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

 

 

CHAPTER 52
REVIEW OF THE 1990 EXTERNAL AUDIT
OF THE STATE BANK

 

 

TABLE OF CONTENTS

52.1 PURPOSE OF CHAPTER

52.2 PLAN OF CHAPTER

52.3 BUSINESS OF BANK AND BANK GROUP
52.3.1 THE BANK
52.3.2 SUBSIDIARIES

52.4 ACCOUNTS OF BANK AND BANK GROUP

52.5 INVESTIGATION OF THE AUDIT PROCESS
52.5.1 PLANNING OF THE AUDIT
52.5.1.1 Matters noted
52.5.1.2 Conclusion
52.5.2 EXECUTION OF THE AUDIT
52.5.2.1 Preamble
52.5.2.2 Matters Noted - Treasury and International
52.5.2.3 Matters Noted - Corporate Lending
52.5.2.4 Matters Noted - Provision for Doubtful Debts
52.5.2.5 Matters Noted - Provision for Taxation
52.5.2.6 Matters Noted - Provision for Self Insurance
52.5.2.7 Matters Noted - Superannuation Provisions
52.5.2.8 Matters Noted - Interest Income and Expense
52.5.2.9 Matters Noted - Other Inadequate Audit Procedures
52.5.3 CONCLUDING PROCEDURES
52.5.3.1 Preamble
52.5.3.2 Matters Noted - Concluding Procedures

52.6 CONCLUSION

 

 

 

52.1 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 1989-90 and significant features of the statutory accounts in respect of the 1989-90 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 1990. The Chapter also concludes as to the appropriateness and adequacy or otherwise of the audit process undertaken.

 

52.2 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; and

(i) Planning of the Audit;

(ii) Execution of the Audit; and

(iii) Concluding Procedures.

(d) Conclusion.

 

52.3 BUSINESS OF BANK AND BANK GROUP

 

52.3.1 THE BANK

The Bank operated a network of 182 branches and 305 agencies including international branches and offices in London, New York, Hong Kong and New Zealand. The Bank's corporate banking section completed project financing for the REMM Group's Myer Centre in Adelaide. This major retail project development is examined in detail in Chapter 14 - "Case Study in Credit Management: The REMM Group" of my First Report.

52.3.2 SUBSIDIARIES

On 29 June 1990, the Bank purchased in New Zealand the United Banking Group Limited and all of its subsidiaries. The due diligence process undertaken by the Bank in relation to the acquisition of the United Banking Group Limited is examined in detail in Chapter 18 - "Case Study in Acquisition Management: The United Building Society" of my First Report.

The Beneficial Finance Group's profit decreased by $25.3M (84.3 per cent) over the previous year to $4.7M while total reported assets increased by $424.2M (18.9 per cent) to $2,674.6M.

 

52.4 ACCOUNTS OF BANK AND BANK GROUP

 

On 23 August 1990 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 1990. 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

1989
$M

1990
$M

1989
$M

1990
$M

Per Cent
Increase
(Decrease)

Profit and Loss Statement

Income

1,364.0

1,759.0

1,727.1

2,258.0

31

Operating Profit

Before Tax

78.5

35.9

97.0

(0.4)

(100)

After Tax and Extraordinary Items

78.5

35.9

90.8

24.1

(73)

Balance Sheet

Assets

Loans, Advances, Receivables

7,959.8

11,123.6

10,269.2

14,758.0

44

Other

4,728.4

6,176.2

4,759.8

6,384.1

12,688.2

17,299.8

15,029.0

21,142.1

41

Liabilities

Deposits and Borrowings

8,833.8

13,357.9

10,888.4

16,684.1

53

Other

2,541.7

2,603.2

2,784.3

3,076.7

11,375.5

15,961.1

13,672.7

19,760.8

45

Net Assets

1,312.7

1,338.7

1,356.3

1,381.3

2

Capital, Subordinated Debt, Reserves

1,312.7

1,338.7

1,356.3

1,381.3

2

Doubtful Debts

Expenses for the Year

56.6

168.4

71.3

218.4

206

Provision at Balance Date

77.2

175.4

108.3

265.6

145

 

52.5 INVESTIGATION OF THE AUDIT PROCESS

 

52.5.1 PLANNING OF THE AUDIT

52.5.1.1 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. A reference in the Audit Approach Memorandum() for the year ended 30 June 1990 states:

"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 the enhanced system of internal control."

In their submission dated 2 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 (ALPS), [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" AUP4-1, more particularly paragraphs 17 and 18. The fact that an auditor may choose not to rely on controls does not necessarily indicate that those controls are inadequate for the business. The auditor is under no obligation to form such an opinion.

... the following summarises the approach adopted ... [in relation to computer controls]

. A preliminary evaluation of EDP general controls was completed;

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

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

This approach is 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.

52.5.1.2 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.

52.5.2 EXECUTION OF THE AUDIT

52.5.2.1 Preamble

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

52.5.2.2 Matters Noted - Treasury and International

(a) Fixed Interest Securities

The audit approach in respect of Fixed Interest Securities, which amounted to $234.0M was documented as follows:

"The planned approach to this section included a confirmation exercise at 31/5/90. Due to the fact that the client was not able to provide accurate information regarding the securities selected for confirmation, many of the confirmation requests were unsuccessful.

In view of the above, the following alternative approach was adopted. It is focussed on verification of balances at year end rather than those at 31/5/90.

(i) Balances successfully confirmed as at 31/5/90:

review and determine whether any movement has occurred between 31/5/90 and 30/6/90. Where no movement, accept 30/6/90 balance as effectively confirmed. [$77.0M tested in this way]

(ii) Confirm at 31/5 unsuccessful due to securities being with Austraclear:

obtain Austraclear portfolio listing at 30/6 and check off against KAPITI as at 30/6. (100%) [$61.0M tested in this way]

[Austraclear is an independent company which acts as a central clearing and storage agency for government issued discount securities. Many trading operations do not take physical delivery of securities which they purchase but lodge them with Austraclear.]

(iii) Non responding confirms as at 31/5:

review to determine whether any balance at 30/6 - if so, vouch 30/6 balance to deal slips/counterparty confirmations. Where no balance at 30/6: NFA [$25.0M tested in this way]

The result is that as at 30/6/90 we have confirmed $162,807,000 out of the total of $234,959,000 or 69%." ()

The confirmation exercise carried out as at 31 May 1990 sought to confirm the Bank's holdings with registrars of the fixed interest security (that is, the organisation nominated by the issuer of the security to maintain a register of holdings) and with counter parties from whom the Bank had purchased the security.

The audit approach adopted is deficient in a number of ways:

(i) Certain of the balances confirmed as at 31 May 1990 were confirmed with the counterparty who sold the security to the Bank, and the testing of balances at 30 June 1990 included tracing a sample of purchases to deal slips. The prime objective of audit work in the area of securities is to establish that the securities are owned by the Bank as at the date of the accounts. This objective is not achieved by confirming the purchase details. The joint auditors failed to recognise that their techniques did not enable them to achieve the prime objective as they were unable to identify securities which were sold to a third party between the date of purchase and the year end.

(ii) No further audit work was performed on the securities which were confirmed as at 31 May 1990 and which were still included in the ledger as at 30 June 1990. As a result, the joint auditors would not have identified securities which were held at 31 May but sold prior to 30 June. For the joint auditors' technique to be acceptable the controls in this area of the system would have to be satisfactory, and the joint auditors should have carried out roll forward procedures to review movements in investments between confirmation date and balance date. This aspect is discussed later in this Chapter, in the Section headed "Other Inadequate Audit Procedures: Confirmation Requests of balances at Dates other than balance date".

The joint auditors submit "that the Bank maintains most of its files of supporting documentation to transactions in counterparty order rather than in transaction type or date order. Accordingly, the substantive procedures of going to the counterparty deal slips and confirmations to vouch the purchase of assets necessitated a review of all documentation on the file. Given the files contain all the supporting documentation for both the purchase and sale of assets by counterparty, the substantive procedures would have had a high probability of detecting instances where asset purchases had also been sold prior to 30 June." ()

In making this assumption the joint auditors are placing reliance on the Bank's system for filing of documentation in respect of sales. In my opinion it is inappropriate for the joint auditors to rely on this system of filing to provide assurance that the information contained in the transaction files is appropriate for audit purposes. Furthermore, in my opinion, failure to document such an important element of the audit procedures constitutes a deficiency in the audit procedures.

(b) Floating Rate Notes

There is insufficient evidence in the audit work papers that the following assets were audited so as to confirm their existence, that they were owned by the Bank and that their carrying value was not materially misstated.

(a) Floating Rate Notes (Int'l)() $57.0M

(b) Floating Rate Notes (Aust)() $52.0M

An important audit procedure in respect of the floating rate notes should have been either a physical examination of the securities on balance date if held on the Bank's premises, or, the obtaining of a certificate from independent custodians as to their holding on behalf of the Bank at balance date.

An important submission the joint auditors state that() the audit approach adopted was to agree details of the "International" floating rate notes to counterparty confirmations (ie those confirmations received at the date of purchase verifying the purchase of the Floating Rate Notes by the Bank). The joint auditors further submit() that the Bank maintained many of its files of supporting documentation in counterparty order rather than transaction type or date order, and hence in tracing the details to the supporting documentation these procedures would have had a high probability of detecting instances where asset purchases had been sold prior to 30 June.

In making this assumption the joint auditors are placing reliance on the Bank's system for filing of documentation in respect of sales. In my opinion it is inappropriate for the joint auditors to rely on this system of filing to provide assurance that the information contained in the transaction files is appropriate for audit purposes. Furthermore, in my opinion, failure to document such an important element of the audit procedures constitutes a deficiency in the audit procedures.

The joint auditors further submit() that they formally requested information from the Sydney office in respect of a number of matters including documentation supporting the balance of Australian Floating Rate Notes. The memorandum requesting the information was sent on 21 August 1990 and no answer was received prior to the signing of the accounts on 23 August 1990. When an answer was finally received from Sydney in late September 1990 no information regarding the Australian Floating Rate Notes was included in the response. The joint auditors did however consider that the amount of audit work performed in respect of Floating Rate Notes in total was adequate.

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 abovementioned 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.

52.5.2.3 Matters Noted - Corporate Lending

The Bank's corporate commitment register was used extensively by the joint auditors in the audit of corporate lending for the year ended 30 June 1990. During the course of the audit the joint auditors became aware of several problems with the new corporate commitment register that had been introduced during the year, including:

(a) In a memorandum dated 7 August 1990 from Mr Van Ruth of Touche Ross & Co to the joint auditors concerning the review of internal audit reports in the information systems area, the following comments were noted concerning implementation of the new corporate commitment register.

The conclusion reached by Internal Audit was :

"... the controls over programme change management, testing and implementation of the register are inadequate to enable assurance to be gained from programmed application controls." ()

"AUDIT to ensure that no inadvertent reliance is placed on the computer system or the reports it produces" ()

(b) Several significant exposures were not recorded on the commitment register or were incorrectly recorded. These included Waltham Cross Pty Ltd $100.0M() and John Fairfax Group $43.49M.()

The joint auditors have submitted that these errors were highlighted by them in their checking/reconciliation procedures and that the exposure to Waltham Cross was covered in their doubtful debts review at 30 June 1990.()

(c) The commitment register was not reconciled to the general ledger at April or May 1990 when used for third party confirmations and credit review purposes.()

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.

The importance of the reconciliation was evidenced by the joint auditors in their letter dated 3 May 1989 to Mr K L 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 ...".

The joint auditors submitted that the risk of omission in the months of April and May 1990 was mitigated by the fact that the register was used and relied upon by management, and that the joint auditors could gain some assurance from this as to the overall reliability of the report.() In my opinion, it was inappropriate for the joint auditors to rely on management's use of the register as providing assurance that the information contained in it would be complete and accurate for audit purposes.

(d) When the commitment register was reconciled to the general ledger at 30 June 1990 there were significant reconciling items and some residual unexplained differences.()

The audit papers noted:

"Numerous errors were noted on the individual reconciliations ... Due to complexity of exercise it wasn't surprising that some reconciliations resulted in unexplained differences." ()

The joint auditors submitted that the net unexplained difference arising from the June 1990 reconciliation was only $2.71M out of principal commitments of over $3.0B, and that no significant difference between June 1990 and earlier months was indicated.()

Furthermore, the joint auditors submitted that the reconciling items were reviewed to ensure that they did not impact on the May 1990 accounts selected for confirmation() and that by reperforming/reviewing the reconciliation at June 1990 sufficient assurance was obtained so that the commitment register could be used as a "selection source".()

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 Corporate lending, 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.

