Mr Craig recommended. The joint auditors have submitted:
"Bank management did not accept the view that a higher risk factor (2.5 per cent instead of 0.5 per cent) should be applied to higher risk loans, believing that the applied risk factor of 0.5 per cent took account of the risky assets. However, some increases in general provisioning ... were made as a result of the joint auditors' persistence ... The joint auditors did not consider the amount of $6.4M to be a precise amount by which the general provision was understated and certainly not an amount of the joint auditors should have insisted upon being taken up in the annual accounts." ()
(iv) The joint auditors identified that the general provision levels against exposures in the New York and Auckland branches, based on risk factors of 0.04() per cent and 0.02() per cent respectively were significantly lower than the risk factor of 0.13() per cent applied to London branch exposures. An average of 0.303() per cent applied to all exposures arising from Australian operations. The audit files noted:
"Some justification for risk factors used for New York and New Zealand required from K Copley" ()
There is no evidence that these risk factors were justified to the joint auditors by Mr Copley. After late adjustments the London and New York risk factors actually decreased to 0.03 per cent each, although the New Zealand provision was increased to 0.2 per cent.
In my opinion, there was no justification for the risk factors used for the branch general provisions being lower than the risk factors applicable to the Australian operations. For example, had an average risk factor of 0.303 per cent been appropriate to the overseas branches' total exposures, an increase in the general provision in the order of $3.73M would have been required. The joint auditors submitted that the phased introduction of a proposed level of provisioning for a new branch, where most of the portfolio represents new lending, was acceptable practice. () These considerations were not recorded in the audit files. I am not, therefore, satisfied that the matters were adequately considered in the course of the 1989 audit.
(h) Reliability of source records
There is no evidence that the source record used by the joint auditors for the selection of exposures for credit reviews was tested by them for completeness by reference to the Bank's trial balance and supporting financial information.
The Bank's commitment register was used extensively as a source record for the joint auditors' credit review of the Bank's exposures. The joint auditors were aware that this register could not be reconciled to the general ledger and the joint auditors were, therefore, unable to obtain adequate assurance as to its completeness.
Without the reconciliation between the commitment register and the general ledger at the date the register was used, the joint auditors could not have known whether the commitment register represented a complete listing of the facilities comprising the receivable balance being audited.
This fact was recognised by the joint auditors in their letter dated 3 May 1989 to Mr Copley, Chief Manager, Group Finance, which presented their comments on the half-year review of the Bank as at 31 December 1988, the auditors stated:
". . . As previously noted, and now re-iterated, we are concerned that there is still no reconciliation between the Corporate Banking Commitment Register and the Bank's F.I.S. [Financial Information System] general ledger.
As a result, it is not possible to know whether or not all commitments and direct liabilities have been recorded on the register . . ." () [Emphasis added]
The joint auditors' submission in this matter stated that their provisioning review work acted as a test of the commitment register and its non-reconciliation did not negate the usefulness of the record. ()
I am not satisfied that the auditors carried out appropriate and adequate audit procedures in relation to this matter.
(i) Matters not Reviewed
A material exposure was highlighted on the commitment register as selected for credit review by the joint auditors; there is, however, no evidence that such a review was carried out.
The exposure, to "Client A" was $33.6M. Failure to perform a credit review of this exposure assumes more significance in the light of a credit review performed by the joint auditors of "Client B", related through ownership to "Client A". The "Client B" exposure of $4.3M was identified as high risk by the joint auditors in a letter to Mr T M Clark (Group Managing Director) dated 18 August 1989.() The high risk classification of a related party ("Client B") renders more serious the failure to complete the audit review procedure on this selected loan, as recoverability of the "Client A" exposure could be expected to be affected by similar considerations as those applying to the exposure to "Client B".
The joint auditors have submitted that the loan files were referred to in the course of checking the various facilities and that given the performing status and the adequacy of the security the "Client A" exposure was not subjected to further review.()
In my opinion it was inappropriate and inadequate for the joint auditors to fail to document their procedures or reasoning on this matter.
(j) Inadequate Reporting to the Bank
In the letter dated 18 August 1989 to Mr T M Clark(), the joint auditors detailed their conclusions from their audit of the Bank's credit exposures and their assessment of the adequacy of the provision for doubtful debts. The main conclusions arising in this letter are as follows:
"The provisions which have been set aside by the Bank in its Financial Accounts ... are acceptable to us for audit purposes. As indicated ... the level of provisioning is, in our view, the minimum required. We would have preferred the Bank to have taken a more conservative approach particularly in the present difficult economic environment, but realise that this is a matter of Board policy."
