2nd of two files to First File
15.121 We will now examine the compilation of the auditors' "unders and overs" schedule.
15.122 E & Y provided us with an original "Error Schedule" prepared by them in respect of their audit of the accounts to March 1990. This records the basis of their conclusion that the distortions to the Bank's profitability arising from various sources, including the arrangements, were not material. That schedule concludes that there was a profit overstatement of $7.3 million for the March 1990 year. A copy of the schedule is included in the report at Appendix M.
15.123 E & Y's "Audit Planning Memorandum for the year ending March 1990, when discussing "Planning Materiality", includes:
We believe that the operating results and shareholders equity will be the key figures on which external users of the financial statements will focus, and we will therefore used these figures as the base for our calculations of PM (planning materiality).
15.124 The document then reviews a number of measures, based on averages of the outcomes over the preceding four years, but also including the budgeted profitability for the year, before concluding:
The most appropriate figure for PM therefore appears to be $8M based on operating results before provisions and tax, budget 1990 profit after tax, and shareholders equity.
This gives a tolerable error of $4M.
15.125 On the face of it a net overstatement of profit of $7.3 million, on a reported profit before tax and extraordinaries of $100 million, is in the marginal area but may not be considered material. We note that it is at the limit of the level of E & Y's "planning materiality".
15.126 We have carefully reviewed E & Y's approach to the calculation of audit differences. There are a number of areas where we disagree with their assessments. Later in this section we present our own revised schedule. The purpose of this is not to restate "overs and unders" with the benefit of hindsight, but to exclude errors which should have been clear at the time.
15.127 We accept without comment the three items, "Sale of London Building", "Overaccruals" and "Gratuities Overstated".
15.128 We have already reviewed E & Y's treatment of the arrangements. As we noted, in our view E & Y should have included a variance of $55 million arising from the misstatement of income from the arrangements, not the $27 million which they did.
15.129 The Error Schedule also includes a net-of-tax amount of $13 million ($20 million before tax), shown as an understatement of profit, and explained as:
Restructuring costs taken up in the accounts which we do not consider to be required as they are an ongoing expense.
15.130 We note that the Bank treated its restructuring provision as an extraordinary item. Accordingly in our view this understatement is not relevant when computing the impact of the various accounting differences on the Bank's profits before tax and before extraordinaries. It should not have been brought into the schedule. In our revised schedule we have omitted this item from the assessment of the overstatement of pre-tax profitability.
15.131 Trow has given evidence that may commentators would have been returned the restructuring provision to an "above-the-line" item when analysing the Bank's financial statements, and he considers the Commission should do likewise.
15.132 Whatever commentators may have done, the Bank included the restructuring provision below the line and the auditors did not qualify the accounts as a result of that treatment. We have to deal with the financial statement as they were presented by the Bank and using the contemporary materiality measures.
15.133 We include a further item in our schedule relating to an income overstatement on account of the Bank's treatment of its issue of Perpetual Subordinated Capital Notes ("the capital notes") which were made in 1988. We were alerted to this item both through Sadler's note to the Board identifying that $32 million was included in the Bank's 1990 profits on account of the amortisation of these notes and because E & Y included variances in subsequent "summaries of audit differences" schedules for 1991 and 1992.
15.134 By way of explanation the Bank raised US$200 million by the issue, through a subsidiary, of the capital notes. The interest rate the Bank paid was related to market benchmark rates. The Bank immediately purchased, for around US$54million, a zero coupon bond with a maturity value of US$200 million in 15 years time. The investors in the capital notes have control of the zero coupon bond as we understand will be repaid from its proceeds in the year 2003.
15.135 The capital notes have been recorded in the Bank's balance sheet at their net value i.e. the original issue price less the current assessed value of the zero coupon bond. As the value of the zero bond goes up the Bank's net exposure to the capital notes goes down.
15.136 The Bank's 1989 financial statements did not include any adjustment on account of the increasing value of the zero coupon bond. It was explained to us that this was an oversight because there were so many other issues being dealt with in the accounting area at the time. In 1990 however the Bank "caught up" and included adjustments for both 1989 an 1990. The gross amount taken was $32 million, of which $16 million related to 1989/90.
15.137 We agree that the increased value of the zero coupon should be recognised in the Bank's income. Arguably the inclusion of the 1988/89 adjustment in March 1990 income should have been separately disclosed, given its size. Our concern, however, relates to the Bank's method of calculation, which was to record the accretion in value of the zero coupon bond on a straight-line basis. Thus the growth of the bond over 15 years, around US$145 million, was being brought into come at the rate of US$10 million per year.
15.138 In our view the accretion to income should have been computed on a YTM basis especially as the bond was of a type computed with a fixed yield over a fixed period of time.
15.139 Coopers, in their Operational Review Report in March 1991, advised that YTM was the correct accounting treatment. They computed the variances arising from the difference between a straight-line and a YTM basis. For the years 1989 and 1990 these income differences amounted to US$6.2 million and US$5.8 million respectively. This meant that the Bank had overstated its income in 1990 by US$12.0 million @ 0.58) $20.7 million.