52.5.2.4 Matters Noted - Provision for Doubtful Debts

The provision for doubtful debts appearing in the Bank's 30 June 1990 accounts, of $175.362M, comprised the following:

(a) specific provision of $136.113M, relating to an assessment of recoverability of individual loans; and

(b) general provision of $39.249M, 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) Joint Auditor's Conclusions on Provisioning Prior to 30 June 1990

30 June 1989

As noted in the preceding Chapter, the auditors reported to the Managing Director by letter dated 18 August 1989 that, although provisions were acceptable to the joint auditors for audit purposes, the level of provisioning was in their opinion the minimum required.

31 December 1989

Prior to finalisation of the 31 December 1989 accounts the Bank became aware that they were significantly under provided in the area of provisions for doubtful debts. In addition a sale and leaseback transaction was proposed by Bank management (Mr Copley) during December 1989 which would have resulted in recognition of approximately $37.0M extra profit for the group from a transaction whereby the form of the arrangement met the requirements of an operating lease but the substance was that no change in ownership occurred. After lengthy discussions with Peat Marwick Hungerfords technical section it was decided that Peat Marwick Hungerfords could not accept the recording of profit on the transaction.

A file note by Mr T J Whimpress dated 20 December 1989 stated:

"K.L.C. rang back later in the morning to say that he had talked to T.M.C. and they had also decided to seek an independent accounting opinion. In order to take the strain of 31/12 deadline away from the transaction, he asked if we would be concerned if:-

(a) The transaction, when and if cleared, took place in the New Year, but

(b) For the purpose of 31/12 profit reporting, the Bank took up only its budgeted additional provision for doubtful debts.

He understands that we are not signing an audit report at 31/12/89 but would want us to state to the Board only that "budgeted doubtful debt provisions have been picked up at 31/12/89 on the clear understanding that whatever provisions are necessary will be made at 30/6/90" rather than any statement that doubtful debts are under provided by $?M at 31/12/89.

I discussed this with Bruce Edwards at TR & Co in Melbourne, and later confirmed to KLC that we would accept this approach." ()

Mr Copley issued a confidential memorandum to various Bank management personnel which confirms the understatement of the provision for doubtful debts. The memorandum states:

"Further to the paper prepared following the last Lending Credit Committee, it has been agreed that the "extra allocation" will not be taken up in the six months ended 31st December 1989.

Specifically, if we don't take up the extra specific provision indicated for Equiticorp Corporate $28,000,000, Equiticorp N.Z. $3,188,533, Health and Life Care $4,000,000, then our total provision required at 31st December should equate to our provision, after allowing for some growth in December assets.

Please ensure the above is reflected in the 31st December 1989 accounts." ()

Accordingly, the half year accounts to 31 December 1989 did not include substantial extra specific provisions of approximately $35.0M which the Lending Credit Committee had approved.

The only Board member who was also a member of the Lending Credit Committee at the time this decision was made was Mr T M Clark. Accordingly, it was likely that Mr Clark was the only director who was aware of the significant underprovision as at 31 December 1989.

According to Appendix 1 to the report written by the joint auditors on 1 March 1990 to Mr K S Matthews, Chief General Manager, Group Risk Management, of the Bank, the joint auditors were aware that the accounts for the half year were substantially underprovided. The joint auditors have submitted that they drew this matter to the attention of Mr Copley and Mr Matthews, who agreed that there was scope for further provisioning at 31 December 1989.() The joint auditors submitted that Mr Copley and Mr Matthews advised the joint auditors that, in their opinion, any further provisioning in the second half of the year would be off-set by profits expected to emerge in that period.() The Investigation has not sought comment from Mr Copley and Mr Matthews with respect to that matter, and no finding is made concerning them.

Submissions have been made on behalf of certain former Non-Executive Directors that the Board did not receive a copy of the report from the joint auditors dated 1 March 1990 and that the Board were unaware that the half year accounts were substantially underprovided.()

The joint auditors have submitted that they "are unable to comment on the extent of knowledge of any of the directors as to underprovisioning as at 31 December 1989." ()

In my opinion, the above matters raised questions about the objectivity and reliability of management with regard to provisioning which the joint auditors should have brought to the attention of the Board.

(b) Remm Group Ltd - drawn Exposure $197.1M

Inquiries of the joint auditors

The Myer centre in Adelaide was being developed, constructed, and managed by the Brisbane based Remm group. Total facilities for this project were $580.0M, $360.0M of which were syndicated prior to 30 June 1990 with first ranking security, known as the "A" facility.

Facilities provided by the Bank totalled $290.0M which included the entire $190.0M second ranking "B" facility, participation of $70.0M in the "A" facility syndication, (due to other banks withdrawing at a late stage) and $30.0M sundry other exposures.

The facility covered development costs during construction and the anticipated interest servicing shortfall (ie interest less rentals received) up to the "A" facility re-payment date of 31 March 1992.

At 30 June 1990 the $360.0M "A" facility was drawn to $188.4M (of which the Bank had advanced $36.6M), the $190.0M "B" facility was drawn to $142.0M and the $25.0M "C" facility was drawn to approximately $18.5M. It is not clear from the audit workpapers whether the $5.0M "D" facility (overdraft) was in use at 30 June 1990. The total amount drawn down was $348.9M (of which the Bank had advanced approximately $197.1M).

As at 30 June 1990 the only valuation available for the development was that prepared by Colliers on 1 May 1989 and confirmed in December 1989.() This opinion was that an "on-completion" market value as at September 1990 would be $557.0M. The anticipated completion date of September 1990 was in July 1990 pushed back to December 1990 on account of various delays in the construction program.

At 30 June 1990 the facility "A" and "B" drawdown schedule indicated that the maximum usage on completion would be $545.2M.() Assuming no additional usage on the $30.0M "C" and "D" facilities, beyond the $18.5M drawn down, total debt would reach $563.7M.

The joint auditors submitted that they reviewed the position concerning the Bank's exposures on the Remm project in the period January to July 1990 because it was such a significant exposure of the Bank, and not because it was considered doubtful.() The joint auditors monitored the progress of syndication arrangements which were finalised in March and April 1990.() The joint auditors noted that the first drawdown under the syndicated "A" facility took place on 18 June 1990.() The reasons for the delay are noted in Chapter 14 - "Case Study in Credit Management: The REMM Group" of my Report published 31 March 1993.

The joint auditors did not consider the Remm exposure as a possible doubtful debt at 30 June 1990. Mr B H Edwards gave evidence that he took the view that interest to accrue to the Bank after 30 June 1990 should be excluded from the total project exposure for the purpose of the joint auditors satisfying themselves that the Bank's exposure would be covered by the anticipated "on-completion" market value.() The reason for this was that the Bank could suspend the accrual of interest due to it if the recoverability of its exposure was considered unlikely. I accept that it was and is generally accepted accounting practice to approach doubtful debt provisioning on this basis.

Mr Edwards gave evidence that the Bank was not of the view that the recoverability of the Bank's exposure was considered doubtful.() While I do not consider that the joint auditors should have been overly influenced by the Bank's views, I note that Mr S G Paddison, Chief General Manager, Australian Banking, had informed the Under Treasurer of the State on about 31 August 1989 that on current projections there would be a substantial principal loss on the project.() The Investigation also noted that the Remm exposure was discussed by the Chairman and Managing Director of the Bank on 23 April 1990, who appear to have contemplated that a loss could occur, although they apparently considered that any loss would not crystallise until the "A" facility repayment date in 1992.() It is not suggested that the joint auditors knew, or ought to have known, of those matters.

Mr Edwards said in evidence that it was obvious from a casual inspection of the project drawdown schedule, work paper 10572, that the anticipated total project exposure obviously included a very great amount of interest due to the Bank in future, which the Bank could cease to accrue if any doubt should arise as the recoverability of its exposure.() The joint auditors submitted that from a casual inspection of the project drawdown schedule there was $137.0M future interest due to all lenders, including the Bank, and the margin of cover implied by that figure was obviously so great that it did not require further documenting.() The joint auditors submitted that the amount of interest due to the Bank was properly calculated as being $65.0M, so that when the total project exposure is reduced by this, there would be a surplus of $58.0M, or 11.6 per cent.()

On 19 May 1993 Mr B Lander QC, Counsel for the joint auditors, submitted to the Investigation that not only should future interest due to the Bank be excluded but, because the valuation being used was as at completion date, post-completion interest accruing to other lenders should also be excluded.() Mr Lander pointed out that the drawdown schedule included the period after completion of the centre up to the due date for repayment of the "A" facilities on 31 March 1992. He submitted that on this basis the full $137.0M future interest must be excluded, and the margin of cover would therefore be in the order of 30 per cent.() Mr Lander was quite frank in stating that the joint auditors had not thought of the argument about post-completion interest until then.()

The drawdown schedule appearing as work paper 10572 indicates that the $137.0M future project interest is comprised of pre and post-completion components, and that each is comprised of interest due to the Bank and interest due to other "A" syndicate lenders. The figure of $65.0M future interest due to the Bank identified by the joint auditors in their December 1992 submission can in my opinion be excluded even though it includes pre and post-completion components. However, in my opinion Mr Lander is not correct in saying that the entire balance of the $137.0M future interest can be excluded, because, some of it, about $14.0M, would accrue to other secured lenders prior to completion of the project. The syndicated lenders rank ahead of most of the Bank's exposure.

The joint auditors also appear to have overlooked that the drawdown schedule included a credit of $56.7M for post-completion rental. Accordingly, if one excludes post-completion interest, due to the non Bank lenders, then one should also exclude post-completion rental.

In my opinion, if the joint auditors had properly calculated the anticipated capital exposure on completion of the project, they would have arrived at the following figure:

$M

"A" and "B" Facilities Total as per drawdown schedule

545.2

Sundries facility drawdown as at 30 June 1990

18.5

563.7

Future interest due to the Bank ($65.0M) and
post-completion interest due to the other lenders ($58.0M)

123.0

440.7

Add back post-completion rentals

56.7

497.4

The joint auditors submitted that there was such an obviously great margin of cover that it was not necessary for them to pursue the matter any further. Calculated as above, however, the margin was $60.0M or 10.6 per cent of the $557.0M valuation. In my opinion, the margin of cover was not so great as to assure a reasonably component auditor that he need not give any consideration either to the prospect of cost overruns or to the reasonableness of the valuation.

Possible delays in Completion

There is a copy of a letter in the audit working papers from Mr P Wilkinson, Managing Director, Myer Stores Limited to Mr M Brown, Managing Director, Remm Group Limited dated 27 June 1990 which states:

"Mike, I must privately re-iterate to you my deep misgivings that we have a realistic opportunity to open the Centre and our store on 3 December, 1990. It does appear to me that your team are hoping for best case outcomes over all issues during the period ...". ()

Mr Wilkinson went on to say:

"Myer Stores Limited will not accept any risk attached to them as a result of provisioning or moving to set up the store should the opening date need to be aborted. We recognise a need to minimise the potential cost of an aborted December opening but indicated to you that the minimum likely exposure will be in excess of $5M.

It will therefore be necessary for us to establish the absolute level of exposure and write that into a separate agreement with your company that zeros our responsibility and transfers it to you in the event of failure to open." ()

Another letter on file, from Mr R Wright, Director, Remm Group Limited to Mr P Baldwin, Group General Manager - Property and Development, Myer Stores Limited dated 29 June 1990 states:

"... the latest date Myer will open prior to Christmas is 3 December 1990 ... if Remm commit to 3 December 1990 and do not open, it would cost Myer somewhere between 5 and 12 million dollars or even more ...".()

Given the concerns expressed by the anchor tenant in the centre, the joint auditors should have made detailed enquiries to assess the impact to the Bank of a delay in completing the centre.

A review of the Bank's Board docket prepared for the Board meeting of 26 July 1990 reveals:

"Remm considers inclement weather to be the only major variable preventing it from achieving the target of a pre-Christmas opening." ()

An independent opinion as at 4 July 1990 indicated that the project was four days behind schedule and that a further six days had been lost due to inclement weather:

"Remm believes it can recover the time lost to date and provided further delays do not exceed 15 - 20% of the time remaining, completion within the period 25 November to 10 December is still achievable."

"Meetings have been held with Myer who also support a pre-Christmas opening and are prepared to reduce the required stockout period from 50 to 14 days provided the centre opens no later than 10 December 1990." ()

Clearly prior to the end of July 1990 some slippage was evident and failure to open prior to Christmas should have been regarded as a real possibility. The joint auditors have submitted that they were entitled to rely on the independent opinion that a pre-Christmas opening was achievable.() In my opinion, however, the joint auditors should have considered the implications of further delay on the margin of cover between the on-completion valuation and the Bank's exposure on the project, but the joint auditors failed to do so.