In relation to the general provision, the joint auditors concluded:
"We have had several discussions with Messrs Matthews and Copley concerning the level of the General Provision in the course of which we suggested that a higher factor be applied to certain identified risk loans. However, in their opinion, the present factors are intended to cover such loans and there would be difficulty in agreeing `risk loans'...
We have, in conclusion, accepted the General Provision as now calculated but suggest that the factors be reviewed in the future to ensure that they take account of write-off experience and prevailing economic conditions."
It is evident from these comments that the joint auditors believed that, as at 30 June 1989, a reasonable case for increasing both general and specific provisions could be made.
Mr Edwards said he did not believe that the Bank's provisions were understated(). Mr Whimpress gave evidence in relation to certain specific accounts, and the substance of his evidence was that he considered the Bank's provisions to be adequate and reasonable.() Mr Craig gave evidence that he formed the opinion that the provision for doubtful debts for the Bank and the Bank Group was understated but that the understatement, while just in excess of 10 percent of group profit, including desired increase in the general provision, was not sufficiently material to warrant qualifying the audit report.() In my opinion it was inappropriate that this difference of opinion between the three partners involved in the audit of the doubtful debt provision should not be resolved and documented in the working papers.
Mr Craig said in evidence that the report to the Managing Director was prepared, discussed with management, and sent to the Managing Director at Mr Craig's suggestion.() The reason for Mr Craig's suggestion is that in July and August 1989 he formed the view that the Bank's level of provisioning was "rock bottom" and he considered that the Board should be made aware of the difference between the Bank's level of provisions and the level which the joint auditors considered appropriate.() Initial drafts of the letter discussed between Mr Craig and Mr Whimpress contemplated both that a copy of the letter would be addressed to the members of the Board and that the Report would include a comparison of the Bank's provision and the joint auditors' preferred provision.()
In the end result, the joint auditors' letter dated 18 August 1989 was directed by them only to the Managing Director, and did not include any reference to the level of provisions preferred by the joint auditors. Mr Edwards gave evidence that the existence of the letter was made known by the joint auditors to the Board at the meeting on 24 August 1989 when the Board approved signing the accounts for the year ended 30 June 1989, and that Directors could therefore have obtained a copy from management if they wished to see it.() I have received submissions on behalf of certain former Non-Executive Directors of the Bank who have submitted that the joint auditors' report was not made available to them.()
Mr Edwards gave evidence that management of the Bank were made aware of the joint auditors' view as to the preferred level of provisions, because earlier drafts of the report to the Managing Director stated this view and had been discussed with management.()
Mr Edwards gave evidence that he did not consider it appropriate for the joint auditors to express any opinion to the Board as to their preferred level of provisions, in case they might be subsequently criticised if their preferred level proved to be inadequate.() I reject that proposition because: first, the joint auditors' preferred level of provisions was in fact discussed with management; second, the joint auditors were sufficiently concerned about the level of the provisions to inform the Board that provisions were at the minimum level; third, such information would be unhelpful without any indication of the possible range between "minimum" and "preferred"; and fourth, even if the auditors were wrong, having regard to their concerns about the low level of provisions adopted by the Bank, the Bank's provisions would have been even more inappropriate. I acknowledge that the auditors might risk criticism if they caused the Bank to adopt unnecessarily high provisions, however, the mere expression of a view by the auditors for consideration by the Board would not necessarily have any effect on the Bank's accounts. Mr Craig said it was not his practice to give positive opinions on individual areas of the financial statements, since the audit report is on the financial statements as a whole.() He did say however, "If you have a problem you outline the problem, but you do not say that you are satisfied as to the levels." ()
In my opinion, the joint auditors should have informed the Board of the potential significance for the truth and fairness on the accounts as a whole of provisions being adopted at the minimum level. That is, in my opinion, the joint auditors should have stated their view as to what they considered to be the preferred level, so that the Board could have considered the auditors' view in forming their own view as to the appropriate level of provisions.
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;
(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 ;
(c) the provision for doubtful debts of the Bank was materially mis-stated by at least $22.0M in respect of the following exposures -
National Safety Council $12.0M
Equiticorp $10.0M
(d) it is possible that further provisions would have been required if appropriate and adequate audit procedures had been carried out; and
(e) consequently, the accounts of the Bank failed to give a true and fair view.
51.5.2.5 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' submission on the subject. The conclusion which follows draws on that discussion.
