1990 Bank of New Zealand "Audit" - Summarised Version

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A high standard of accounting integrity is a necessity for a modern economy and at the moment NZ does not have it. Public Funds stand to be siphoned off into private hands for which they are not intended by various accidentally on purpose means.

As substance to this allegation I cite to you the audit of the 1990 annual accounts of the Bank of New Zealand, major players in which have never been censured and remain in high office for, I suggest, the protection of each other, so ensuring that such practices can continue.

The "audited" 1990 Annual Profit of the BNZ was inflated by the misreporting of income from of two parcels of zero coupon bonds, each of about $200m, which had effectively been purchased or subscribed for by the Bank as investments.

Several years prior to 1990 the inappropriate calculation of income from zero and low coupon bonds in income reporting had supposedly been stamped out with the mandatory adoption of a specific "Yield to Maturity" calculation to arrive at a given year's income derived from such bonds. The 1990 BNZ auditors and indeed the company accountants would have been highly aware of this directive. The Yield to Maturity method had been adopted by the Inland Revenue Department in 1988.

One of these two zero coupon bond parcels went through the classic misuse of zero coupon bond income procedure. It was purchased early in the 1989 income year. Because a catastrophic loss was incurred in that year additional overstatement of loss was unlikely to attract any additional outrage. The Bank advised that because of the general commotion occasioned by the loss they had overlooked the crediting of the income on the bonds. Whether the auditors picked up the omission at this time is unknown.

Then in the 1990 year one could argue the Bank management would be keen to be able to report a profit similar, or as close as possible, to those immediately prior to 1989, but the records showed the profit to be somewhat short of such a target. The management caught up with need to credit the bond income and made a calculation for both the 1989 and 1990 income and treated the amount for both years as income for 1990 in the accounts. But also the calculation which they used was the outdated and discredited Straight Line method which gave an answer which was almost double that of the correct Yield to Maturity method for each of the two years.

The Bank's accountants had apparently not attended any courses or read any literature covering the adoption of Yield to Maturity. Not so the auditors. From their audit records they appeared to be conversant with Yield to Maturity and were aware that the Bank had used the Straight Line. However "unfortunately" they were ignorant of or unconcerned about the fact that two years income had been declared as being earned in the one, and they got confused with Bank borrowing at a variable interest rate by way of perpetual notes which was associated with the bonds and apparently thought that the variable interest rate applied to the bonds. They then, it is explained, decided that Yield to Maturity could not be applied to a variable interest rate so the Straight Line method could be accepted. It would be equally difficult to apply the straight line method to a variable interest rate, but one is asked to believe that this did not raise their academic curiosity. It should be noted that the Auditors had advised the Bank's audit committee that the perpetual notes were one of two things that they were looking into. There is no indication that there was anything wrong or controversial with the perpetual notes as such. Its seems they saw the Straight Line method as the problem but their looking into it was not sufficient for them to get to grips with the matter, or so they want people to believe.

To summarise, with respect to these bonds the purported mistakes were (1) $16m of 1989 income reported as 1990 income, (2) thinking that the zero coupon bonds had a variable interest rate despite looking into the issue, (3) thinking that a variable interest rate could be handled by the Straight Line method but not by the Yield to Maturity method, (4) taking the attitude that if the standard procedure won't work anything else will do and not trying to quantify the distortion to reported profit.

The second parcel of zero coupon bonds was dressed up by the Bank as an Insurance Policy at a cost of over $1m of shareholders' funds. The Bank's argument was that because it was dressed up in this way it could be used as a valid reported income "smoothing" device which could even allow income on the bonds which was scheduled to be earned in future year to be applied in a given year to offset losses. The argument was that because such schemes had been used by insurance companies in the UK in the early 1980s (stopped because of emerging scandals) and there were some reported instances of them being used by banks in other countries at a later time, they constituted "generally accepted accounting practice" in New Zealand and hence were valid. On that basis tax evasion is OK since there are numerous reported instances.

In 1990 the Bank claimed $94m from this "Insurance policy" and charged a $22m "premium giving it a $72m net reported benefit as against $17m under a Yield to Maturity calculation on the bond, giving an unjustified boost to reported profits of $55m.