Reliance on Colliers Valuation

The joint auditors knew in July 1990 that management of the Bank were reviewing progress of the project on a daily basis because of the significance of the exposure.() The joint auditors knew, or ought to have known, of the project's labour and sub-contractor problems and the delay encountered with the construction program. The joint auditors knew there were concerns whether the project would be completed by December

1990.() The joint auditors knew that the Bank had classified the Remm account as "limited financial strength, vulnerable to market conditions, unreliable cash flow, doubtful or second class security".()

I have had regard to the following professional standards and practices. Statement of Auditing Standards AUS1, paragraph 18, requires an auditor to obtain reasonable assurance that work performed by an expert is adequate for the auditor's purpose. Auditing Practice Statement AUP22 "Using the Work of an Expert" provides some guidance as to the auditor's responsibility in relation to using the work of an expert. The following extracts are relevant:

"12. The auditor should seek reasonable assurance that the expert's work constitutes appropriate audit evidence in support of the financial information, by considering:

(a) the source data used;

(b) the assumptions and methods used, and if appropriate, their consistency with the prior period; and

(c) the results of the expert's work in the light of the auditor's overall knowledge of the client's business and the results of the audit procedures ...

14. The appropriateness and reasonableness of assumptions and methods used and their application are the responsibility of the expert. The auditor should understand, as a reasonable person but not as an expert, the nature and results of the expert's work. However, the auditor should obtain a general understanding of those assumptions and methods to determine that they are reasonable based on the auditor's knowledge of the client's business and on the results of the audit procedures."

The auditors provided, in support of their submissions, a report by Mr P Wenham, an independent expert retained by the joint auditors.() With regard to the relevant matter of auditing practice, Mr Wenham expressed the following opinion:

"Before deciding to rely on the December 1989 valuation of the security supporting an exceptional loan of this nature, the joint auditors in our opinion, should at least have considered whether there had been changes in the economic environment which could have impacted basic assumptions underlying the valuation. If it appeared that such changes had occurred, then in the special circumstances of this loan, we consider the joint auditors would have been obliged to refer to the valuer for confirmation of his original valuation." ()

Accordingly, in my opinion, notwithstanding the apparent margin of coverage, the joint auditors should have considered whether there had been changes in the economic environment or other matters adversely affecting the assumptions made by the valuer, thus adversely affecting the reliability of the valuation for the purposes of obtaining reasonable assurance that the Bank's exposure was covered.

The principal assumptions underlying the Colliers valuation were set out in a project overview and valuation summary contained in the Audit Working Papers.() These assumptions were:

(i) Capitalisation rate of 7 per cent;

(ii) Rental rates based on 1989 dollars escalated at presumed growth rates to expected completion date of the project in 1990; and

(iii) The centre being fully let prior to completion, with projected rental income in the first year of about $40.0M.

Mr Edwards gave evidence that he did not in connection with the 1990 audit make any enquiries or give any consideration to the continued validity of the assumption underlying the valuation.() He said he could not recall reading the valuation itself, but that he had seen in the course of the 1990 audit the document referred to above which summarised the assumptions concerning yield and rentals.()

In my opinion, it was inappropriate for the joint auditors to have omitted to review around June 1990 the key assumptions underlying the valuation. The following matters were noted in the May 1989 valuation report:

(i) Colliers assumed the design, construction and facilities would be of a standard not previously seen in Adelaide, which would distinguish the centre from other CBD retail facilities, so as to attract rentals at a level sufficient to ensure the project's feasibility, that is, rentals at a premium over other retail facilities;()

(ii) Colliers noted a perceived higher element of risk associated with the two theme/fantasy floors;()

(iii) In relation to the office space, Colliers noted that an increase in overall vacancy rates during the next two or three years may retard growth and lead to payment of substantial inducements to secure major leasings;()

(iv) Colliers noted that rental levels for the speciality retail levels were determined by reference to comparable facilities in the Rundle Mall and rentals negotiated in the Brisbane Myer Centre, and that there was no meaningful evidence available within the Adelaide market for upper levels of speciality retailing;()

(v) Colliers advised that the capitalisation rates should be reviewed periodically during the project because of the difficulty of predicting so far ahead;()

(vi) The development was of unprecedented magnitude for Adelaide, and a valuation required a large number of assumptions about the future course of events in both local and national property markets, the validity of which assumptions can be tested with the passage of time, and that the performance of the Brisbane Myer Centre would provide a better guide to the likely success of the project that has previously been available;()

(vii) The valuation was based on evidence of rental and sales transactions in a relatively buoyant commercial property market, and it is difficult to predict future levels of capital growth, and that if interest rates remain high demand should quieten and purchasers will find themselves in a position of greater relative strength than has been the case in the recent past.()

Mr Edwards said that his recollection was that he was not in July/August 1990 aware of any change in economic conditions which would have caused him to inquire as to the continued validity of the assumptions.()

Information obtained by the Investigation suggests that in July/August 1990 the perception of persons not expert in the property market was that the Rundle Mall retail sector of the commercial property market was holding at June 1990 and that the assumed capitalisation rate of 7 per cent was no less appropriate at that time than when it was set. Mr Edwards said that this was so and that he had no reason to suspect that conditions in that sector of the property market were changing adversely by August 1990.() I accept this evidence.

Information obtained by the Investigation suggests that persons expert in the Adelaide property market would have been aware by July or August 1990 of the appearance of a change in relevant market conditions. Economic indicators suggest that the growth of retail sales in South Australia was weakening in the June quarter of 1990 and would have declined in real terms in the September quarter, probably due to the slower growth, generally difficult economic conditions and reduced consumer confidence.() Research data also suggests that prime Adelaide CBD retail rents showed steady growth up to the June quarter 1990 but ceased to grow after June 1990.() I am not, however, satisfied that these trends should have been apparent to non-experts such as the joint auditors.

The joint auditors submitted that it was always intended that the Remm Centre would command a premium above Rundle Mall retail rentals, and hence prevailing market rentals and market conditions alone were not determinative indicators of the continued validity of the valuation assumptions.() I accept that submission. In my opinion, actual leasing experience would have been the best indicator of whether the valuation assumptions were achievable.

Mr Edwards gave evidence that no enquiries were made in the course of the 1990 audit as to the leasing progress of the centre, nor would he have expected such enquiries to be made.() In my opinion, it was inappropriate that the joint auditors omitted to make such enquiries. In my opinion, the joint auditors should have taken the opportunity to monitor leasing as it progressed to see if adequate information was available at the time of the 1990 audit to verify the validity of the valuer's assumptions. Such enquiries in my opinion would be the only reliable way to confirm whether assumed rentals, and assumed full occupancy by opening date in December 1990, were achievable.

Mr Edwards said in evidence that he was aware that leasing progress was slow and for that reason he would not have thought reliable information could be had by August 1990 as to the possible impact on valuations assumptions.() In my opinion this was inadequate, as the joint auditors should have been put on enquiry by the slow leasing progress.

Further, the joint auditors knew that in July and August 1990 there was excess capacity in Adelaide CBD office space.() I note that rentals from office space contributed about $30.0M to the Colliers valuation of the Centre. In my opinion, the joint auditors should have been put on enquiry by this matter.

Had the joint auditors inquired as to leasing progress the following information was available from board papers and the more detailed monthly leasing reports which were provided to the Bank as a member of the "A" lending syndicate:

(i) The 5 June 1990 leasing report noted a significant downturn in retail sales nationally over the past three months with no change foreseen by retailers before 1991, potential retail tenants were cautious about committing to tenancies, were delaying as long as possible, and were demanding and were expecting to receive inducements.

(ii) The 1 August leasing report noted an improvement in activity during July, but the prevailing conditions are delaying commitments by prospective tenants, and the detailed rental report, on the basis of 9.3 per cent of retail space let, indicated (according to calculations done by the Investigation) that speciality retail rents net of inducements were in aggregate under the level assumed in the valuation by about 14 per cent.

(iii) Significant areas of the centre were let to Remm, and there was no indication whether sub-letting was at a sufficient level to support Remm's rental obligations.

The Investigation has been unable to determine beyond the above matters what conclusion a reasonable auditor would have reached if he had made further enquiries in July and August 1990 as to the likely shortfall in rentals. Accordingly, I make no finding on this matter. I note, however, that by 22 October 1990, Board papers indicate that, based on leasing experience up to that date, the projections indicated that once fully let, speciality retail rentals would average 25 per cent to 30 per cent under budget. The aggregate budget rental approximately corresponds to the aggregate rental assumed in the Colliers valuation. Specialty retail rentals were the centre's major source of income. There was no indication at that time whether full occupancy was likely. The pre-Christmas opening was postponed on 22 October 1990.

Monitoring up to signing of the accounts

The joint auditors were aware that Myer had in June required Remm to indemnify it for any set-up costs which Myer might incur if the pre-Christmas date were to be aborted, and that Remm had not agreed to do so.() This issue and the contractual disputes referred to above were unresolved at August 1990.

In my opinion, the joint auditors should have monitored the account up to signing of the Audit Report, but they failed to do so. If they had, they would have noted that a proposal dated 15 August 1990 was approved by the Bank on 23 August 1990 for additional funding of $15.9M to meet additional construction costs of attempting to achieve a pre-Christmas opening. This represented a cost increase which reduced the cover available from the on-completion valuation.

Although the Board meeting on 23 August 1990() was the meeting at which the accounts were signed, the Board docket was prepared on 15 August, so the information was available in sufficient time to be considered by the joint auditors. The joint auditors submitted that it was neither practicable, nor reasonable, to expect the joint auditors to be aware of this matter.()

Remm had undertaken to enter into a head lease for the theme park, tavern and fast food centre, however, in order to facilitate a December opening Remm had asked the Bank to consider providing further funds for the fitout (later estimated to be $25.0M):

"Independent opinion has advised that as at 24 July 1990 construction progress was 7 days behind program for a 25 November 1990 completion. Since that report approximately 5 days have been lost due to inclement weather."

"Remm and the programmer are of the opinion that the delays experienced to date are recoverable provided inclement weather does not exceed 15 - 20% of the (time) remaining to completion."

"Final project costings provided by Remm indicate that the additional costs likely to be incurred to achieve a pre-Christmas opening will total $15.9M ...".()

Accordingly, there was further evidence available to the auditors in August, if they had inquired, that sufficient slippage had occurred such that a pre Christmas opening was doubtful.

The impact of the completion slippage and the $15.9M additional costs on the security position and the likely recovery were not considered by the joint auditors. The joint auditors have submitted that it is unreasonable to have expected them to monitor the exposure up to signing of the accounts.() For the reasons set out above, I reject this submission.

Was Remm Covered at 23 August 1990?

In my opinion, if appropriate and adequate audit procedures had been carried out, on the information available to the joint auditors during July/August 1990, it is likely that the joint auditors would have become aware that the matter of the continued validity of the valuer's assumptions would have to be referred to an expert for comment.

As calculated above, the valuation of $557.0M provided a 10.6 percent margin of cover for the total lending exposure of the Bank to Remm. As the Bank's exposure was substantially second-ranking to the "A" syndicate, any deficiency would represent a loss of principal to the Bank.

Available evidence in August 1990 suggested that there was a real prospect of a rental shortfall exceeding 10 per cent (the margin of cover calculated above). Further, in my opinion the available evidence suggested that there was a real prospect of further delays in the construction program, and hence cost over-runs. The further funding approved by the Bank on 23 August 1990 was evidence of that, and significantly reduced the apparent margin of cover.

Accordingly, information was available from which the joint auditors could have made the following calculation as to the available cover under the valuation at 23 August 1990:

$M

Colliers valuation reduced by 14 per cent rental shortfall.

479

Total project exposure excluding future interest and rental
(calculated earlier in this section)

497

Deficiency

18

Additional funding approved 23 August 1990

16

Deficiency

34

This calculation does not necessarily indicate that a loss of that magnitude should have been recognised by the Bank as at the time of signing its accounts on 23 August 1990. It could, in my opinion be argued, although this was not raised by the joint auditors in their submissions or evidence, that the proper point in time to compare the lending exposure with the valuation of the centre would be the "A" facility repayment date of 31 March 1992. This would require escalating the Colliers "on-completion" valuation of $557.0M to that date to reflect anticipated growth/depreciation in the value of the centre over that period. The growth rate assumed by the Bank in its projections was 9 per cent per annum. In my opinion, the advice of a valuer would have been required in the light of market conditions prevailing in July/August 1990 to confirm an appropriate escalation rate. Although I am informed that Remm had been writing minimum 9 per cent rental growth rates into leases, it remained to be seen whether budgeted rentals could be achieved on those terms.