In the Bank's 1989 accounts the State income tax was shown as an appropriation of the year's profit in a manner of a dividend rather than as a charge against operating profit before arriving at the amount of profit available for distribution by dividend.
If the presentation used for the 1985 and 1986 years (and followed by the Bank for 1991) had been continued in the 1989 accounts, then the Bank's operating profit, including extraordinary items, would have been $63.0M, twenty per cent lower than the figure of $78.5M actually disclosed.
There is no evidence in the audit work papers that the joint auditors considered the appropriateness of the treatment of the State Government tax as a distribution rather than an expense in the 1989 accounts or its implications when forming their opinion as to the truth and fairness of the accounts.
Note 1(h) to the 1989 financial statements states that:
"The Bank has adopted Tax Effect Accounting in accordance with Australian Accounting Standard AAS3, which allowed the Profit and Loss Statement to disclose the income tax expense that is applicable to the accounting profit, irrespective of when the income tax is payable. The tax effect of timing differences are shown in the Balance Sheet included in Other Assets or Bills Payable and Other Liabilities. The Provision for the Deferred Income Tax and the Future Income Tax Benefit are shown at current taxation rates ..."
It is evident from the treatment described above that AAS3 was not complied with in relation to the disclosure of and accounting for income tax expense, as suggested by Note 1(h).
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 1989 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 1989 were as a result materially mis-stated is considered under the section headed "Conclusion" at the end of this Chapter.
51.5.2.6 Matters Noted - Provision for Self Insurance
Chapter 46 - "The External Audits of the State Bank: Background Information" provides a discussion of this matter and a consideration of the joint auditors' submission on the subject. The conclusion which follows draws on that discussion.
The 1989 accounts of the Bank did not disclose the accounting principles giving rise to the provision for self insurance and contingencies of $5.675M. The provision was not supportable on the basis of audit work performed.
The audit work papers() indicate that the increase in the provision of $0.675M during the year was simply the difference between the premiums that would have been paid during the year if the Bank took out insurance with a third party, and the `insurance expense' which comprised self insurance claims arising during the year.
The audit work papers() indicate that the `Projected Extra Self-Insurance costs for 1988/89' total $0.28M. This is the only accrual identified at 30 June 1989. No other evidence was recorded to support a provision of $5.675M in the accounts at 30 June 1989.
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;
(b) the balance was materially mis-stated.
The question of whether the accounts of the Bank at 30 June 1989 were as a result materially mis-stated is considered in the section headed "Conclusion" at the end of this Chapter.
51.5.2.7 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.
Included in note 12 to the Bank's accounts is a provision of $105.1M in respect of its obligations for employee entitlements to pensions, retirement allowances and accrued leave, of which $72.4M represents the Bank's obligation to provide superannuation benefits.
(a) Note 1(k) to the Bank's accounts 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 $10,298,000 arising from revaluation of these properties has been credited against Staff Superannuation Fund liabilities".
The revaluation surplus of $10.298M mentioned above was in fact credited in the Bank's profit and loss statement. A lesser amount of $9.8M was charged to the profit and loss statement and credited to the provision for employee entitlements, and $5.177M() of this was credited to the Superannuation Provision. The remainder of the revaluation surplus of approximately $0.5M effectively became part of the Bank's profit for the year.
(b) Note 19 of the Bank's financial statements states, inter alia:
"There are numerous superannuation and retirement benefit plans within the Group ... All defined benefit 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 most recent actuarial review of the superannuation fund was performed as at 30 June 1984.
There is no evidence in the audit work papers that the joint auditors considered whether a calculation of the superannuation liability at 30 June 1989 based on actuarial information generated five years previously was likely to be materially mis-stated, and hence whether the transfer to the superannuation fund provision described in part (a) was sufficient to meet the Bank's obligations. The joint auditors submitted:
"Bank policy as set out in the "Group Accounting Policies" required an actuarial review of superannuation commitments every three years.
In the joint auditors' management letter (Executive Summary) of 15 November 1988 reference was again made to the requirement for [actuarial] 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 dated 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 1989 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."
Division 3 of Schedule 7 of the Companies (South Australia) Regulations, Clause 32 (2)(e), 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."
Details of the most recent actuarial valuation of the Bank's superannuation funds were not disclosed in the Bank's financial statements in contravention of Schedule 7 of the Companies (South Australia) Regulations.