The auditors decided to take a halfway house position. They did not accept that premiums could be charged against income each year regardless of any compensation received, presumably because they did not accept it to be an insurance policy. Ms Hickey, the auditor's senior technical partner, had earlier advised the bank that the treatment of the policy which had been agreed to in 1988 "may not now be in line with emerging and developing accounting practices" and recorded in the Audit notes that the treatment adopted was unacceptable on a matching basis.

But they decided that net proceeds could be claimed in excess of that which had been earned under the Yield to Maturity calculation. The explanation as given by Ms Hickey in the audit notes was that because the bad debt provisions being claimed against would not accrue further interest she had accepted a treatment that did not involve interest on the deferred settlement of the insurance claims. They decided that because an "insurance claim" was being made of half the maturity value of the bonds, then half the cost price should be expensed, allowing half of the total earnings of the bonds over their life to be credited as income to the one (1990) year. Ms Hickey's argument was that the insurance proceeds were being offset against debts which would not accrue "further" interest. She later explained that for trade debtors accounts, or other debtors accounts which were not interest bearing, it was not normal practice to provide for interest which will be lost because of deferred settlement but "interest bearing receivables are recognised at an amount that reflects the time value of money". The Bank's debtors which were purported to be offset by the "insurance claim" were interest bearing advances. There is no reason why they should have ceased to so be other than to allow Ms Hickey to apply her argument concerning inherently non interest bearing receivables. Her rule seemed to be "if the account is assessed to be good, then charge interest, if not don't charge interest, so that it will then be a non interest bearing receivable and it will not be necessary to reduce its value for deferred settlement of principal from the insurance proceeds". It is like the joke about a failed commercial enterprise being a non profit making institution. "Interest bearing" refers to what is allowable and not necessarily to what is effected. Here the auditors have gone out of their way to find an argument to get around the sound principle, fully known to them, of interest bearing receivables being recognise at a value which reflects the time value of money, so allowing the reported profit of the Bank to be distorted. This is not acceptable behaviour for accountants.

Continuing the list of "mistakes" in summary, now considering the parcel of bonds dressed as an insurance policy we have (5) recognising it was not an insurance policy by disallowing annual increments of premium then claiming it was an insurance policy so the "claim" could be justified as valid income (6) claiming bank advances were non interest bearing because purportedly the bank had chosen not to charge interest (7) thinking that a large non interest bearing receivable due for an assured settlement several years hence with no interest chargeable, in times of high interest rates, should be included in annual accounts at face value without considering its true value and the effect of the difference on reported profits (8) deciding that the difference between the cost price and maturity value of half of the bonds could be put into one year's profits, knowing that there were rules for allocating this income between years. (9) deciding that cost price (premium) of 45% of maturity value had to be charged against income in respect of the "claim" and then when the claim was reduced from $100m to $94m reducing the assessed excess profit by $6m instead of 55% of $6m. This was acknowledged as a mistake but that does not disqualify it from being a "mistake".

As a result of their disallowing of certain of the "insurance" income the auditors had an item of $27m on their unders and overs schedule. Their calculation of the allowable net variance of profit was $4m. Six other items are entered or referred to on the Unders and Overs schedule, all claiming to be unders, ie offsetting the $27m over.

Largest of the offsetting items was for $13m. The narration for it on the schedule was "reconstruction costs taken up in the accounts which we do not consider to be required as they are an ongoing expense". By "taking up" one assumes that this expense has been included in the in the year prior to them being paid out. Restructuring costs are generally a cost of doing business in past years and in principle it would seem that the earlier that such expense is declared the better although there could often be practical problems in so "taking it up". The fact that it tends to be a ongoing expense does not change the situation. If there was to be a change in policy the bank would have been obliged to declare distortions to profit due to a change in policies. In this case the distortion would be that the bank would report a year which was free of this ongoing cost. This $13m entry said that the bank should have the benefit of an unjustified distortion.

The restructuring costs were shown in the accounts as a extra- ordinary item but as an ongoing cost that would not be appropriate. That unders and overs schedule related to the Bank's profit before tax and extraordinary items.

Effectively what was shown as a $13m understatement should have been an overstatement of similar amount.