Calculations of available cover at the facility repayment date would require taking into account post-completion interest and rental applicable to other "A" syndicate lenders.

If the 9 per cent growth rate was thought to be valid, calculations corresponding to those above as at the facility repayment date, based on a 14 per cent shortfall in rentals, would give the project a cover of about $16.0M. This represents a 2 per cent "cover" inherent in the escalated Colliers valuation. I note, that latest CPI figures for Adelaide available in August 1990 indicated inflation at the rate of 6.7 per cent for 1989-90.()

In my opinion, it is beyond the scope of this Investigation to attempt to determine the views an expert valuer might have expressed on the above matters in August 1990 if he had been asked by the Bank to express an opinion.

Assets of Remm

The joint auditors noted in their work papers() that Remm's unaudited accounts at 31 December 1989 showed a shareholders' equity of $57.5M. The independent expert retained by the joint auditors for the purposes of this Investigation was of the opinion that an auditor should not have accepted those accounts as contributing to the overall security available to the Bank, for the following reasons:

(i) Approximately one half of the assets were in the form of property, plant and equipment, the realisable value of which in the event of sale might well have been less than book value; and

(ii) The funding of the Myer project was advanced in the first instance to Remm and then on loaned to the construction entity. In the event that the project encountered serious financial difficulty, this would place at risk the full recovery of the amount advanced by Remm to the project.()

In my opinion the Remm shareholders' equity of $57.5M should not be treated as contributing to the "cover" available to the Bank.

Interest brought to account from Remm

The joint auditors noted in their work papers that total interest brought to account by lenders under the "A" and "B" facilities to 30 June 1990 amounted to about $72.0M. It is likely that a large proportion of this interest would have been due to the Bank since the first draw down under the facility from other lenders did not take place until 18 June 1990. Some of the interest would have been derived by the Bank in relation to its first ranking loan under the "A" facility and the balance under the second ranking "B" facility.

If there was any doubt about the Bank's exposure at 30 June 1990 being covered by the available security, a question would arise whether any part of the interest brought to account by the Bank should be reversed on the basis that it would not be recoverable.

In my opinion, the joint auditors did not have sufficient appropriate audit evidence to support their opinion that they could accept management's assertion that interest receivable should not be reversed, that a provision was not required, and that the accounts of the Bank gave a true and fair view. The audit was therefore inappropriate and inadequate by reason of the acts and omissions of the joint auditors noted above. It is not practicable for me to conclude, however, whether there was any material mis-statement of the accounts in respect of Remm.

(c) Somerley Pty Ltd - drawn exposure $58.0M

The Bank and Beneficial Finance each provided facilities in 1988 to Somerley relating to the funding of a construction project in Melbourne. The Bank participated in a loan syndication, and its security was a registered first mortgage over the development. Beneficial Finance's exposure was principally in the form of a guarantee given to State Bank of Victoria. This guarantee crystallised in March 1990 on the collapse of the Interwest Group (one of the sponsors of the project), at which point Beneficial Finance was faced with a potential loss of $24.2M, ie the whole facility provided.

On 22 March 1990, the Bank's Board approved a facility to Beneficial Finance to enable the latter to buy out the existing first mortgage syndicate (including the Bank) to "ensure maximum debt recovery".() The Board Paper proposing the facility noted that:

"In the normal course, the Bank would not consider providing the funding as sought on a project basis, however, the action proposed is designed to limit the risk to the Group ...".()

It later transpired that the Bank itself bought out the other members of the first mortgage syndicate, not Beneficial Finance.

The Board also approved, on 22 March 1990, the provision of an additional facility of $19.5M to cover expenditure to continue with the project so that the first stage of the development (the car park and part of the retail component) could be completed.

At 30 June 1990, the Group's exposure, including projected outgoings to complete stage one, stood as follows:()

$M

SBSA principal debt, plus due and anticipated feesand interest costs

58.0

Additional costs to complete stage 1

19.5

potential Penalty Costs

3.5

81.0

Beneficial exposure (excluding interest)

24.2

105.2

This compares with an estimated value on completion for Stage 1 of the development of $75.1M provided in an earlier Board paper of 20 March 1990.() Mr T G Hallion (Audit Manager, Touche Ross & Co) noted:

"On that basis the Bank would lose $5.9M (Beneficial to take up?) + their own (ie Beneficial Finance's) o/s of $24.2M." ()

The Board paper does not cite a source for the estimated value of $75.1M. Bank Group internal documents in June 1990 use a figure of $70.5M, described as a Richard Ellis valuation dated March 1990.()

The issue of whether Beneficial Finance would be called upon to meet any loss suffered by the Bank in excess of Beneficial's own $24.2M facility is mentioned in Board Paper 90/230, dated 19 July 1990, jointly prepared by Mr I McLennan and Mr P Walkom of Beneficial Finance, and presented to the Bank Board by Mr M G Hamilton, which states:

"The facilities [as originally proposed to enable Beneficial Finance to buy out the First Mortgage syndicate] were provided on the basis that any loss incurred on the project in the future would be solely to Beneficial's account." ()

In view of the Bank ultimately providing the facility itself, it is unclear from the audit work papers whether the Bank or Beneficial Finance would be responsible for such excess loss, although the joint auditors stated in their report to Mr Clark on 16 August 1990:

"Under the reported terms of its agreement with BFC, the Bank is not expected to incur any loss." ()

Beneficial Finance made no provision for this exposure at 30 June 1990. In Chapter 59 -"Review of the 1990 External Audit of Beneficial Finance" I conclude, that Beneficial Finance's exposure of $24.2M should have been provisioned. That conclusion takes into consideration the alternative options open to the Bank, including the option to continue the development until full completion. The principal reasons for discounting that option as a means of recovery are set out in Chapter 59 - "Review of the 1990 External Audit of Beneficial Finance".

In summary, it could not in my opinion reasonably be concluded on the available evidence that full completion would be likely to result in a more favourable result for the Bank Group than the construction program for Stage 1 which had been approved by the Bank in March 1990. In my opinion, Stage 1 would be likely to result in a loss for the Bank Group of $30.5M excluding interest, ie a loss of $24.2M for Beneficial Finance and $6.3M for the Bank.

There is no evidence on the audit files that the joint auditors discussed responsibility for reviewing provisioning of the Somerley exposure with the auditors of Beneficial Finance, in spite of their view that Beneficial Finance was to be relied on to cover any loss of the Bank. The joint auditors concluded that the Bank could expect to lose $5.9M and Beneficial Finance $24.2M, based on March 1990 figures.() In my opinion, it was inappropriate to rely on March figures, and the joint auditors should have obtained more up-to-date figures. As noted above, a loss of $6.3M excluding interest was recorded in memos between officers of Beneficial Finance and the Bank in June 1990. According to the evidence of Mr Edwards, the joint auditors concluded that the $5.9M loss was to have been covered by Beneficial Finance.() On the other hand, Mr Whimpress gave evidence that he reviewed the audit files of Price Waterhouse and accepted the conclusion of Price Waterhouse that no provision was required.() Mr Whimpress, however, was also clearly of the view that any loss which the Bank may have suffered would have been to the account of Beneficial Finance, and the Bank need not provide in any event.()

In my opinion, the joint auditors should have verified this conclusion by reference to the auditors of Beneficial Finance. This would have alerted them to the fact that, based on their conclusion, the Bank Group may have been under provided by an amount of $30.1M against this exposure.

Mr Whimpress gave evidence that Price Waterhouse did not either in their working papers or in anything said to him in connection with his review of their working papers lead him to believe that Price Waterhouse were taking responsibility to review provisioning in the accounts of Beneficial Finance in respect of the Bank Group's exposure.()

I accept the evidence and submissions of Price Waterhouse that they were not aware at any time in connection with their 1990 audit of Beneficial Finance of an obligation of Beneficial Finance to bear any loss the Bank Group might incur in respect of Somerley over and above Beneficial Finance's $24.2M exposure.() I accept the submissions of Price Waterhouse that there was nothing in the papers of Beneficial Finance made available to them in connection with their review of Somerley which should have put them on further inquiry as to possible obligations of Beneficial Finance.()

The joint auditors submitted that it should have been clear to all concerned from the terms on which the Bank on 22 March 1990 approved Special Submission 297, the proposal to advance further funds to Somerley to take the project to Stage 1, that Beneficial Finance was to be responsible for any loss which the Bank Group might incur on Somerley.() This the joint auditors submitted was clearly recorded in the Board paper of 19 July 1990 presented by Mr Hamilton to the Bank Board, which had been jointly prepared by Mr McLennan of the Beneficial Finance Asset Management division. That Board paper, quoted above, recorded that the approval of the Bank Board was "provided as a matter of policy to enable Beneficial to recover its position and limit the risk of the Group" and on "the basis that any loss incurred on the project in the future would be solely to Beneficial's account."

Presumably a copy of that paper would have been available from Mr McLennan, the Beneficial Finance officer responsible for managing the Somerley account, if Price Waterhouse had any cause to inquire after it.

I am not satisfied that Price Waterhouse had cause to inquire, or if they had, that the reference in that Board paper should have been picked up by them and should have led them to inquire as to the terms of any obligation on the part of Beneficial Finance. If Price Waterhouse had pursued the matter, they would have been directed to the document dated 9 April 1990 signed by Mr Hamilton on behalf of the Bank and Mr J A Baker on behalf of Beneficial Finance which provided that Beneficial Finance would for management reporting purposes only bear any loss incurred by the Bank on advances made to Somerley. The document expressly provided that it was not to constitute a legally binding agreement between Beneficial Finance and the Bank.

I accept the submissions of Price Waterhouse referred to above that the existence of the above document was not known to them at any time in connection with their 1990 audit. In my opinion, knowledge of it would not have put Price Waterhouse on notice of a greater exposure of Beneficial Finance than they actually considered in connection with Somerley.

I accept the evidence of Mr Whimpress that he was not aware, at any time in connection with the 1990 audit, of the management reporting indemnity dated 9 April 1990 to which I refer below.() Mr Edwards said he could not recall whether he saw the document or not in connection with the 1990 audit.()

Mr Lander QC submitted, in the course of oral submissions on behalf of the Bank's joint auditors, that even if they had seen the management reporting indemnity of 9 April 1990, the joint auditors were entitled to have regard of the substance of the arrangement rather than the legal form, ie the lack of a legally binding indemnity.() In my opinion, as Beneficial Finance was a borrowing corporation, and secured creditors would be relying on Beneficial Finance's accounts correctly recording assets and liabilities, it would not be appropriate for Beneficial Finance to take up a "liability" in its statutory accounts where there was not intended to be a legally enforceable liability. Mr Lander submitted that the critical question was whether Beneficial Finance intended to honour the indemnity, in which case it would suffer the loss.() In my opinion, the reference to "management reporting" in the document could be taken to mean that entries would be made in management accounts without affecting the statutory accounts, in which case Beneficial Finance would not bear the loss. I do not accept these submissions on behalf of the joint auditors.

Mr Edwards gave evidence that he attended a special Board meeting of the Bank on 1 August 1990 which was also attended by Mr Giles of Price Waterhouse(). The principal purpose of the Board meeting appears to have been to receive a written report from Price Waterhouse on Beneficial Finance's doubtful debt provisions, to which Mr Giles spoke at the meeting. The joint auditors have submitted, and my inquiries have confirmed, that no minutes were kept of this Board meeting. I am satisfied, however, that a meeting of the Board did take place on 1 August 1990 which was attended by Mr Giles and Mr Edwards.() Mr Edwards gave evidence that he made a comment in the course of the meeting, in the presence of Mr Giles, that because of the arrangement referred to above, the Bank would not be making a provision and that Beneficial Finance should provide for any loss.() Mr Edwards gave evidence that he could not recall any recognition having been given by Mr Giles to indicate that he had heard and understood the implications of Mr Edwards' comment.() It is the evidence of Mr Giles that no such remark was made to him by Mr Edwards during the time Mr Giles was present at the meeting.() I accept the evidence of Mr Giles that no such comment came to his attention at the meeting.

In my opinion the joint auditors did not confirm with Price Waterhouse that Price Waterhouse and Beneficial Finance would attend to possible provisioning of the whole Bank Group exposure in respect of Somerley. In my opinion, such confirmation should

have been sought in writing if the joint auditors intended to rely on an assumed obligation of Beneficial Finance to bear the loss.

Mr Lander submitted that the joint auditors were justified in inferring, from statements in documents available to them that "full development was likely to be the best prospect for recovery", that such option would be likely to produce a better outcome for the Bank than completion of Stage 1.() In my opinion, the joint auditors should have obtained reasonable assurance that there was an adequate basis for that view, but they did not.