The joint auditors 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 accounts. However, the joint auditors do not see this non-disclosure as material to users of the financial statements nor do they see it as giving rise to an inappropriate audit opinion being given in relation to the financial statements or the Bank for the year ended 30 June 1989." ()
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 taking the asset revaluation surplus of $5.177M to the credit of the Superannuation Provision rather than to the Asset Revaluation Reserve;
(b) the joint auditors did not have sufficient appropriate audit evidence to support their conclusion that the Superannuation Provision was not materially mis-stated; and
(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), and similar errors in prior years, the profit for the year would have been overstated by $9.2M.
The question of whether the accounts of the Bank at 30 June 1989 were as a result materially mis-stated is considered in the section headed "Conclusion" at the end of this Chapter.
51.5.2.8 Matters Noted - Sub-ordinated Debt
During the year ended 30 June 1989, the Bank issued sub-ordinated debt, on two occasions. These were:
(a) $US 150.0M 10 year term issued to South Australian Government Finance Authority in December 1988; and
(b) $US 100.0M 7 years 7 months and 14 days term issued to ANZ Executors & Trustees in March 1989.
There is no evidence in the audit work papers that the joint auditors verified (either directly by confirmation with ANZ or South Australian Government Finance Authority or examination of relevant agreements) the terms of the sub-ordinated debt issues or the balance outstanding at 30 June 1989.
The joint auditors state in their submission () that the audit of capital was considered to be low risk, and as a consequence the audit procedures adopted basically comprised ensuring that the loans had been properly accounted for at balance date, particularly ensuring the debt had been correctly revalued at year end exchange rates, which they considered to be the only area where there may have been some potential risk of mis-statement.
However, the new issues were material in terms of capital resources, with potential for errors in disclosure, and therefore the terms should have been examined for accounting ramifications.
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 obtain sufficient appropriate audit evidence to support the Bank's treatment of the sub-ordinated debt as part of total capital resources, however, I have no reason to believe this failure to obtain appropriate and adequate audit evidence resulted in a material mis-statement in the Bank's accounts.
51.5.2.9 Matters Noted - Interest Income and Expense
(a) Interest accrued
At 30 June 1989 an accrual for $245.5M was made in general ledger account BNK 008387 in respect of interest receivable on treasury instruments.() The amount accrued was agreed to a detailed breakdown in the Bank's sub-ledger report of future maturities of these instruments. There is no evidence that the joint auditors tested the interest accrual calculations in the future maturities report in respect of the amount recorded in account BNK 008387.
The joint auditors' computer specialist reviewed the Bank's Treasury computer systems. He concluded() four days after the audit report had been signed that the computer environment was not sound and could not be relied upon. There is no comment in the audit working papers indicating that the joint auditors relied on the computer systems for the accurate calculation of interest receivable, and in view of the comments of their computer specialist it would have been inappropriate for them to have done so. Accordingly, there is no evidence in the audit files as to how this material accrual of $245.5M was verified by the joint auditors.
The joint auditors have not made a submission on this matter.
(b) Analytical Review Procedures
The joint auditors performed analytical review procedures on a number of the Bank's Corporate, Treasury and Retail products, to gain evidence to support their conclusions as to the completeness and accuracy of income and expenses generated by those products. Significant income and expense categories on which these procedures were carried out included the following:
Treasury - interest income $359.0M
Treasury - interest expense $557.0M
Fully drawn advances - interest income $249.5M
Negotiable certificates of deposit - interest expense $149.9M
Term deposits - interest expense $ 50.1M
Fluctuating overdrafts - interest income $ 39.3M
Cheque accounts - interest expense $ 34.5M
In my opinion, the procedures carried out by the joint auditors in relation to the income and expense categories listed above were not sufficiently detailed and thorough to support a conclusion that income and expense was materially complete and accurate.
Examples of kinds of deficiencies identified by the Investigation in the examination of the analytical review procedures referred to above are as follows:
(i) Treasury Interest Income $359.0M
Interest Expense $557.0M
The analytical review performed() consisted of a calculation of average yields on treasury assets and liabilities for each of the four quarters during the year to 30 June 1989, and review of a schedule of interest income and expense accounts for the year to 30 June 1989, the half year to 31 December 1988 and the year to 30 June 1988. Additionally filed were extracts from the Bank's quarterly operating reviews for Treasury and International throughout the year.
Several deficiencies in this work are evident:
. There is no evidence of any commentary produced by the joint auditors or their staff to explain a number of differences and discrepancies arising in trends of average yields. For example, interest expense average yield on Eurobonds and Euronotes rose from 8.28 per cent in the quarter to March 1989, to 22.7 per cent in the quarter to June 1989. Furthermore, in each quarter average yields of certain assets and liabilities rose compared with the previous quarter, whereas other asset and liability yields fell. These fluctuations and inconsistencies were not explained.
