What an SMSF auditor can do to avoid litigation
A couple of key cases this year have led to major settlements against the auditors of SMSFs for failing to let the trustees know of dodgy investments.
In both instances, the trustees of the SMSF invested with a trusted friend or adviser, who also owned a percentage of the firm preparing the financial statements of the SMSF and who ultimately scammed them out of their investment.
When I audit a club or association, I automatically qualify the audit report every single time, with something like: “As is common for organisations of this type, it is not practicable for the club to maintain an effective system of internal control over cash receipts until their initial entry in the accounting records. Accordingly, as the evidence available to us regarding revenue from XXX activities was limited, our audit procedures with respect to XXX activities had to be restricted to the amounts recorded in the financial records. We, therefore, are unable to express an opinion whether all income relating to XXX activities is complete.”
This protects me from the fact that I can’t ascertain that all income has been banked and, to be frank, the most likely time that money goes missing in a small club or association is before it is banked.
Should I now also add a qualification to all SMSFs who invest in unlisted unit trusts, private companies and unsecured loans? In a lot of cases, it is difficult to confirm the accuracy or value of private companies. It is even more difficult to get information as to the recoverability of unsecured loans. I have relied on trustee valuations or emails from the CEO to value unit trusts or private companies. These are the same trustees that the courts have reduced the damage payments by a mere 10 per cent for contributory negligence.
What about the SMSFs that have all their assets in a property? This means that in pension phase, they are unlikely to have sufficient cash flow to pay pensions. And unless there is a reversionary pension in place, they will also have to dispose of the property on the death of a member because you cannot do a journal to transfer a death benefit to another member account (ATO ID 2015/23).
Similarly, what about those who have just made bad investment decisions? Whiskey barrels anyone? Currency trading? In fact, do I as an auditor need to see an SOA? Do I need a full understanding of their outside investments to ensure they are diversified? Do I need to advise them that their investment strategy is unlikely to achieve their desired retirement income outcomes? That their 0-100 per cent asset allocation strategy is not sufficient? The auditor in Cam & Bear, Mr Goldrick, was paid around $350 for his audit. The administration fees paid to Databank, whih also prepared the accounts, was almost $40,000 over the period, yet the judge stated:
“There was no evidence that Databank was more than a ‘compiler’ of the accounts … Moreover, for all the evidence indicated, the terms of Databank’s retainer may have included an express and relevant disclaimer of responsibility. I also add that the proposition, asserted in Mr McGoldrick’s submissions, that Databank was paid ‘almost $40,000 in administration fees by the fund’ does not enable any inference favourable to Mr McGoldrick’s case to be drawn as to the nature and extent of Databank’s responsibilities.”
SMSF trustees are supposed to be sophisticated investors. SMSF trustees are supposed to be able to make their own investment decisions and understand them. The court cases have shown that not only do trustees not understand their role and responsibilities, but when losses are made, the only reliable source of recoverability is the auditor’s professional indemnity insurance. In Ryan Wealth Holdings Pty Ltd v Baumgartner (Ryan) the judge stated:
“Ms Crittle did depart from the standard of care that a reasonable person would have applied to protect his or her own interests, but the departure from that standard was very limited. Even a person with Ms Crittle’s lack of financial sophistication or relevant occupational experience should reasonably have considered the prudence of supplying significant amounts of money to Turnbull Hill Lawyers to be invested by Mr Moylan without further inquiry.”
Ms Crittle deposited over $7 million dollars into an account and had the advice of a financial planner with an AFSL. Yet even though she had significant funds in her SMSF and was taking advice from a financial planner, she was not considered to be sophisticated and therefore her contributory negligence was reduced.
“Further, Ms Crittle knew that the super fund was required to have an auditor; she thought their job was to scrutinise what work the accountants did; and her limited knowledge of the role gave her great comfort. Nonetheless, the lack of sophistication and her reliance upon the advice of Mr Moylan and Mr Hill limits the criticism that can be made of her.”
Limits the criticism? In both decisions, the criticism on the auditor was that earlier notification would have reduced the losses. In Cam & Bear Pty Ltd v Mc Goldrick (Cam), the unsecured loans were incorrectly classified as “Cash – LSL Holdings”, yet the trustees had signed a management agreement in which:
“Lewis Securities, being the fund manager, has the power ‘in its sole discretion’ to purchase, to invest in, to acquire, to sell, to transfer, to exchange, to dispose of, or otherwise to deal with an authorised investment in the management of the fund. An authorised investment, as recorded by the defendant, included unsecured deposits at call with Lewis Securities.”
Furthermore, “Dr Bear accepted that it would have made no difference to him, in terms of his investment policy, if, instead of the description ‘Cash’, the accounts had said ‘Loan to LSL Holdings’. Dr Bear did not appreciate the difference.”
Yet the court of appeal judges felt the original ruling of 35 per cent contributory negligence was too high and reduced it to 10 per cent. So, the trustee is only 10 per cent responsible for trusting a friend, signing over his power to invest, for not making enquiries as to where his money was actually invested and signing financial statements and trustee declarations that he was responsible for the accuracy of such statements?
One of the key takeaways for auditors in the Cam case is the below steps or enquiries that the auditor should have included (but are not limited to):
- Communication with those charged with the governance of the fund, as well as administrators and investment managers as considered necessary;
- Request and review any agreements relating to the balance, to understand the arrangements including the rights and obligations of the parties;
- Request and review the financial reports of LSL Holdings;
- Enquiries about the financial condition and going concern of LSL Holdings, with corroborative evidence and cash flow projection;
- Written representations from the administrator, custodian, investment manager and trustee;
- The existence of any financial guarantees or letters of financial support, verifying the existence of undertakings between corporate bodies upon which the fund would need to rely; and
- Communication with the trustee to alert them to any concerns arising from the audit procedures and the potential impact on the accounts and auditor’s report from such concerns.
Communication directly with the trustee is essential, whether it be via management letter or as a qualification to the audit report and maybe we need a standard qualification paragraph for these types of investments, something like:
“We are limited in our ability to accurately value unlisted unit trusts and private companies without a formal valuation. Accordingly, as the evidence available to us was limited, our audit procedures in respect to the XXX investment had to be restricted. We are therefore unable to express an opinion on the value or recoverability of your investment in XXX unit trust.”
Meanwhile, I’m not looking forward to my PI insurance renewal notice this year as no doubt our insurance providers have been watching these cases and reassessing our premiums accordingly.
Deanne Firth, director, Tactical Super