Mr Lander also submitted that the documents to which I have referred in Chapter 59 - "Review of the 1990 External Audit of Beneficial Finance" in concluding that a loss of $30.5M had been sustained by the Bank Group were not available to the joint auditors.() Mr Whimpress gave evidence that he was aware that management of the Somerley account was being undertaken by the Asset Management division.() The documents to which I have referred include a memorandum of 13 June 1990 from Mr Baker and Mr McLennan of Beneficial Finance to Mr Hamilton of the Bank, which shows the calculation of the Group loss of $30.5M. I am satisfied that, upon appropriate enquiry, the documents to which I have referred would have been available to the joint auditors.

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

(i) the provision against the Somerley exposure should have been approximately $6.3M higher than that carried by the Bank in its 1990 accounts;

(ii) the provision against the Somerley exposure should have been approximately $30.5M higher than that claimed by the Bank Group in its 1990 accounts; and

(iii) the amount of these under-provisions and the consequent overstatement of the Bank and Bank Group's operating profit was material.

(d) Chase Corporation Australia Ltd - drawn exposure $25.977M()

A special report was being prepared at the time of the audit for the General Manager Corporate Banking by Mr P Ryan (consultant to the Bank) concerning this facility, the recovery of which was dependent on the value of shares held by Chase in Interchase, the owner of the Brisbane Myer Centre. As his report was not complete at the date of the audit review the joint auditors' manager, Mr Hallion, met with Mr Ryan to discuss his draft findings.()

Mr Hallion recorded in his work paper that Mr Ryan had informed him that an offer of $320.0M had been made for the Brisbane Myer Centre, and that the Bank's internal valuer had valued the property in the range of $335.0M to $375.0M, with a mid-range estimate of $350.0M.() Mr Ryan had then calculated the net tangible asset backing of the Interchase shares using the mid-range $350.0M.() The joint auditors noted that the Commonwealth Bank ranked in priority to the Bank under a first ranking charge covering actual amounts drawn down of $133.0M together with an undrawn amount of $27.0M in respect of costs, fees, interest and a tax indemnity.()

Mr Hallion gave evidence that he could not recall discussing with Mr Ryan whether the rental income of Interchase would cover its interest obligations.() There is no record in the work papers of that matter having been discussed. Mr Hallion said that he did not inquire into the reported offer of $320.0M for the property, or the implications of this for selecting the mid-range estimate of $350.0M.() Mr Hallion concluded that the Bank's provision for its exposure to Chase was adequate "provided the [net tangible asset backing] of the Interchase shares holds at 81 cents or more".() It was put to Mr Hallion that his conclusion failed to address whether it was reasonable to consider that the net tangible asset backing would hold at 81 cents per share.

Mr Edwards gave evidence that all of the indications were that the Brisbane Myer Centre would be sold if reasonable offers were made.()

In my opinion, as is demonstrated by the discussion of the Remm account in this Chapter, it would have been appropriate when calculating the likely recovery to the Bank, to take into account future interest to accrue to lenders ranking in priority to the Bank prior to anticipated realisation of the security.

The joint auditors submitted that the use of a "net tangible asset backing" approach to a valuation is based on an assumption that the company would continue to be a going concern, and that they were entitled to infer from Mr Ryan's use of that approach that he had satisfied himself that Interchase would be able to service its interest obligations.() It was also submitted that the auditors had no reason to question the valuation of $350.0M adopted by the Bank for the purpose of determining a provision on this account.()

In my opinion, it was inappropriate that the joint auditors failed to test for themselves the reasonableness of the assumptions and approach used by the Bank in determining the amount of the provision required on this account.

In my opinion, the joint auditors did not have sufficient appropriate audit evidence to support their conclusion that they could accept management's assertion that no provision was required in respect of Chase. The audit was therefore inappropriate and inadequate by reason of the omissions of the joint auditors noted above. I am unable to conclude, however, whether there was any material mis-statement in the accounts as a result.

(e) Equiticorp Australia Ltd - net exposure $7.38M

The exposure originally recorded at 30 June 1990 of $49.0M was written down to $7.38M following recommendations by the Bank's Lending Credit Committee in July 1990.

In their 16 August 1990 letter to Mr Clark, the joint auditors noted:

The balance of the debt ($7.380M) is expected to be covered by the estimated recovery of $7c in the $." ()

The 7c recovery rate was close to the most optimistic level in the liquidator's most recent assessment at the time.

The above conclusion is incorrect. Based on an original exposure of $54.0M, of which $5.0M had been recovered through a risk underpin arrangement with another bank, the expected recovery at a rate of 7c in the dollar would be $3.78M, leaving a net loan of $3.6M.

During the 1989 audit of the Bank, the auditors relied on a $10.0M risk underpin agreement with Beneficial Finance when assessing the adequacy of the Equiticorp provision. The 1990 audit work papers concluded:

"There is no provision against this remaining outstanding debt as the Bank has recourse to Beneficial Finance to underpin $10M of any loss." ()

There is no evidence that this underpin was discussed with the auditors of Beneficial Finance in respect of the 1990 audit, in spite of the failure of Beneficial Finance to make a provision in 1989 when required to do so (for details, refer to Chapter 51 - "Review of the 1989 External Audit of the State Bank" of this Report). The joint auditors have submitted that they were still entitled to rely on the underpin agreement in 1990.() Mr Whimpress gave evidence that no enquiries were made with Price Waterhouse.() Again, in 1990, no provision was booked by Beneficial Finance in respect of this exposure.

Based on the evidence examined by the Investigation, and for the reasons set out above and in the previous Chapter, the Equiticorp exposure was under provided by $3.6M in the Bank and Bank Group accounts at 30 June 1990.

(f) General Provision

Risk percentages were set by reference to a formula which was approved by the Board of Directors in 1987 and expanded in August 1989. This formula fixes risk percentages for certain categories of exposure, and provides 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 timing of some increases was amended in 1990.

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 percentage of 0.025 per cent at 30 June 1990 whereas credit card loans were provisioned using a percentage of 1 per cent. The largest categories of corporate exposures, excluding bill acceptances, were weighted at 0.5 per cent. No risk percentages at 30 June 1990 exceeded 1 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 misstated 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 did not have 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) The joint auditors accepted the Bank's calculations based on the formula constructed in 1987 and amended in 1989. This formula which, when introduced, at least halved the risk percentages applicable to categories of corporate exposure from those used at the 1986 year end, was, according to a comment by the joint auditors during the 1987 audit, a copy of which was placed in the 1990 audit files:

"... acceptable given low levels of write-offs in the last 2 years" (to 30/6/1987). ()

The Bank's net bad debt write-offs (after recoveries) in the year ended 30 June 1989 were $10.490M and in the year ended 30 June 1990 were $70.169M. These write-offs, and particularly 1990's, were considerably higher than those in the years when the formula was accepted and accordingly the basis for accepting risk percentages calculated from that formula was no longer valid.

In my opinion, the joint auditors failed to properly consider the impact on general provision levels of the problems identified in the bank's loan portfolio in 1990. In view of the large increase of specific provisions in 1989 and the even larger increase in 1990, and evidence of deterioration in a number of significant exposures, for which specific provision had not been made they should have reassessed the appropriateness of the abovementioned formula, and the adequacy of the risk percentages used, particularly for corporate exposures. Examples of exposures that had deteriorated were Adsteam, Pratt Finance, Chase Corporation, Fairfax, Remm and "XYZ" Ltd.

A Bank memo on file dated 9 July 1990 from Mr G Bungey, Manager - Finance Operations to General Manager - Group Finance schedules all current percentages and their growth path and includes the following statement:

"The risk factors in respect to corporate banking have not been revised for three years, since that time corporate banking have experienced massive write-offs ... The factors enumerated highlight the need to urgently review the process of determining the prudent general provision for doubtful debts." ()

The joint auditors considered 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, which was also included in the 1989 audit files, clearly shows that the Bank's general provision was significantly lower than each 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, with a range 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 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 in this Chapter and in Chapter 51 - "Review of the 1989 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) In 1989 the joint auditors concluded that the general provision should have been increased following their identification of a number of "special mention" accounts totalling $426.0M which were considered to be of higher than normal risk. The general provision was increased by $2.15M at 30 June 1989 to cover these higher risk accounts. The report of the joint auditors to the Managing Director dated 18 August 1989 included the following in relation to "risk loans":

"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 much difficulty in agreeing 'risk loans'.

The present general provision of $30M approximately, compares with specific provisions and write-offs of $50M approximately in the 1988/89 year, and the budget for total provisions of $70M in the 1989/90 year.

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".

The joint auditors did not pursue in 1990 the approach of suggesting an increase in the general provision in respect of "risk loans". The joint auditors submitted that it is well accepted that when assessing the general provision it is appropriate to consider the level of prudence and conservatism employed in the Bank's specific provisioning exercise.() I would expect, therefore, that an optimistic or "minimum" approach to specific provisions would indicate that some special attention, that is, a pessimistic or "maximum" approach, should be taken to the general provision.

(iii) A policy was introduced in 1989 to increase off-shore branch risk percentages to 0.25 per cent over a five year period from the commencement of each off-shore branch. According to the audit work papers,() on this basis offshore risk percentages at 30 June 1990 should have ranged from 0.075 per cent for New Zealand to 0.183 per cent for SBSA Asia Limited, with differences being due to different commencement dates.

An internal memorandum from Mr T L Mallett, Chief General Manager - International Banking to the Executive Committee dated 6 December 1989() recommended increasing the general provision risk percentage for international banking to 1 per cent by 30 June 1993.

Actual percentages used in the calculation of the general provision at 30 June 1990 were 0.25 per cent for each branch.() That is, the increase to 1 per cent by 30 June 1993 recommended by Mr Mallett was applied to both offshore branches and international banking.

In my opinion, the joint auditors did not adequately consider whether it was appropriate in the circumstances to build up the general provision over five years. If a level of provision of say one per cent is considered necessary for a particular portfolio then in my opinion that level of provision should be established at that time. To allow the provision to be built up over a period of five years could be a form of profit smoothing and should have been questioned by the joint auditors. This is especially the case given that the Bank's existing level of general provision at 30 June 1990 appeared to be significantly below industry levels, and that the Bank was currently experiencing a large increase in its bad debt write-offs. There was also internal pressure in the Bank for an increase in provision levels. 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 both realistic and reasonable and was a widely accepted approach in banking in Australia.() 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 1990 audit.

(iv) In reporting the results of the New York and Grand Cayman branch audits Deloitte & Touche, the branches' auditors, reported on 14 August 1990 that:

"As a result of our review of the corporate loan portfolio, it was determined that the Branch's portfolio has a relatively "high risk profile". Local management consider that the appropriate allowance for the portfolio is 2% of the outstanding amount. As of June 30, 1990, the Branch had an allowance of $2.3 MM. 2% of the outstanding portfolio is $10.6 MM (difference of $8.3 MM).

This issue has been discussed with Bruce Edwards and Terry Hallion of KPMG Adelaide; SBSA Head Office has adequate general provisions to absorb potential loan losses suffered at the Branch in excess of the general provision of $2.3 MM as of June 30, 1990, although it does not appear as if the Head Office would officially provide comfort to cover such losses ...".()

This difference of $US 8.3M equates to approximately $10.0M.

This matter was included in the joint auditors' report to Mr Clark concerning the audit of the corporate banking division for the year ended 30 June 1990 dated 16 August 1990.() However, the impact of this difference was not included in the summary of possible adjustments (Touche Ross) or the summary of audit differences (Peat Marwick).

There is no evidence in the audit working papers as to how the joint auditors satisfied themselves that the Head Office general provision could absorb a further $10.0M of potential losses when, as commented on above, it was apparently below industry levels, the Bank was experiencing mounting bad debt write-offs and there was concern within the Bank over the low level of the general provision.

The joint auditors submitted that it is normal and reasonable practice in banking to build up a general provision over a period in a start up situation so that the increase in the general provision would be brought to account over the life of the loan book in order to obtain a proper matching of income and costs.() In my opinion, this submission does not explain the apparent failure of the joint auditors to consider the advice from the branch auditors that the branch portfolio had a relatively high risk profile. In my opinion, the joint auditors did not adequately consider whether it was appropriate in the circumstances to accept management's general provision in respect of the New York and Grand Cayman branch portfolios.