. The commentary provided in the Bank's quarterly operating reviews was not tested for authenticity, and bore only limited evidence of review by the audit manager.
. There is no evidence that average yields had been compared for reasonableness against market indicator rates.
. There is no evidence on the audit work papers that the income and expense amounts listed had been agreed to the trial balance or financial statements.
(ii) Fully Drawn Advances - Interest Income $249.5M
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 and corporate for the year to 30 June 1988, the half year to 31 December 1988 and the year to 30 June 1989.
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 and corporate, Fully Drawn Advances had increased during the year whilst the average yield on business Fully Drawn Advances had `decreased slightly'.
The joint auditors did not adequately explain why their calculated average yield on corporate fixed rate Fully Drawn Advances had increased from 8.1 per cent at 30 June 1988 to 23.1 per cent at 30 June 1989.
This significant increase in the average yield should have also been compared to the average yields on other categories of Fully Drawn Advances which ranged from 13.8 per cent to 15.6 per cent at 30 June 1989.
The following explanations were provided by the joint auditors for fluctuations in the average yield of corporate fixed rate Fully Drawn Advances:()
"... interest rates have increased due to market forces ...
[This was an explanation frequently provided for fluctuations in the average yields]; and
"... the corporate loans dept structures some of its loans with low interest rates and high establishment fees to give favourable tax advantages to its clients and this explains why the interest rate fluctuates."
It was also noted that:
"TR & Co. have performed analytical review on corporate a/cs." ()
The analytical review work performed by Touche Ross & Co on corporate accounts did not, however, include an analytical review of interest income.
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, an effective analytical review of interest income on Fully Drawn Advances should have included calculations and review of average yields on a monthly or possibly weekly basis rather than on a yearly and half yearly basis.
(iii) Negotiable Certificates of Deposit - Interest Expense $149.9M
In performing an analytical review of the interest expense on Negotiable Certificates of Deposit issued the joint auditors calculated an estimated `expense' using the average balance of Negotiable Certificates of Deposit issued for the month and the average yield which was reported in the Monthly Operating Review prepared by the Bank. As the joint auditors simply used the yield rate recorded in the management report, it was hardly surprising that the results of their analytical review was consistent with the balance in the general ledger and management report.
The joint auditors should have ensured that average yields were consistent with those achieved on maturity of the certificates.
The joint auditors have submitted that:
"Analytical review basically involved the comparison of interest income/expense against average asset/liability balances. This was done on either a monthly, quarterly, six-monthly or annual basis, depending on the particular area.
Generally, the joint auditors believe that the results of their analysis were satisfactory in most areas, although insufficient to provide the joint auditors with the level of comfort to enable a reduction in the extent of other substantive audit procedures. The joint auditors' 'risk' approach requires very satisfactory results from 'other substantive analysis' (i.e. analytical review) to reduce the extent of other substantive procedures.
Where little comfort can be gained from analytical review, 'high' other substantive analysis risk is factored into the sample size determination formula, increasing the extent of other substantive testing to compensate for the lack of reliance on the results of analytical review.
Generally, 'high' other substantive analysis procedures were adopted in the 1989 audit. Accordingly, the results of analytical review had no significant impact on the joint auditors' overall audit." ()
However there is no evidence of any "high other substantive analysis procedures" in the audit working papers.
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 and expense referred to above were appropriate and adequate to provide the joint auditors with reasonable assurance that the categories of interest income and expense examined were free of 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.
51.5.2.10 Matters Noted - Other Inadequate Audit Procedures
(a) Third Party Confirmations
The joint auditors state in their submission () that the items selected for comment in this section of the report are not representative of the confirmation exercises carried out for the majority of financial statement captions tested in this way. I acknowledge that there were a number of other areas not mentioned which were completed satisfactorily, however, in my opinion the matters raised in this section still represent inadequacies in the audit procedures.
In examining the audit working papers of the joint auditors, the following matters were noted:
(i) Semi-government securities of $272.0M() were owned by the Bank at 30 June 1989. Circularisation of custodians holding these securities on the Bank's behalf to verify both ownership and value was performed by the joint auditors as at that date, but a poor response was received (12 replies to the 40 confirmations sent).
Floating rate notes of $118.3M() were owned at 30 June 1989, but the custodians were not circularised by the joint auditors.
