Notes

Item 2. This Item is closely related to Item 1. Ms Hickey has rejected the arrangements as an insurance policy but decided to allow the cash due in three years time to offset "debt" at face value. The Securities Commission report rejects the validity of this action with reasons but does not refer to the reasons which Ms Hickey has submitted to justify the action. This is probably because they did not want to further expose the weakness of these arguments. In her audit notes Ms Hickey says it was "because the bad debt provisions against which the insurance claims are being netted will not accrue further interest over the period until the claims are paid". The first problem with this reason is that on page 143 (para 15.6) the report advises that only $54m of the $94m claim was to reduce the provision for doubtful debts. $22m was to reduce reported operating expenses (presumably excluding the doubtful debts provision) and remainder of $18m was to increase reported operating income.

As to why she thinks that if no further interest is accrued it is ok not to recognise the time value of money we have her paragraph to the Securities Commission entitled "Value at which Assets Recognised". She says that the cost system of accounting usually recognises receivables and payables at their face value except where they are interest bearing when if the interest rate is realistic the time value of money is effectively recognised. This is probably a fair enough statement. Most trade receivables and payable are settled in a month or two and the interest forgone or saved is relatively little. But the BNZ's debts would be interest bearing and it was not a logical or traditional action to stop accruing interest. Only such debt as could be paid off in full, including interest up to settlement date, from the proceeds of the arrangements, could be considered to have been made good by the arrangements and hence offset by them.

As further discussed in Item 5 the distortion of profits via the disregard of the time value of money had been given much consideration in the years prior to 1990 where high interest rates had ruled, and Ms Hickey would be well aware of it. Her notes do not reflect any concern for reporting a fair profit or consideration of the amount involved. Her purported expertise seems to be only in historic practices. Her mission seemed to be to help the bank declare an unfairly high profit by the most acceptable reasoning which she could determine.

Item 4 . It goes without saying that income earned in an earlier year from the one under review does not belong in the annual profit figure. The securities commission seemed to be well aware of this in suggesting that because of its magnitude this item should perhaps be separately disclosed. Given that this has not been done it follows that the full $16m should be entered in the Unders and Overs schedule as a check against such items being significant in aggregate. There is no excuse for either the Auditors or the Securities Commission not doing so in their respective versions of the Unders and Overs schedule.

The argument that if it hasn't been part of previous years profits it is ok to include it as profit of this year has long been discarded in accounting theory, dating back to Royal Steam Packet case. The idea of the profit statement is to measure how well the entity has performed in the year being reviewed without any distortion from undeclared profits of yesteryear, whether the failure to declare previously was accidental or otherwise.

Item 5. The use of zero coupon and low coupon financial instruments to radically distort reported business profits had become recognised and by accounting consensus been stamped out by 1989. The Inland Revenue department made it mandatory to use Yield to Maturity calculations to determine the interest of such investments in 1988. They claimed that this was bringing them in line with what was then required with respect to financial reporting. As a financial reporting specialist Ms Hickey would be fully aware of these discussions and determinations and hence of the magnitude of the profit distortions of failure to take the time value of money into account in the high interest environment then prevailing.

The bank had borrowed by way of the issue of Perpetual Subordinated Capital Notes with a variable interest rate based upon an LIBOR interest rate and at the same time had invested in a zero-coupon bond. The bond was held as security by the holder of the notes and so the two securities were linked. The Securities Commission asks the readers of its report to believe that Ms Hickey, and presumably Mr Garty who had also taken an interest in these notes, had not realised that there was both a bond (asset) and the notes (liability) involved and thought that there was just one or the other (just which is not clear) which were referred to as notes. They were aware that the bank had applied a straight line interest calculation to the securities, and they presumably would have vouched this journal transaction which would have indicated the securities to be an asset but if done correctly would not have referred to them as notes. The treatment of the notes in the balance sheet would indicate them to be a liability. Ms Hickey at least knew that Straight Line interest apportionment was now taboo. The more complex but technically correct Yield to Maturity calculations should apply. But she is purported as having a problem. She thought that the securities over which the straight line calculation had been applied were also the securities which carried the variable interest rate. This would have created as much of a problem for calculating straight line interest apportionment as it would for utilising the Yield to Maturity calculation, but, we are expected to believe, it never occurred to Ms Hickey to check out how the bank had allowed for the variable interest in its calculations.