(g) Reliability of source records

There is no evidence that certain source records used by the joint auditors for the selection of exposures for credit reviews were tested for completeness and accuracy, 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. For reasons discussed under the section above on Corporate Lending, in my opinion the joint auditors knew or ought to have known that the commitment register was subject to error. As the credit reviews are designed to assess the recoverability of loans, advances and receivables shown in the balance sheet of the Bank, it is in my opinion essential that the complete population of exposures comprising that asset balance is available for the selection of individual exposures for review. Despite the joint auditors being aware of large exposures omitted from the commitment register, the absence of a reconciliation between the commitment register and the general ledger at the dates used to select loans for review and the significant numbers of reconciling items between the commitment register and the general ledger when it was reconciled in June 1990, the joint auditors did not perform additional audit work to enable them to assess the reliability of the commitment register and thus whether that record was suitable for selection of exposures for credit reviews.

(h) Inadequate consideration of potential downside risk of loss

In their report to Mr Clark dated 16 August 1990() concerning the audit of the Corporate Banking division for the year ended 30 June 1990 the joint auditors stated:

"The specific provisions for doubtful debts which have been set aside by the Bank in its Financial Accounts are acceptable to us ... the Bank's specific provisioning is, in our view, at the minimum level required ... It will be noted in some cases the Bank's provisions are marginally less than our assessment." ()

In certain cases the joint auditors reached the above conclusion without reference to the potential downside risk of loss on a given facility. There was inadequate consideration of the implication of certain key future events expected by the Bank not coming to fruition.

The following are examples of loans selected for credit review for which there was inadequate consideration of the potential downside:

(i) Blanche Pty Ltd (Hooker Subsidiary): Exposure $69.89M()

The summary of the loan review in the audit files includes the following comment:

"Accordingly until some of the matters as noted in para (iv) come to fruition it is not possible to conclude on whether a provision is necessary." ()

According to the joint auditors' letter dated 16 August 1990 to the Managing Director of the Bank, the Bank's exposure was in relation to the construction of the Australis Centre, which was expected to cost $105.0M to complete. The bank's exposure was secured over the property, and valuations ranged from $65.0M to $89.0M. The bank had a right to claim cost overruns in excess of the original $73.0M from Hooker Group, however, on then current estimates the recovery from the liquidator might only yield $5.3M. The potential loss on the account therefore depended on the outcome of the negotiations regarding the lease or sale of the Australis Centre. The joint auditors noted in their letter to the Managing Director that -

"We had been advised by Corporate Banking management that the Bank is currently negotiating an outright sale of the building. No loss is expected at this time, and accordingly, no provision has been made."

The joint auditors submitted that on 19 July 1990 they had been informed by the General Manager, Banking that negotiations were at an advanced stage with a party (confidentially disclosed to be SGIC) for the purchase or lease of the building on the basis of which a full recovery would be made by the Bank.() Mr Edwards gave evidence that he was informed that the transaction was highly confidential and that no documents could be produced.() Mr Edwards stated that he did probe the identity of the purchaser and the prospects of the transaction proceeding.() Mr Edwards said that he was aware that a sale of the property for at least $88.0M would be sufficient to recover all of the Bank's principal.() In my opinion, it was inappropriate for the joint auditors to rely solely upon information provided by management without gaining further assurance that full recovery was likely.

(ii) "XYZ" Ltd: Exposure $122.182M()

The company, a major operator of media licences in Australia, was loss-making during the year to June 1990 and was suffering liquidity problems, preventing a scheduled debt repayment to the Bank.

The Bank's security was primarily the media licences held by the company. No up to date valuation was made available to the joint auditors, in spite of their request for one at their December 1989 half year review.

In view of:

. the terms of the facility being breached (the ratio of the Bank's exposure at 30 June 1990 to the most recent valuation of licences was to be no more than fifty per cent, but in fact it substantially exceeded this level);

. extreme difficulties encountered in selling existing licences to raise extra funds; and

. the financial difficulties being experienced by the industry (due to an advertising revenue decline as the recession deepened) and the likelihood that buyers of licences would become harder to find.

The joint auditors should have insisted on receiving the up to date valuation which they had requested prior to concluding on the exposure .

In their letter to Mr Clark dated 16 August 1990 the joint auditors recognised the exposure's risk when they commented that:

"The account has the potential for causing serious loss to the Bank if not handled with extreme vigilance".()

The joint auditors submitted that it was appropriate for them to rely on the 1989 valuation in forming their audit opinion since it was only one year old and provided a margin of $42.9M or 26 per cent against the Bank's exposure at 30 June 1990.() In my opinion, this was inappropriate.

(h) Inadequate reporting to the Bank

The issuance of reports by the joint auditors in the corporate banking area was in my opinion inadequate and inappropriate in a number of respects.

In their report to Mr Clark concerning the audit of the corporate banking division for the year ended 30 June 1990, dated 16 August 1990 the joint auditors stated:

"The specific provisions for doubtful debts which have been set aside by the Bank in its Financial Accounts are acceptable to us ... the Bank's specific provisioning is, in our view, at the minimum level required ... It will be noted in some cases the Bank's provisions are marginally less than our assessment. We have taken the view that one of the purposes of the General Provision is to cover any specific shortfall which may eventuate." ()

The table below raises questions about the conclusions apparently reached by the auditors in their doubtful debts reviews to support the above statement. Specific underprovisions identified in the corporate banking area were $6.95M which was material in the context of both joint auditors' materiality. The largest reported underprovision was $3.15M which could not be considered "marginally" different to the Bank's provision.

When combined with the corporate banking general underprovision and the retail banking specific underprovision which were included in the joint auditors' list of unadjusted differences(), total provisions for doubtful debts appeared to be understated at 30 June 1990 by $10.044M.

The following is a summary of possible underprovisions identified by the joint auditors in their report to the Managing Director :

Corporate - Specific (as reported)

$M

"ABC" Group

1.000

"DEF"

0.300

Barrack House Group

3.150

General Investments

1.600

Equiticorp

0.400

Westmex Operations

0.500

Sub-total

6.950

Corporate - General (as reported)

2.248

Retail - Specific (as reported)

0.846

Total Doubtful debts underprovision

10.044

Mr Edwards gave evidence that, apart from the underprovisions noted in respect of "DEF" and General Investments, Corporate-General and Retail-Specific the report to the Managing Director dated 16 August 1990 was in error in that the other named accounts were not regarded by the joint auditors as being underprovided.() Mr Edwards explained that the schedule attached to the report to the Managing Director was updated progressively during the course of the audit and, while the true position supported the joint auditors' conclusion that they could accept management's provision for doubtful debts, the information in the report to the Managing Director was not in all cases updated.

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 and Bank Group gave a true and fair view ;

(c) the provision for doubtful debts of the Bank was materially mis-stated by at least $12.6M (and the Bank Group by $36.8M) in respect of the following exposures:

$M

Somerley

  • Bank

6.3

  • Group

30.5

Equiticorp

3.6

"DEF"

0.3

General Investments

1.6

Retail

  • Specific

0.8

(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 and Bank Group failed to give a true and fair view.

52.5.2.5 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' submissions on the subject. The conclusions which follow draw on that discussion.

In the Bank's 1990 accounts the state income tax was shown as an appropriation of profit in the manner of a dividend rather than as a charge against operating profit before arriving at net profit after income tax.

The tax calculated in respect of profits for the year ended 30 June 1990 was, according to the joint auditors, a benefit of $16.4M.() If the presentation used for the 1985 and 1986 years (and followed by the Bank for 1991) had been continued in the 1990 accounts, then the Bank's operating profit, including extraordinary items, would have been $52.279M, and not the figure of $35.879 actually disclosed.

As stated, the benefit of $16.4M referred to above is based on tax computations included in the joint auditors working papers. In the section in this Chapter headed "Other Inadequate Audit Procedures" and under the sub-heading therein of "Disclosure Issues, State Government tax" there is comment on concerns over the validity of an agreement between the Bank and South Australian Government Financing Authority which, among other matters, varied the manner of computing State Government tax from that laid down by statute. The agreement purported to authorise a tax deduction for dividends paid to South Australian Government Financing Authority when computing State Government tax.

In the calculation of the tax benefit of $16.4M a tax deduction has been taken for the full $92.3M dividend paid to South Australian Government Financing Authority in 1990 by the Bank, even though arrangements were later made to refund $68.0M of it as explained under the heading of "State Government tax". If the view was held that the tax deductibility of the dividend was incorrect then the tax benefit of $16.4M becomes a tax expense of $19.6M. In that case, if the presentation used for the 1985 and 1986 years (and followed by the Bank for 1991) had been continued in the 1990 accounts, then the Bank's operating profit after tax, including extraordinary items, would have been $16.279M, and not the figure of $35.879M 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 1990 accounts or its implications when forming their opinion as to the truth and fairness of the accounts.

Note 1(h) to the 1990 accounts states that:

"The Bank has adopted Tax Effect Accounting in accordance with Approved Accounting Standard ASRB 1020 and Australian Accounting Standard AAS 3, which allows 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 ...".

The note also describes the Bank's obligations in respect of the State tax. Whilst this note may have justified the inclusion in the Bank's balance sheet of a future income tax benefit of $49.930M as an asset (see note 13 to the accounts) 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 1990 Profit and Loss Statement of the Bank;

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

(c) the joint auditors wrongly accepted management's assertion that the dividend payable to South Australian Government Financing Authority was available as a tax deduction.

The question of whether the accounts of the Bank at 30 June 1990 were as a result materially mis-stated is considered under the section headed "Conclusion" at the end of this Chapter.

52.5.2.6 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' submissions on the subject. The conclusion which follows draws on that discussion.

The 1990 accounts of the Bank did not disclose the accounting principles giving rise to the provision for self insurance and contingencies of $6.683M. The provision was not supportable on the basis of audit work performed.

The audit work papers () indicate that the increase in the provision of $1.008M during the year was simply the difference between the premiums that would have been paid during the year if the Bank had taken out insurance with a third party, and the "insurance expense" which comprised self insurance claims arising during the year. However no audit work was carried out to ascertain the appropriateness of the balance of the provision at the end of the year.

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

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

(b) the balance was materially mis-stated.

The question of whether the accounts of the Bank at 30 June 1990 were as a result materially mis-stated is considered in the section headed "Conclusion" at the end of this Chapter.

52.5.2.7 Matters Noted - Superannuation Provisions

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 17 to the Bank's accounts is a provision of $118.2M in respect of its obligations for employee entitlements to pensions, retirement allowances and accrued leave, of which $93.8M 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 ... The surplus of $7,860,000 arising from revaluation of these properties has been credited against Bank's liability to the Staff Superannuation Fund".

The taking of the revaluation surplus to the Provision for Superannuation is contrary to the requirements of the Professional Accounting Bodies' Statement of Accounting Standard AAS10 "Accounting for the Revaluation of Non-Current Assets" and the Approved Accounting Standard ASRB1010 of the same name.

(b) Note 23 of the Bank's accounts states, inter alia:

"There are numerous superannuation and retirement benefit plans within the Group ... All defined benefit plans are subject to actuarial review. Funds are sufficient to satisfy all benefits that would have been vested under the Funds in the event of termination of the Funds ...".

The joint auditors submitted:

"A review was received 8 July 1990 based on 30 June 1989 liabilities and the Public Actuary's conclusion was that a surplus of $5,313,000 existed.

This surplus was not brought to account in any way by the Bank in determining the results of the SPTF nor was it recorded in the results of the Bank at 30 June 1990." ()

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 1990 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 accounts 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 accounts 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, this non-disclosure is not seen as material to users of the financial statements nor is it seen 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 1990." ()

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 $7.8M 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 a 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 $17.0M.

The question of whether the accounts of the Bank at 30 June 1990 were as a result materially mis-stated is considered in the section headed "Conclusion" at the end of this Chapter.

52.5.2.8 Matters Noted - Interest Income and Expense

There is no evidence in the audit working papers that the following items of income and expense were audited so as to confirm the completeness, accuracy and validity of the amounts included in the general ledger.

Interest Expense on:

(i) Negotiable Certificates of Deposit() $148.0M

(ii) S.T. borrowings 7 day/11am call() $127.0M

(iii) Loans reliquefied() $119.0M

(iv) Eurobonds-AUD funding() $85.0M

(v) Euronotes-AUD funding() $26.0M

(vi) Foreign Exchange mon mkt deps() $118.0M

(vii) Eurobond F/currency funding() $120.0M

Interest Income on:

(i) Prime assets() $107.0M

(ii) Commercial bills() $183.0M

(iii) Foreign currency lending() $241.0M

The accounts are marked in the trial balance dated 17 July 1990 as being audited by Peat Marwick Hungerfords but there is no reference to any audit working papers and there is no other evidence in the audit files that the accounts have been audited.

The joint auditors have submitted() that they tested, on a sample basis, the accrued interest expense portion of these amounts by recomputation of accrued interest on individual account balances outstanding at year end.