In each of these cases, alternative substantive procedures were performed which comprised agreement of details, where possible, to the deal confirmation received from the counterparty at the time the asset was purchased. For a number of securities, however, no external deal confirmations were available, and the joint auditors were only able to check against confirmations produced by the Bank.
These procedures were inadequate to provide audit assurance as to the ownership and book value of the assets at the year end. Both semi-government securities and floating rate notes are negotiable assets which could have been sold by the Bank between the date of purchase and 30 June 1989. Such sales would not have been identified by the verification technique employed by the joint auditors.
In view of the poor response to the confirmations sent in respect of semi-government securities, the joint auditors should have followed up non-replies by direct contact with the custodian, either by telephone or writing, to obtain a response to their request. The joint auditors should have also circularised the custodians of the floating rate notes.
The joint auditors submit () that they recognise that both semi-government securities and floating rate notes are negotiable assets which could have been sold between purchase date and year end but that such sales would generate cash which would be captured in the normal course of business by the Bank's accounting systems as securities sales. In addition, no queries were noted on the twelve replies received. Accordingly, the joint auditors believe the procedures carried out were adequate and appropriate and such assets were fairly stated in the Bank's financial statements.
However, these procedures are not sufficient to identify instances of securities being misappropriated or the proceeds of sale of securities being mis-appropriated.
(ii) Foreign currency advances totalling $312.0M were to be audited for existence and accuracy by selecting a statistical sample of 19 balances (77 per cent of the total by value) for confirmation with the borrowers.
A memorandum on the audit working papers() dated 4 October 1989 stated:
"At 30/6/89 client had considerable difficulty in locating documentation in relation to these advances."
This memorandum was preceded by a file note dated 21 August 1989 by Mr M Penniment, stating:
"Due to the difficulty in locating documentation sample of 4 vouched by alternative procedure rather than confirmation." ()
The four items audited by alternative procedures accounted for approximately $20.0M, or only six per cent by value, of the foreign currency advances balance. This compares with an expected coverage of 77 per cent, had all of the items selected for third party confirmation been sent and responses received.
The fact that the Bank's staff were having `considerable difficulty' in locating the necessary documentation to enable the planned circularisation to take place should have increased the joint auditors' concerns as to the validity of this balance. It was inappropriate that alternative procedures were performed on only four of the nineteen items selected. This reduction in testing meant that the joint auditors did not gain the level of assurance as to the existence and accuracy of this balance which, according to their calculations of sample size, they required.
In the joint auditors submission() they state that the existence of recorded foreign currency advances was considered to be a low risk area and accordingly the joint auditors exercised their judgement in reducing the original sample selected for confirmation. No exceptions were noted from the alternative procedures taken.
(iii) Foreign Exchange Money Market Deposits totalled $939.9M at 30 June 1989.() Of this balance, accounts totalling $816.7M were identified as suitable for testing by circularisation. There is no evidence to indicate how the remaining balance of $123.2M was audited. A sample of forty four items (not quantified in the audit work papers) was selected for confirmation with depositors, of which thirty four items were designated individually significant and hence automatically chosen, and ten items were chosen from the remaining balances.
Only one response from the thirty four individually significant items was received, and in total only about $8.0M was confirmed, less than one per cent of this category of deposits. Alternative procedures were said to have been performed on all non replies, but a lack of detail in the audit work papers prevents identification as to what these procedures were and an assessment of their adequacy. There is no evidence that the work papers which document the items selected for testing, and the alternative procedures said to have been performed, were reviewed by an audit manager or partner.
The response rate was very low for this type of confirmation procedure, and should have alerted the joint auditors to the possibility of error or irregularity. There was no evidence in the audit working papers that the reason for the failure of the confirmation procedure had been addressed.
In my opinion, if such matters had been considered by the joint auditors, the failure to document them in the working papers would, having regard to applicable Professional Standards and Practices,() constitute an inadequacy in the audit procedures.
The joint auditors submit that:
"... the alternative procedures adopted were to vouch the transaction to the deal docket and counterparty confirmation. While the workpapers do not evidence review by an audit manager or partner all other related workpapers in that section were signed by the audit manager. It is confirmed that these workpapers would have been reviewed by the audit manager.
There were considerable delays experienced by the joint auditors in having reports run and obtaining information to be confirmed before the confirmation were sent out around 28 July 1989. The low rate of response was due to the delay in sending out the confirmation. No errors were noted from the replies received." ()
(iv) The joint auditors sent confirmation letters to third parties who were holding debentures on behalf of the Bank. A reply was received from Permanent Trustee Company Limited() dated 14 July 1989, addressed to L K Hall (Senior Manager, Finance) which indicated that they were unable to confirm the details requested. The debenture in question had a face value of $5.0M(). One of the joint auditor's staff had noted on the letter from Permanent Trustee:
"NEED TO FOLLOW UP"
There is no evidence that the matter was followed up.