Apart from this, having encountered the problem Ms Hickey apparently did not attempt any approximations with the Yield to Maturity method, say by assuming an average rate for the LIBOR interest, and then comparing it with the results which the bank had got. If she had done so and discussed her results with the Bank officials the alleged misunderstanding over the nature of the securities would have become clear. Indeed if she had just told the officials "I can't figure out how to do a Yield to Maturity calculation when variable rate interest is involved" they would surely have enlightened her by saying its the notes that have the variable interest and the bonds which require interest apportionment. Then why should a security carrying a realistic interest rate have such a big difference between its issue and maturity values? It is not conceivable that Ms Hickey could be so misled. She was too quick to decide not to do anything at all as soon as a hiccup appeared to get in the way in appling the YTM calculation.

The Securities Commission in paragraph 15.142 claims that income overstatement also occurred with respect to the actual notes but does not explain how this comes about. The $7.7m income overstatement is based upon an undisclosed calculation method supplied by Coopers and Lybrand. Their first assessment of the variance was $10.2m ($16m - $5.8m) and was explained. The adoption by the Commission of an undisclosed method should be considered to be unacceptable. They could have got a copy of the calculations by fax if they had wanted to.

Item 6. Restructuring costs, shown in the accounts as an extraordinary item were described by Mr Garty as "ongoing costs", which is inconsistent. Submissions were made to the Securities Commission suggesting that these costs should not be treated as extraordinary and no contrary argument was advanced. The profit before tax and extraordinaries has therefore been overstated by this amount.

Item 7. Mr Garty's explanation indicates that the bank had a policy of declaring its restructuring costs, or certain of them, in the accounts of the year prior to them being paid out. These costs (presumably redundancy payments and the like) are a cost of doing business in earlier years and the matching process would suggest that the earlier that they are declared the better. The fact that they had become a regular expense does not alter the situation. However one might accept that for reasons of practicality or whatever the bank might at some stage choose to alter its policy on the matter. If and when the bank chose to do this it would create a year "free" of the expense in its profit statement for that year if some compensating adjustment was not made. This would be because the current year's payout had already been declared while the next year's payout would be included in the expenses for the next year. There has long been provisions in accounting standards for the declaring of changes in accounting policies and advising the effects of same on the accounts presented. It would probably be more acceptable to put in a dummy entry so that a typical annual amount of the expense concerned is included in the accounts so that the readers are not left to make such an adjustment for themselves, something that they may fail to pick up on and so be mislead by.

The BNZ had not altered its policy and even if upon Mr Garty's request it decided to do so it was not entitled to have a year that did not contain this expense in the accounts given that such expense was regular.

It is submitted that the only rational explanation was that Mr Garty wished to provide items of profit understatement to offset the overstate of the captive insurance on their schedule.

Item 8. The commission decided not to comment on this and the following two items. They seemed to be careful not to say that that they had not looked at them nor to say that they seemed to be genuine anomalies. The profit on sale of a building is likely to have been earned or gained in previous years and hence it is doubtful whether it should be included in the year's profit.

Items 9 & 10. Like the restructuring costs these presumably are items scheduled for paying out in the new year. Postings to the Unders and Overs schedule need to be items which in the Auditor's view are decidedly wrong and would result in an adverse report if sufficiently significant. The lack of information on the schedule makes one suspicious that the are somewhat discretionary items which have been trimmed back by the auditors to balance their schedule.

Item 11. It would not seem proper to introduce lingering doubts onto the Unders and Overs schedule. Auditors must consider items issue by issue and decide wether they should tag their report because of it excluding significance considerations, and if the answer is affirmative, post the variance to the schedule.

In fairness it is not an item on the schedule. It would seem to be a reason, by way of a footnote, to justify not issuing a tagged report.

It would be fair to say that at the time the average business person would express surprise or disbelief that there was need for a greater provision for bad debts in the Australian property market than in the New Zealand one. But the Auditor is there to check out what the records show, on behalf of the public, and not to discount it because of popular disbelief.

In considering the bad debt situation auditors of course can check on the latest situation concerning default. What other information they had access to is not clear.

The auditors had a duty to check whether any post balance date events should be declared. One would think that management or directors would be asked to sign a statement saying that they knew of no such events which affected the relevance of the accounts, prior to the audit certificate being issued. It would seem that this should have brought the true Australian situation to light. This issue was presumably outside the undertaking of the commission.

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