I do not consider that testing the year end accrual is an appropriate test to verify the accuracy of interest income or interest expense for the entire year. For example, this method of testing would not identify instances where interest was incorrectly paid or not received during the year on a balance which had been repaid. Nor would it identify incorrect journal postings to the income or expense accounts during the year.

Based on the evidence obtained 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.

52.5.2.9 Matters Noted - Other Inadequate Audit Procedures

(a) Third Party Confirmations

(i) International Treasury Balances

The operations of International Treasury involve products such as loans, deposits, Eurobond issues, interest rate and cross currency swaps and forward rate agreements. One of the principal audit procedures in respect of such products is to confirm a sample of transactions in existence at year end with the counterparty to the transaction.

No confirmations were sought in respect of the International Treasury balances. A work paper in the control section of the audit file notes:

"KPMG planned to perform audit confirmation procedures for both Australian Treasury and International Treasury a/cs as at May 31 1990. Due to the very time consuming and resource intensive process required to produce confirmations 3 weeks of (sic) internal audit time was allocated to assist KPMG with the task.

Since the task became very time consuming, Australian Treasury a/cs confirmations were completed whilst International Treasury had just begun. Since many of the parties regard (sic) international a/cs were overseas, time constraints and reporting deadlines restricted our completion of confirmation work at International Treasury, since responses would not be received in time.

Because International Treasury was much less significant compared to Australian Treasury - testing was performed using alternative substantive procedures, such as agreeing deals to deal slips and counterparty confirmations. Also a significant amount of International Treasury liabilities related to off-shore capital raising/(note issues) which were substantially supported by reviews regarding comfort letters issued in respect of such issues during the course of the year" ()

Examples of balances tested in this way include the following:

. Foreign Currency Loans() $3,106.0M DR

. FX money market deposits() ($2,329.0M) CR

The joint auditors failed to recognise that, by not confirming International Treasury deals at 30 June 1990, they would not have been able to detect deals which were terminated, repaid, assigned or sold to a third party between the date of inception of the deal and the year end. Instances of termination or assignment of deals are not uncommon in the banking industry. Consequently, the joint auditors' procedures could not provide sufficient assurance as to the existence of such deals at the year end.

The joint auditors submit:

"... that the Bank maintains many of its files of supporting documentation to transactions in counterparty order rather than in transaction type or date order. Accordingly, the substantive procedures of going to the counterparty deal slips and confirmations to vouch the purchase of assets necessitated a review of all documentation on the file. Given the files contain all the supporting documentation for both the purchase and sale of assets by counterparty, the substantive procedures would have had a high probability of detecting instances where asset purchases had also been sold prior to balance date." ()

In making this assumption the joint auditors are placing reliance on the Bank's system for filing of documentation in respect of sales. In my opinion it is inappropriate for the joint auditors to rely on this system of filing to provide assurance that the information contained in the transaction files is appropriate for audit purposes. Furthermore, in my opinion, failure to document such an important element of the audit procedures constitutes a deficiency in the audit procedures.

(ii) Corporate Banking Receivables

The Bank's exposures in Corporate Banking at 30 June 1990 amounted to $4,030.0M(). The joint auditors sought to confirm a sample of these with the borrowers at 30 May 1990. This confirmation exercise was deficient in a number of respects, as detailed below:

. Source documents used for selection of circularisation targets

As noted in the Section headed "Corporate Lending" the joint auditors used the new corporate commitment register as a source for selecting circularisation targets without adequately testing to ensure it was a complete and accurate record of the general ledger balance at that date.

Accounts for third party confirmation were selected from the detailed corporate commitment register for May 1990 following a preliminary review of a summary commitment register (extract) as at April 1990. ()

At a meeting with Mr K Kotsiou was noted:

"Kon indicates that Actual commitments (per the register) remain unreliable for purpose of confirmation exercise. Indicated we will not use without first advising him. Other option would be to go back to individual systems to obtain balances. Appears too time consuming." ()

Despite their knowledge of the unreliability of this record the joint auditors did not perform further procedures to compensate for the known inaccuracies in the corporate commitment register when selecting accounts for confirmation.

The joint auditors submitted:

"The corporate commitment register was used as the first source of information for selection as it was the only record which brought the various facilities of a particular exposure together and which the joint auditors knew would ultimately be reconciled to the general ledger. This reconciliation was performed at 30 June 1990 and the reconciling items were reviewed to ensure that they did not impact on the May 1990 accounts selected for confirmation ...

As the joint auditors knew of the possibility of errors, Internal Audit were asked to ensure that the information for the confirmation was first extracted by them and then forwarded to respective account managers to check the confirmations prior to despatch. This was to ensure that balances were correct and that unconfirmed lines or other erroneous information was not included on the confirmations ...

Paragraph 2 of workpaper 6988 evidences the fact that the joint auditors also checked the confirmation back to source records prior to despatch. Considerable audit time and effort was put into the checking and re-checking of confirmations prior to despatch." ()

. Execution

The confirmation requests were prepared and despatched by Internal Audit. There were many errors in the execution of this exercise, and these were summarised in an audit work paper dated 9 August 1990:

- "I/A failed to properly control the exercise ..."

- "Compilation of data was given to account managers. Data included in confirmation letters at times doesn't resemble, details on the commitment register."

- "Confirmations at times have been despatched twice.

- "Changes in address etc made between first and second letters."

- "Items not intended to be confirmed have been."

- "Confirmations despatched with errors contained"

- "Some confirmations were not despatched. Presume based on instructions of Neil Gillespie. To be followed up". ()

(Neil Gillespie was a Bank employee)

There is no evidence in the audit files of the implications of these matters on the validity of the circularisation exercise, some of which have the potential to negate the whole exercise.

The joint auditors have submitted:

"To put [the above workpaper] in context, it was placed on file,

(i) as a matter of record;

(ii) to serve as a reminder for future confirmation exercises to ensure that the shortcomings were not repeated; and

(iii) to use as a basis for bringing these matters to the attention of Internal Audit." ()

There is no work paper on the audit files that compares confirmations actually despatched to those which were originally selected for confirmation or to compare those dispatched to replies received. Comment has already been made above that an unknown number of confirmation requests were not actually sent out in respect of some selections on the instruction of a Bank employee.

The joint auditors have submitted:

"A working paper which reconciled the confirmations dispatched compared to those selected was prepared and, as with the tickmark legend, this paper was included in the December 1990 half year review files.

It is not correct to say that an unknown number of confirmations were not sent. These were listed in memoranda dated 5 and 25 July 1990 to the joint auditors from the Corporate Banking Manger, Corporate Administrations and Operations. The "interference of a Bank employee" referred to by the Auditor-General was at the joint auditors' request as they were asking N Gillespie who was independent of account management to review the confirmations for obvious inaccuracies compared to Bank records etc.

The majority of confirmations that were held back by the Bank were either inter company exposures or uncommitted lines." ()

The workpaper referred to by the joint auditors above records the number of confirmations only, and was prepared on 31 August 1990, after the date the audit report was signed. There are no workpapers dealing with dollar values, such as dollar value amount confirmed as a percentage of population.

It is noted that out of seventy replies, nine had queries, thirty four were returned correct and agreed to the commitment register and twenty seven were returned correct but did not agree to the commitment register. This was further evidence of the potential unreliability of the commitment register.

The memoranda referred to above have now been supplied to the Investigation. They do note the details of confirmations not to be sent and in some cases reasons are given. The memoranda also note that many changes were required by Mr Gillespie to be made to the confirmations. There is no evidence that the auditors sought to corroborate the changes suggested by Mr Gillespie.

The Investigation raised several matters with the joint auditors concerning alternative procedures to be adopted where a reply is not received for a confirmation request. The joint auditors submitted () that where the facility was subject to detailed review for doubtful debt purposes, the loan reviews are a satisfactory audit alternative verification procedure to obtaining a confirmation.

(iii) Confirmation requests of balances at dates other than balance date

Where balances in an entity's accounting records are confirmed at a date other than balance date, the auditor should perform additional work to satisfy himself that the balances shown in the accounting records at balance date (being the date of the accounts upon which he reports) are also not materially mis-stated.

Depending on the circumstances, these procedures normally include:

. ensuring that there is an effective system of internal control in relation to the specific assets, liabilities and records involved in order to gain assurance that transactions processed between confirmation date and year end are complete, accurate and valid; and

. ensuring that movements in the balance between the date of confirmation and balance date:

- appear plausible;

- agree with underlying accounting records; and

- those accounting records have been subject to test, either presently or in the past and were found to be reliable.

These post confirmation audit procedures are often referred to as "roll-forward" procedures.

According to the audit working papers in respect of the 1990 accounts of the Bank, confirmation of certain balances was performed at interim dates without any roll-forward procedures or with inadequate roll-forward procedures being performed. Examples are:

. Corporate Banking

In the audit of Corporate Banking at 30 June 1990 the joint auditors did not consider the need for, or perform any, roll-forward procedures from 31 May 1990 to 30 June 1990.

The joint auditors have submitted:

"that in relation to the audit of Corporate receivables, a roll-forward was conducted on an exposure by exposure basis. This was performed at the time of each of the individual account reviews where the joint auditors noted the balances as at May and as at June to compare/review balances/movements ... Overall analytical reviews of total receivables balances were also conducted to compare June 1989, December 1989 and June 1990." ()

Having considered the joint auditors submission I am of the opinion, that they have not adequately tested the transactions recorded in June 1990 in respect of balances which were confirmed or otherwise tested at 31 May 1990. The roll forward conducted by the joint auditors would not have detected, for example, invalid loans made in the months to June 1990.

. Treasury and International

For audit confirmations to be carried out at a date prior to balance date, the controls in the relevant systems must be satisfactory to give audit assurance that nothing untoward is likely to occur between the early confirmation date and the date of the accounts. In the case of Treasury balances the applicable system is Kapiti. In his report() dated 28 August 1989 Mr Van Ruth, the joint auditors' computer specialist, noted:

"There were 35 detailed findings by I/A of weaknesses ... Until these areas are corrected the environment surrounding the WANG applications is not sound and cannot be relied upon."

"Currently I believe the bank does not meet an acceptable level of industry standard of security over the WANG machines."

"... the environment is considered weak and specifically as it relates to Kapiti. The most significant weakness in the security area was the lack of segregation of duties." ()

His recommendation for required audit action was:

"AUDIT to ensure reliance on computer application controls in the WANG environment (especially Kapiti) is supported by compensating manual controls."

There is no evidence in the audit files that the joint auditors gave weight to their specialist's comments on the Kapiti system and his recommendation when they implicitly relied on the system when selecting a 31 May examination date for securities recorded on the system.

The joint auditors submit() that no audit reliance on the Kapiti system was assumed in planning substantive audit procedures.

A `high' internal control risk factor was used in determining the sample of 31 May confirmations because no reliance at all was to be placed on any internal controls, (including any computer application controls). In other words the sample size was increased to compensate for the lack of internal controls. No amount of audit as at 31 May 1990 would detect an invalid transaction processed in the month of June 1990.

The joint auditors also submit that if they:

"had planned to place any reliance on any Kapiti systems controls (if tested satisfactorily), these would not have been the type of controls on which Mr Van Ruth has commented on weaknesses in his report. These controls are predominantly `security environment' (ie operational controls) related and are not the sort of controls that auditors would normally test and rely upon in a financial statements audit (ie financial controls)." ()

Having considered the joint auditors submission I am of the opinion, that they have not adequately tested the transactions recorded in June 1990 in respect of balances which were confirmed or otherwise tested as at 31 May 1990.

. Fixed Interest Securities

Of the total balance of $234.0M, $77.0M was tested by confirmation with an independent third party at May 1990.

No roll-forward procedures were performed in respect of transactions processed in the period from 31 May 1990 to 30 June 1990.

. Borrowings: 7 day/11am call()

These borrowings (recorded in general ledger account 6166) were tested by confirming balances with counterparties as at 31 May 1990 and by performing limited roll-forward procedures in respect of the movements in the account between 31 May and 30 June 1990.

These roll-forward procedures were inappropriate and inadequate because they failed to take account of known deficiencies in the Kapiti system discussed above.

The joint auditors submission() states that a judgmental sample of transactions during the month of June 1990 was verified by tracing to internal documentation.

However, these procedures were only carried out in respect of new deposits and not in respect of repayments of borrowings. In addition, the recorded transactions were not tested for completeness.

(b) Disclosure Issues

(i) Related Party Transactions

There was incomplete disclosure of related party transactions in the 1990 accounts, despite the fact that there was a requirement for full disclosure under the Professional Accounting Bodies' Approved Accounting Standard AAS22, "Related Party Disclosures" (issued June 1988).

