15.105 It was the view of E & Y that the influence of the arrangements on the Bank's reported profits after taking account of their "unders and overs", had not been material in any of the years under review, including in 1990.
15.106 E & Y said "matching" was an appropriate treatment for the arrangements in 1990. It should be noted, however, that this was a different concept of matching than that view described by us in this report. Hickey said that it would have been reasonable for the Bank to have adopted the "matching" principle from 1988 to 1991. She said in a written submission:
In March 1988 (and until comparatively recently - 1992 issue of ED60 Statement of Concepts), the matching of expenses and revenues was a primary accounting principle.
SSAP 1 para 4.2(b) "Matching of Expenses and Revenues
Under accrual accounting, expenses and revenues are recognised as they are incurred or earned (rather than as money is paid or received) and recorded in the financial statements of the period to which they relate. Results for the period are determined by matching expenses with the related revenues."
ED60 continues with the accrual basis of accounting, rather than the cash basis. However it indicates a shift in emphasis from "matching" as a primary accounting principle, to emphasis on recording assets and liabilities. ...
Value at Which Assets Recognised
The historical cost system of accounting does not usually recognise the time value of of money. That is a future receivable or payable is recognised at the nominal amount to be received or paid without regard for the time period until expected receipt or payment. (Interest bearing receivables or payables are recognised at an amount that reflects time value of money, in respect of the total cash inflows or outflows, provided the interest rate reflects approximate market rate.
15.107 In response to questioning Hickey said at p.611:
... .I can accept that the alternative of an appropriate matching was perfectly acceptable at the time as well. In other words the treatment that I came up with in May 1990 . [the YTM method]... was my view of accounting for the transaction in terms of its substance but there were arguements that could be made that an acceptable alternative was to account for it in terms of a matching concept. I believe that this alternative was an accaptable alternative in 1988, I believe it was still an acceptable alternative in 1990 but I believe the people looking at the transaction now in 1993 would not regard the matching as an acceptable alternative and the reason I say this is because of those two papers, the UK paper and the US paper in September and December of 1991 which deal specifically with the transaction as opposed to the references ... made to FAS 5 and FAS 97...
15.108 E & Y included an assessed income overstatement of $27 million arising from the use of the arrangements in their 31 March 1990 "Error Schedule" (see appendix M). This is described thus:
Insurance Policy Overstatement - on a net present value method the insurance benefits have been taken up in excess of the related costs.
15.109 -E & Y explained that they derived this amount by applying the "matching" principle to the arrangements. Based on the Bank's originall intended 1990 claim of $100 million, that is half of the total sum insured E & Y considered that the Bank should expense half the premium ie. $55 million. Since the Bank was only charging $22 million in premium this meant there was an undercharge against income of $33 million. When the final claim was lowered to $94 million E & Y also took $6 million off the amount of premium undercharge in their unders and overs schedule giving $27 million. They acknowledge they should only have deducted $3 million.
15.110 E & Y's computation takes no account of the fact that the Bank would not receive the proceeds of it's claim for three years. Their reasoning is explained in a file note "Bank of New Zealand 31 March 1990 Year End Issues" dated 11 May 1990 and signed by Hickey. She said:
Because the bad debt provisions against which the insurance claims are netted will not accrue further interest over the period until the claims are paid, I have accepted an accounting treatment that does not involve recognition of interest on the deferred settlement of the insurance claims.However, the accounting treatment currently adopted by the BNZ is unacceptable on a matching basis. The insurance premiums should be matched against recognition of the claims, and not on a time basis.
15.111 We do not agree with this line of reasoning for the following reasons:
(a) The arrangements were not in substance an insurance arrangement with the transfer of risk. The amount the Bank could claim was determined solely by the interest yield obtained on the investment of the premium payment. Settlement of claims was deferred solely in order to allow that interest income to accumulate;
(b) Non-recognition of the interest on the deferred settlement of the insurance claim is the equivalent of recognition of the compounding interest on the zero coupon bonds as income in advance of the periods in which that interest would be derived. Such anticipation of income is unacceptable;
(c) As we outlined earlier in our report, it did not recognise the substance of the arrangements.
15.112 In our view E & Y's version of "matching" was flawed. The matching approach used by the Bank in earlier reporting periods had regard to both the amortised premium cost and the interest accruing (foregone) on the deposit/bonds. The later version used by E &Y does not take account of the interest "foregone" by the Bank.
15.113 In our view E & Y did not correctly apply the "matching" principle to the arrangements.
15.114 In our view the appropriate level of overstatement to have been recognised in the "Error Schedule" on account of the arrangements should have been the $55 million difference between the application of the YTM basis and the basis used by the Bank.
15.115 The Directors of the Bank received advice from E & Y that the Bank's proposed treatment of its intended use of the arrangements in 1990 may have been incorrect. The first record of this is in the minutes of the Audit Sub-committee meeting of the Bank on 11 May 1990 where it is stated:
In this years audit review Ernst and Young have utilised their senior technical partner, Liz Hickey, with a full review of all the Bank's accounting policies and practices including this (loss insurance) policy. Ms Hickey indicated that the accounting treatment which was agreed by the auditors in financial year ending 1988 may not now be in line with emerging and developing accounting practices. In reviewing these comments the directors noted there is now variance on this matter and they consider it appropriate to maintain a consistent treatment for this policy. Later Peter Garty reconfirmed the accounting treatment included in the Draft Accounts.
15.116 Apart from this reference there is no evidence that Garty "reconfirmed the accounting treatment" for the arrangements. We know the auditors accepted the financial statements as a whole. We note from E & Y's records, in the file note referred to in para 15.110, that Hickey says:
However, the accounting treatment currently adopted by the BNZ is unacceptable on a matching basis.
15.117 Garty, in a file note "Bank of New Zealand 31 March 1990 Year End Issues", dated 11 May 1990 said:
I also informed the meeting [of the Bank's Audit Sub-committee] that we were looking at the treatment of the perpetual notes and the insurance policy. A discussion ensued .... I noted that there were some problems with the insurance policy and matching the revenue with the related costs. The Directors are of the view that this insurance policy value, ie $200m can be taken up at any stage as this is the nature of the product. However I stated that they may have to match the premiums against the value they take up. I do not believe that the directors accept this position. We will need to follow- up with Don Shelton and Charles Purvis.
15.118 Garty's subsequent "Report to Management 1990", provided to the Bank under cover of a letter of 17 July 1990 addressed to Pyne said:
BNZ Group Accounting Issues
1. Insurance Premium
The insurance premium of $110m is being taken to Profit and Loss account on a straight line basis over the five year "life" of the policy.
In our opinion, the treatment is not strictly correct and the premium should be matched against the revenue taken under the policy.
In 1989 there was no effect of adopting our recommendations because under either method the amount taken to income and expenditure was the same. However in 1990 a difference of $27m exists between the two methods.
Although we did not propose an adjustment for the above, because of its immateriality when considered with other possible adjustments of lesser amounts, we would recommend consideration be given to adopting the method we have suggested in the 1991 Financial Statements.
15.119 It has been noted that Hickey had advised the Bank that the treatment agreed by the auditors in the 1988 financial year "may not now be in line with emerging and developing accounting practices". The minutes in question do not state whether Hickey also added that the 1990 treatment had departed from that used on 1988.
15.120 We conclude that the auditors did not approve the accounting treatment adopted by the Bank for the arrangements in the financial statements for the year ended 31 March 1990 and observe that this view was expressed by Garty to the members of the Bank's Audit Sub-committee at this meeting on 11 May 1990. It was confirmed in the Report to Management of 17 July 1990.
continued on 2nd file