15.140 We have subsequently received a submission from RWS that Coppers' computations were not correct and that on an alternative calculation basis, a basis which we are told was used by the Bank in November 1992 to restate the value of the Notes in the bank's financial statements, the overstatements are less. Coopers are said to have agreed that their earlier calculations were incorrect. We have decided to accept the revised basis put forward by RWS for the purpose of restating the Error Schedule. On the revised basis the income overstatement for 1990 is US$9.23 million @ 0.58, $15.9 million.
15.141 E & Y looked at this issue in 1990. In Hickey's file note of 11 May 1990 she describes the capital notes but does not indicate an awareness of the zero coupon bond. She acknowledges that the Bank is using a straight-line basis rather than a yield to maturity basis but concludes:
Because the interest rate is a floating one based on LIBOR, it is not possible to calculate the reduction in the perpetual capital notes on a yield to maturity basis. Accordingly, the Bank's adopted straight-line basis is accepted.
15.142 In fact the amount of the income overstatement relates to both the interest rate on the capital notes, which was floating, and the yield on the zero bond, which was fixed.
15.143 It is worth noting that in November 1992, following the takeover of the BNZ by the National Australia Bank, the Bank changed its accounting policy with respect to the capital notes so that they were recorded on a YTM basis. The immediate impact of this change of accounting policy was reflected in an increase in the carrying amount of the Capital Notes from $198 million at 31 March 1992 to $227 million at 9 November 1992.
..., on the basis of our review of the Australian loans we believe that there were some conservative provisions made in Australia and additionally there was general provisions made in excess of what we had expected. It is difficult to quantify this amount, however, it may be in the region of $20-30 million.
15.145 We have the report Garty made to the Bank following his visit to Australia. In a letter dated 8 June 1990 to Pyne, Garty identifies one or two accounts where additional provisioning is needed and one which is over-provisioned by about $3-5 million. He does not record a view that Australian provisioning is $20-30 million too high. We found no evidence to justify this. Indeed the Bank's directors and management had serious concerns at this time about the Australian position.
15.146 Based on the preceding analysis we have computed the following revised schedule of audit differences:
| Overstatement on account of the benefits taken under the arrangements | $55.0 million | |
| Overstatement on account of the incorrect treatment of the capital notes | $15.9 million | |
| Understatement on account sale of London building | $0.7 million | |
| Overaccruals | $1.0 million | |
| Gratuities Overstated | $5.0 million | |
| Revised overstatement of 1990 profit before tax and extraordinaries | $64.2 million |
15.147 We observe that, after revision of the "Error Schedule", the variance between the Bank's recorded pre-tax profit for the year ended 31 March 1990 and what we consider is the correct figure is now larger than the variance arising from the treatment of the arrangements alone.
15.148 We have already concluded that, in our view, a variance of $55 million in respected of a corrected profit figure of $45 million was material. Our view is even stronger when considering a profit overstatement of $64 million on a corrected profit of $36 million, an overstatement of 177.8%.
E. Our findings on the March 1990 financial statements15.149 The Bank's reported profit before tax and extraordinaries for the year ended 31 March 1990 was $100 million. On our assessment, based on our revised "error schedule", this was an overstatement of $64 million.
15.151 We view the 1990 overstatement o profits as material, a material distortion of the Bank's results for the year which was "fundamental" as the term is used in Auditing Standard No. 10 , "Audit Reporting"' of the NZSA.
15.152 We conclude that the financial statements of the BNZ for the year ended 31 March 1990 did not present a true and fair view of the results for that period.
15.153 The overstatement of the Bank's shareholders' funds, at $55 million or 5.3% of the corrected shareholders' funds amount, was not material.
F. Our findings in relation to the performance of Ernst and Young.15.154 E & Y gave an unqualified audit opinion with respect to a set of financial statements for the BNZ for the year ended 31 March 1990 which did not, in our opinion, present a true and fair view of the results of the Bank for that period.
15.155 Garty, in our opinion, derived false comfort from his error schedule. The incorrect treatment of the arrangements, viewed either in isolation or in conjunction with other variances, was material to the extent that the 1990 annual financial statements failed to show a true and fair view.
15.156 With respect to the Bank's treatment of the arrangements we consider that E & Y should have insisted that the Bank adopt a matching approach which equated the benefits taken by the Bank with the full cost of the arrangements (the amortised premium plus foregone interest) to account for its use of the arrangements in 1990 rather than the version of "matching" which E & Y advocated.
15.157 In our view E & Y should not have incorporated, in their "error schedule", an amount of $27 million as the variance arising from the Bank's use of the arrangements. The amount should have been $55 million.
(a) | we have found no evidence of improper conduct on the part of the Bank's solicitors, Buddle Findlay or on the part of the Bank's auditors, Ernst & Young (formerly Ernst & Whinney) or BDO Hogg Young Cathie; |
(b) | we have found no evidence of breach of fiduciary duty by any director of the Bank; |
(c) | we have found no evidence of any improper influence on the activities of the Bank from either of its substantial security holders, the Crown and Fay Richwhite & Co Limited. |
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