The joint auditors did not make a submission on this matter.
Having taken into account the submissions made by the joint auditors and noted above, I am still of the opinion that the audit evidence obtained in relation to the third party confirmations process in respect of the accounts noted above was inadequate for its intended purpose.
(b) Disclosure Issues
(i) Directors' Remuneration
There was incomplete disclosure of related party transactions in the 1989 financial statements, despite the fact that there was a requirement for full disclosure under the Professional Accounting Bodies' Statement of Accounting Standards AAS22 "Related Party Disclosures" (issued June 1988).
Specifically, the financial statements do not disclose details of directors' remuneration. Disclosure of these details is a requirement of AAS22, paragraph 30, and the Companies (South Australia) Regulations, Schedule 7, Clause 24.
Peat Marwick Hungerfords had listed AAS22 as one of a number of:
"... new accounting pronouncements affecting the client ..."
and as:
"Accounting matters requiring specific attention."
in their Planning Memorandum.()
Touche Ross & Co's audit work papers() contained a copy of an internal memorandum from Mr A G Siebert, Manager, Finance Accounting, dated 22 June 1989, to other departments in the Bank and other group companies, and with copies to Mr Hallion and Mr Penniment, the audit managers. The following comment with regard to related party disclosures was included as item 4 in the memorandum:
"The Auditors have agreed that due to the current confusion over Related Parties and the differences between the AAS22 and the proposed "Approved Accounting Standard" we will not be required to disclose information under this standard this year."
A Peat Marwick Hungerfords (internal) Accounting and Audit Bulletin, AAB 89/7, July 1989 indicated that media releases from the Professional Accounting Bodies provided exemptions to companies governed by the Companies Code from some of the requirements of AAS22, dealing with disclosures in respect of directors, to the extent that its requirements were contrary to the requirements of Schedule 7 to the Regulations of the Companies Code. The other requirements of AAS22 were not affected by the exemptions.
Not being a company it can be argued that the Bank should have complied with all of the requirements of AAS22 or alternatively if the Bank sought to rely on the fact that it did comply with Schedule 7 it should at least have complied with all of the requirements of AAS22 except those dealing with directors.
For reasons set out in Chapter 46 - "The External Audits of the State Bank : Background Information" this lack of disclosure could have rendered the audit report misleading because it states that the accounts comply with Section 269 of the Companies (South Australia) Code, Australian Accounting Standards and Applicable Approved Accounting Standards.
The joint auditors submit that the non-disclosure of related party transactions is not material to a user of the accounts other than the shareholder, and that the shareholder had access to that information if it so desired.
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 statement. 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 disclose 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 J H Richardson of KPMG 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.
(ii) Sub-ordinated Perpetual Debt
In June 1988, the Bank issued sub-ordinated perpetual debt with a face value of $US 150.0M. Although this sum was borrowed in the first instance from the investors, approximately $US 43.0M was held by an independent intermediary, the Bank receiving only $US 107.0M. The interest payable on the face value of the loan together with earnings from the investment of the $US 43.0M provided for both the repayment of the $US 150.0M over fifteen years together with an appropriate return to the investors. Although the borrowing was nominally perpetual the arrangements described above effectively repaid the investors over a fifteen year period.
The "interest" payable on the loan's face value of $US 150.0M was charged as such in the Bank's Profit and Loss Statement, whereas a portion of it was in reality a part repayment of the $US 107.0M loan funds actually received by the Bank. This led to an understatement of the Bank's profit for 1989, but it is not possible to estimate the extent of this understatement based on information contained in the work papers.
Chapter 50 - "Review of the 1988 External Audit of the State Bank", under the heading `Disclosure Issues', details the structure of the issuance of this debt, and concludes that the joint auditors failed to give due consideration to the disclosure of the nature of the transaction and the appropriateness of the method of accounting adopted.
There is no evidence that either the financial statements presentation or the accounting treatment adopted for this sub-ordinated perpetual debt was reconsidered by the joint auditors when forming their opinion on the Bank's 1989 accounts.
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 105.0M 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 is misleading to describe the borrowing as "perpetual" and to classify it within total capital resources.
In my opinion, the debt was not in substance "sub-ordinated", because the debt, along with all other liabilities of the Bank, were 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.