Specifically, the accounts 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 listed ASRB 1017 in their planning memorandum () as one of a number of "accounting matters requiring specific attention". It is also noted in that work paper that:

"... SBSA only required to comply with AASs not ASRBs"

In a letter to Mr Copley dated 30 March 1990() dealing with comments by the joint auditors on the Group Consolidation package, the following statement was made:

"ASRB 1017 Related Party Disclosures

The Bank should comply with this Standard to the extent considered necessary for it to be satisfied that the accounts are "properly drawn up in accordance with the provisions of the State Bank of South Australia Act 1983 (as amended)"."

The following pencil note has been added by Mr M Penniment to the file copy of the letter:

"Tony [Mr A Siebert] has done Board paper and Bank will follow disclosure of major banks with exception that directors and executive remuneration will not be disclosed. Consolidation package to be updated for this"

Indeed, the Directors' Statement in the accounts of the Bank for the year ended 30 June 1990 states that the accounts of the Bank and of the Group have been made out in accordance with Australian Accounting Standards and Applicable Approved Accounting Standards.

There is no discussion as to why the details of directors' remuneration should not be disclosed, nor as to the reasons for the joint auditors' decision to accept non disclosure.

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 was so desired.

They further state that to the extent that a disclosure requirement of the Companies Code is not complied with, this non-compliance is evident to any users of the financial statements. In their view the non-disclosure would not be a breach of any statutory requirement unless the non-disclosure would affect decisions by users of the accounts.

While the immateriality argument might apply to some non-disclosures I do not believe it is available to the non-disclosure of directors' remuneration which according to the Companies Code is required to be disclosed irrespective of materiality to the rest of the accounts. If it were otherwise, very few companies would disclose of directors' remuneration as it is an item which in monetary terms, is generally immaterial to the content of published financial statements.

As regards the argument that the Bank's shareholder had access to the information if it so desired, in oral evidence to the Inquiry () Mr Richardson of KPMG Peat Marwick acknowledged that "the accounts should stand on their own" without the inference that the shareholder could use some other knowledge in its interpretation of the accounts of the Bank.

(ii) Sub-ordinated Debt and Sub-ordinated Perpetual Debt

. At 30 June 1990 the Bank had sub-ordinated debt totalling $450.597M.

There is no evidence in the audit work papers that the joint auditors confirmed the balance outstanding at 30 June 1990.

. In June 1988, the Bank issued what it claimed to be 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 and 1990, but it is not possible to estimate the extent of this understatement based upon the information contained in the work papers. It may also have resulted in an underpayment of tax to the State Government.

Chapter 50 - "Review of the 1988 External Audit of the State Bank" of this Report, dealing with the external audit of the Bank's 1988 accounts 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 accounts 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 1990 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 was misleading to describe the borrowing as "perpetual" and to classify it within other capital resources.

In my opinion, the debt was not in substance "sub-ordinated", because the debt along with all other liabilities of the Bank, was guaranteed by the State Government, and because other security was provided under the scheme for the repayment of the ultimate lenders' principal.

The accounting treatment of this transaction implemented by the Bank is fully discussed in Section 6.6.6 of Chapter 6 - "The Funding of the State Bank" of my First Report.

(iii) Dividend payable to the South Australian Government Financing Authority

On 23 June 1989 further capital amounting to $663.9M was made available to the Bank by the South Australian Treasurer and South Australian Government Financing Authority. Of this amount, $125.0M represented capital subscribed by the South Australian Treasurer on which dividends are payable in terms of Section 22 of the State Bank of South Australia Act, 1983. The balance of $538.9M, provided by South Australian Government Financing Authority, is subject to the payment of dividends by the Bank to South Australian Government Financing Authority calculated as follows:

. $338.9M at 3 month BBSW (7 September) plus 0.65 per cent;

. $100.0M at 3 month BBSW (15 January) plus 0.65 per cent until 15 July 1992, at which time South Australian Government Financing Authority may seek rate re-set dates;

. $50.0M at 3 month BBSW (15 December) plus 0.65 per cent until 15 September 1993, at which time South Australian Government Financing Authority may seek re-set dates; and

. $50.0M at 6 month BBSW (15 March) plus 0.65 per cent until 15 September 1993, at which time South Australian Government Financing Authority may seek rate re-set dates.

[BBSW is the bank bill swap rate, a market rate of interest which is widely quoted].

These terms attaching to the capital contribution are set out in a letter from Mr Copley to South Australian Government Financing Authority dated 24 July 1990, and have been acknowledged by Mr P J Emery (Under Treasurer and Chairman, South Australian Government Financing Authority).() Mr Copley's letter goes on to state:

"3. The return payable to SAFA will be payable out of the profits of the Bank, calculated before any dividend payable to the South Australian Treasurer on his capital contribution and before the calculation of taxation payable to the South Australian Treasurer in lieu of Commonwealth taxes (ie the measure of the Bank's "taxable " profit would be calculated after deducting the payment for the return on SAFA's capital contribution).

4. The return would not be payable in full in any one year only to the extent the Bank makes insufficient profit in that year (before taxes and distributions to the Government) to make such a payment. In that event, the amount remaining unpaid would accumulate to SAFA's account and earn interest for SAFA at the rate relevant for that particular component of capital referred to ... above and be paid in subsequent years ahead of distributions to the South Australian Treasurer.

5. The amount of return unpaid and outstanding at the end of any year shall not exceed the average annual profits in real terms at current prices (before the payment of the return payable under these arrangements) over the previous five years - to the extent such excess results, that excess will be regarded as no longer due."

During the year ended 30 June 1990 the Bank paid a dividend to SAFA of $92.3M calculated in accordance with the above terms. However, it transpired after the year end that the Bank had not made sufficient profits to make this distribution in accordance with the terms on which SAFA had subscribed the relevant capital, and $68.2M which was included in sundry debtors and accrued interest at 30 June 1990 was refunded. On the basis that the dividend was cumulative in nature, this amount became dividend in arrears.

The terms for the calculation of the dividend payable to South Australian Government Financing Authority gave rise to a number of issues as discussed below.

. State Government tax

Section 22(1) of the State Bank of South Australia Act, 1983, sets out the basis on which the Bank pays tax to the State Government. Essentially this is on the same basis as it would have paid Federal tax if the Bank had been incorporated as a company. Tax is payable on the Bank's operating profit after allowing for permanent differences. Dividends represent an appropriation of profits and are not deductible for tax purposes.

Clause 3 of the letter quoted above seeks to vary the method by which State tax is calculated by the Bank, by stating that the dividend payable to South Australian Government Financing Authority will be effectively treated as a deduction in arriving at the tax on the operating profit. This is not in accordance with the method of assessing Federal tax which is the basis set by the State Bank of South Australia Act, 1983.

The practical effect of this arrangement was that in 1990 most of the Bank's operating profit was paid to South Australian Government Financing Authority and no tax was payable to the State Government. In addition, the Bank recommended that no distribution in the form of return on capital be paid to the State Government.

There is no evidence in the audit files that the joint auditors considered whether Mr Copley and South Australian Government Financing Authority had the power to over-ride the method of assessing State tax as laid down by the State Bank of South Australia Act, 1983.

The joint auditors submit () that the letter between Mr Copley and Mr Emery constituted a practical approach to the application of Section 22(1) of the State Bank of South Australia Act, 1983, and that this was appropriate given that Mr Emery was also acting in his capacity as Under Treasurer.

However, as Section 22(1) provides that the basis under which the Bank pays tax to the State Government is the same basis as it would have paid Federal tax if the Bank had been incorporated as a company, and as dividends are not a tax deduction in arriving at Federal tax payable, the treatment adopted is in my opinion at odds with Section 22(1) rather than a practical approach to the application of that Section.

. Cumulative nature of dividend

Clause 4 of Mr Copley's letter makes it clear that the dividend payable to South Australian Government Financing Authority is cumulative in nature. If the operating profit earned in any one year was insufficient to pay the level of dividend to South Australian Government Financing Authority as calculated in terms of the letter, then the shortfall was carried forward (with interest) to be paid out of the next available profit. There was, however, a cap on this liability as provided in Clause 5 of the letter.

Clause 3 of the letter specifies that the dividend payable to South Australian Government Financing Authority was to be calculated before allowing for any distribution payable to the State Government. This in substance meant that the South Australian Government Financing Authority dividend was preferential in nature. Schedule 7 (Cl 14(1)) of the Companies (South Australia) Code, which the Bank purported to follow in the drawing up of its accounts, requires the disclosure of details relating to preference capital, including the rate of dividend and arrears of any cumulative dividend. The following statement appears at the foot of Note 19 to the 1990 accounts:

"Pursuant to the arrangements between the Bank and the South Australian Government Financing Authority (SAFA) relating to the provision of Subscribed Capital, a further amount based upon the operating profit of the Group may be payable to SAFA from profit earned in future years."

There were no details supplied in the accounts of the rate of dividend or any quantification of the dividend arrears at 30 June 1990. These arrears amounted to approximately $68.0M.

There is no evidence in the audit files that the joint auditors considered the disclosure requirements pertaining to the dividend arrangements with South Australian Government Financing Authority, or how they concluded upon the inadequate disclosure at the foot of Note 19, nor is there evidence that they confirmed that the Board had approved the dividend arrangement with South Australian Government Financing Authority.

The amount of the cumulative arrears of dividend due to South Australian Government Financing Authority of approximately $68.0M is material to a user of the 1990 accounts.

The joint auditors() submit that the capital upon which the dividend is calculated is not "preference share capital". They further submit that the disclosure of the $68.0M of arrears of dividends would only be of interest to the South Australian Government, the sole shareholder in the Bank, and that it had access to the information in any case.

In my opinion the dividend is preferential in nature and accordingly should have been disclosed in the accounts.

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) Certain Treasury and International Treasury balances; and

(ii) Corporate Banking receivables.

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 the liability after fifteen years.

(ii) Consequently the Bank's total capital resources were materially overstated.

(iii) The joint auditors wrongly accepted the non-disclosure by the Bank in its accounts of details relating to:

. the remuneration of directors; and

. the dividend arrangement between South Australian Government Financing Authority and the Bank and of the extent of the cumulative arrears of dividend payable to South Australian Government Financing Authority.

However, apart from the non-disclosure of the extent of the cumulative arrears of dividend payable and the incorrect disclosure of the Bank's "sub-ordinated perpetual debt", I have no reason to believe 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 non-disclosure of the cumulative dividend and the incorrect disclosure of the Bank's "sub-ordinated perpetual debt", the question of whether the accounts of the Bank and Bank Group at 30 June 1990 were as a result materially mis-stated is considered under the heading "Conclusion" at the end of this Chapter.

52.5.3 CONCLUDING PROCEDURES

52.5.3.1 Preamble

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

52.5.3.2 Matters Noted - Concluding Procedures

Having regard to the matters noted under the section "Execution" above, I am not satisfied that the procedures adopted by the joint auditors adequately identified all significant matters and that such matters were appropriately dealt with by them.

Based on the evidence examined by the Investigation and for the reasons set out above, I am not satisfied that all significant issues in relation to the 1990 external audit were appropriately and adequately considered by the joint auditors.

 

52.6 CONCLUSION

 

In my opinion, the audit opinion expressed by the joint auditors on the accounts for the year ended 30 June 1990 was inappropriate, and the carrying out of the audit process leading to that opinion was inadequate, in the following respects:

(a) 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;

(b) the Bank's Provision for Doubtful Debts was understated by at least $12.6M and the Bank Group's Provision for Doubtful Debts was understated by at least $36.8M;

(c) the Provision for Self Insurance of $6.7M was materially mis-stated;

(d) the Bank's operating profit after tax was overstated by $19.6M due to:

. the statutory State Government charge in lieu of Federal income tax being treated as a distribution of profit rather than as a charge against profit; and

. the dividends to the South Australian Government Financing Authority wrongly being treated as a tax deduction;

(e) as a consequence of cumulative asset revaluation surpluses of $17.0M 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;

(f) the joint auditors wrongly accepted management's decision not to disclose the amount of approximately $68.0M being the carried forward preferential distribution entitlement of South Australian Government Financing Authority on capital subscribed by it; 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 1990 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 (b) to (g). First, items (b) and (c) were, in my opinion, material in relation to the reported profit for the year of $35.8M before tax. Second, item (d) was material in relation to the Bank's reported after tax profit of the same figure. Third, item (e) was in my opinion material, by its nature and in relation to the Bank's reported reserves of $78.6M and likely impact on profit. Fourth, item (f) was material by the nature of its impact on the Bank's ability to retain future profits. Fifth item (g) was material by its nature, and in relation to the ability to retain Bank's reported total capital resources of $1,338.7M.