Continuing the list of "mistakes" in summary, in respect to these restructuring costs the auditors mistakes were (10) adjusting to take out an expense that was not there, (11) deciding that an expense should not be taken up because it is ongoing, (12) failing to recognise that an ongoing expense is not an extraordinary item.

The unders and overs schedule also referred to the Bank's Australian loans portfolio and suggested that some conservative provisions for bad debts had been made saying it "may be in the region of $20-30m". At the time that this was written the bank had major concerns about the Australian loans, the major cause of a huge loss and government bail out of the bank in the 1991 financial year. The obvious way to check out the suspected overprovision would be to check out what the current situation was either by interviewing relevant staff or looking at the trends of arrears on Australian loans. The Auditors also had a duty to check that there were no significant post balance date events that should be declared in the accounts. The normal way to do this is to have key bank personnel sign a declaration that they have no knowledge of any such event immediately prior to signing the audit certificate. Possibly two more "mistakes" to go on the list.

Clearly the auditors were not prepared to issue a qualified audit report despite one being justified. They also wished to give the impression to critics that they had not accepted the insurance claim as valid revenue by partially disallowing it on the unders and overs schedule and then inventing an item or two as entries to offset it. In 1993 Ms Hickey explained that while the Insurance scheme would not then be acceptable (in 1993) at the time in 1991 it would have been equally valid to have accepted the insurance scheme as adopt the alternative method that she "came up with". This argument should not be acceptable. If the insurance scheme was acceptable in her judgement she had no right to make the entry in the Unders and Overs schedule. That schedule is for things that they believe to be not acceptable.

Information for the above comes from the 1993 Securities Commission report into the matter. The Securities commission found the Bank's 1990 reported profit before tax and extraordinary items to have been overstated by $64m. The Commission went to considerable length to explain why they had come to this conclusion. They also state that they found no evidence of improper conduct on the part of the Bank's auditors. There is no discussion on this and there should have been. Just how many "unfortunate mistakes" all having the effect of allowing the Bank to overstate its profits does there have to be before it constitutes evidence of improper conduct ie deliberate "unfortunate mistakes"? The Commission should have considered that question and should have found the answer to be far fewer than the number of mistakes that these auditors came up with. They also did not disclose that Ms Hickey was in fact a member of the Commission at the time that report was written.

With respect to the bonds associated with the capital notes the Commission says (para 15.158) "The omission of such an adjustment was an unfortunate error". There can be no justification for the making of such a strong statement. How can they know?. No reasons for reaching such a conclusion were given and as I have outlined the evidence shows the opposite to be true.

The Commission did not discuss the absence of a declaration of post balance date events in the 1990 annual accounts of the Bank, nor did it discuss Ms Hickey's incredible "because no further interest will accrue" reason from not taking interest into account in valuing advances being covered by the "insurance claim".

Ms Hickey remains a member or the Securities Commission and is also chairperson of the Financial Reporting Standards Board. Arguably she holds the position of the country's No 1 accountant. She has also been appointed to the board of Radio New Zealand. These continued appointments would appear to be for the purpose of making her unassailable to corruption allegations.

The structure of accounting control is conducive to such malpractice. Large partnerships do not wish to discipline fellow partners for fear of providing evidence which renders them liable to civil action and the controlling body is stacked with members who have vested interest in no action being taken. They frequently take firm action against accountants who are convicted of dishonesty offences (ie falsifying records for direct personal gain) in the Courts but don't promote such prosecutions, and seem to be firm on accountants who display bad manners in a social sense, but generally take no action on instances of bad accounting which one would think is what they are there to do.

The motivation for this false audit would seem to be the wish to keep in with certain high flying directors and be able to gain further work in companies in which they were associated. It would appear that there was a lot riding on the Bank being able to report a $100m profit or close to it. There seems to be a feeling that it is acceptable to fake an audit in such circumstances, but if this is so when are good audits important?

The bank would appear to have made inappropriate loans on more $1b prior to the sharemarket crash. Proper auditing may well have identified and reduced the incidence of such advances, which were probably responsible for New Zealand's boom and bust being more accentuated than most any other country. Because the bail-outs were made without any receiver being appointed it also has to be questioned whether all the loans were genuinely bad. To Top of manuscript"