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 appropriate and adequate 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) semi-Government securities;
(ii) floating rate notes;
(iii) foreign currency advances;
(iv) foreign exchange money market deposits;
(v) debentures; and
(vi) off-balance sheet treasury products,
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 total capital resources 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 total capital resources were materially mis-stated; and
(iii) the joint auditors wrongly accepted the non-disclosure by the Bank in its accounts of details relating to the remuneration of 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 1989 were as a result materially mis-stated is considered under the heading "Conclusion" at the end of this Chapter.
51.5.3 CONCLUDING PROCEDURES
51.5.3.1 Preamble
Chapter 46 - "The External Audit of the State Bank: Background Information" sets out background information on appropriate audit procedures in this area and applicable professional standards.
51.5.3.2 Matters Noted - Subsequent Events Review
The joint auditors did not adequately document the work they performed on events occurring subsequent to balance date and up to the date of signing their report on the Bank and Group accounts for the year ended 30 June 1989. Accordingly, there is inadequate evidence in the audit work papers that an appropriate subsequent events review was performed.
The Peat Marwick Hungerfords' Permanent File of (1989) pro forma audit programmes contains a `Substantive Audit Programme - Events Subsequent to Date of Accounts' which covers a number of appropriate subsequent events procedures. However, there is no programme in the audit files which is completed and cross referenced to relevant work papers where the joint auditors documented any such work they performed.
Minutes of Board meetings up to 27 July 1989 (signed) and 9 August 1989 (unsigned) were reviewed, but apart from that the only evidence of a subsequent events review of the Bank being performed is the signing off of the procedure in the Peat Marwick Hungerfords Completion Memorandum which related to the requirement for a subsequent events review. Although the subsequent events review had been signed off as having been performed there was no cross reference to other work papers where any audit work performed had been documented.
The joint auditors submit() that as a subsequent events review is principally an exception review, there is generally only a limited requirement for the preparation of formal audit workpapers to support the procedures performed. Formal workpapers would normally only be prepared where exceptions do arise (ie where matters are identified after balance date which may have a significant impact on the financial statements).
Usually, the only documentation on file would be minutes of directors' meetings, management representations (both general and specific if required) and solicitors' representations (if obtained). This type of documentation is normally filed in different sections of the audit files.
The consideration of subsequent events is ongoing throughout the audit process and effectively forms part of the audit procedures in all significant areas of the client's business. With a stringent audit deadline such as that of the State Bank of South Australia, the audit procedures are performed right up until the time the joint auditors are in a position to give audit clearance.
This was particularly the case with the review of the high risk area of doubtful debts provisioning where any matter arising since year end in relation to the exposures reviewed during the audit, as well as any matters impacting the loan portfolio generally, would have been taken in consideration when determining the adequacy of doubtful debt provisioning.
The sign-off of the completion memorandum provides evidence that the joint auditors were satisfied that all matters relevant to the subsequent events review had been properly attended to.
I have considered the submission of the joint auditors, however despite the matters raised in the submission the audit workpapers do not evidence any such procedures being carried out.
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 perform appropriate and adequate audit procedures resulted in a material mis-statement in the Bank's accounts.
51.7 CONCLUSION
In my opinion, the audit opinion expressed by the joint auditors on the accounts for the year ended 30 June 1989 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 adequately deal 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 Bank's Provision for Doubtful Debts was understated by at least $22.0M;
(d) the Provision for Self Insurance of $5.7M was materially mis-stated;
(e) the Bank's operating profit and extraordinary items after tax was overstated by $15.5M due to the statutory State Government charge in lieu of income tax being treated as a distribution of profit;
(f) as a consequence of cumulative asset revaluation surpluses of $9.2M wrongly being credited to the Provision for Superannuation, the Asset Revaluation Reserve was materially understated and it is likely the Bank's profit for the year was materially overstated; and
(g) the Bank's total capital resources were materially overstated by the inclusion of "sub-ordinated perpetual debt" of about $134.5M.
By reason of the foregoing, the joint auditors' opinion that the accounts and group accounts for the year ended 30 June 1989 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 (f). First, items (c) and (d) were, in my opinion, material in relation to the Bank's reported profit for the year of $78.5M before tax. Second, item (e) was material in relation to the Bank's after tax profit of the same figure. Third, item (f) was in my opinion material by its nature, and in relation to the Bank's reported reserves of $57.3M and likely impact on reported profit. Fourth, item (g) was material by its nature, and in relation to the Bank's reported total capital resources of $1,312.7M.