Section A – This ONE question is compulsory and MUST be attempted
The State Bank of Forenia (SBF) is the largest bank in Forenia with a very large asset base. However, many of its assets consist of what are known as ‘derivative financial instruments’ or ‘securitised assets’. These are loan certificates held on loans made by ‘third party’ lenders to borrowers of long-term funds. Unfortunately, the original loans were made in highly volatile property markets where the solvency and credit worthiness of the original borrowers was uncertain, making them quite risky. In addition, the bank also lends considerable amounts of funds directly to domestic customers for a variety of purposes, many of them loans over longer term periods. The bank had a lower than recommended ratio of capital and reserves compared with its risk adjusted assets. This ratio is known as the ‘capital adequacy ratio’. To make up any potential or temporary difference or ‘shortfall’ between the needs of borrowers and lenders, the bank was normally able to borrow funds through the Forenia interbank loan system (FILS), which was a fund made available by all banks in Forenia to help each other access short-term funds for their immediate liquidity needs.
The bank had engaged the same auditors for over 20 years. Each year the auditors approved SBF’s going concern statement without qualification. The going concern statement verifies that the bank (and its auditors) is satisfied that it has adequate capital and reserves to meet its liquidity needs, that its assets have reliable values and that the bank is profitable enough to continue trading into the foreseeable future.
The audit partner on the SBF contract and SBF’s finance director had trained as accountants together many years ago, and had remained good friends. The audit partner was aware of other banks operating similar business models, and with comparable portfolios of securities and assets to SBF, and knew that their auditors had consistently given these other banks a clean bill of health. However, the audit partner had occasionally, privately, expressed concerns to the finance director about SBF’s capital adequacy, the reliability of the valuations of derivative financial instruments and the longer term sustainability of the bank’s business model. Despite having expressed his private doubts over SBF’s capital adequacy, and potential falls in asset yields, the audit partner had signed off SBF’s accounts as a ‘fair and faithful representation’ at the most recent audit.
A prominent business journalist had recently begun reporting on worrying trends he had identified in the statements of financial positions and the asset and liability profiles of several Forenian banks, including SBF. He had noticed that these banks not only held asset portfolios for which the values might be questionable, but there was also a continuing reduction in their capital adequacy. He also investigated the role of the bank’s auditors, and realised that these trends had not affected their view of the banks’ going concern status.
The journalist was aware that banks should maintain adequate cash reserves to lend to other bank customers. At the same time, banks must have immediate access to short-term liquidity to fulfil requests for withdrawals of cash from their deposit holders, even in a situation where a significant proportion of customers wish to withdraw their funds at the same time.
As part of his investigation, the journalist interviewed the finance director of SBF, in an attempt to discuss SBF’s financial position. Having received what he considered to be an inadequate response from the finance director, the journalist reported problems with SBF’s financial position on national television. This created panic for customers of the bank, and created severe liquidity problems for SBF as deposit holders queued to take their money out of the bank. Panic amongst bank customers spread, affecting confidence in the banking system in Forenia as a whole.
Because of its immediate situation, SBF found it difficult to borrow sufficiently through the interbank lending system (FILS) and faced the prospect of liquidation. As a consequence, the government was forced to intervene urgently and rescue the bank by taking a 49% share in the bank in return for an injection of cash to increase the bank’s liquidity. Once the bank had acquired renewed capital funding to continue trading, the bank’s borrowers became satisfied that the bank was no longer in danger and the panic at the bank subsided.
The prime minister of Forenia subsequently appeared on national television to say that it was very important to restore confidence in the banks in Forenia, and to make a commitment to do all he could to promote the necessary reforms. In future, because of the introduction of a law passed by the Forenian parliament, banks would be required to report honestly and transparently on each of their material risks, including liquidity risk and about how these were likely to be managed. In addition, they would also have to report by law on their capital adequacy. The prime minister stated that the reforms would provide shareholders with the information they needed and restore longer term confidence in the banking sector.
After the immediate crisis was over, SBF’s non-executive directors questioned the competence of SBF’s auditors and their approval of the financial statements, despite the clear underlying financial weaknesses of the bank. The audit committee was also concerned about the independence of the external auditors, how long they had held the appointment and how close a relationship the auditors had with key executive directors, including the finance director. SBF’s board voted to terminate the audit contract and put the audit out to tender (i.e. to let other audit firms bid for the audit contract). After the audit was put out to tender, the board appointed new auditors with whom nobody in the bank had any previous connections.
Additionally, the non-executive directors believed that the shareholders of SBF should be informed fully about the situation leading up the crisis at the bank. They recommended that their chairman should provide this explanation and give reassurances for the future in a statement on the bank’s website, including a comment on how the directors of the bank had previously failed to meet their fiduciary duties to the shareholders and how they intended to address these weaknesses in future. The SBF chairman, Amy Tan, agreed that this would be necessary and she started to take advice from executive colleagues on how her statement should be worded, and how to make the bank become more financially sustainable in the future. This was seen as very important in reassuring the shareholders of SBF.
Another outcome of the crisis was a discussion amongst SBF board members about the impact of the business journalist’s television report on SBF’s financial position. Some board members believed that the journalist’s reporting had been irresponsible, and that the original panic at the bank was unnecessary as well as harmful to the bank’s reputation. SBF’s chairman (Amy Tan) suggested that the board had to concede that the bank’s capital position had not been adequate and that some of its assets which carried high risk had reduced in value. The chairman reminded the board that the bank was subject to rules, imposed by the stock exchange and other banking regulators, including the newly introduced statutory law on capital adequacy and accurate and transparent reporting.
Amy Tan also pointed out that there were other regulations and listing rules which the bank should have complied with, including reporting provisions and rules on going concern safeguards. Finally, Amy Tan emphasised how the internal auditors had obligations to report on compliance with external regulations as well as internal requirements, and also to report on any other issues which arise by exception.
A further outcome of the crisis at SBF was that the board decided on key changes in the interests of improved reporting and transparency within the bank. The executive board decided that instead of the current practice of it receiving audit and internal control reports directly, in future the bank’s audit committee would receive these reports first in order to make unbiased recommendations, as is more usual. The main executive board would only receive audit and internal control reports after the audit committee had fully considered and reviewed them, and made recommendations for the board to consider. Indeed, the audit committee had been pressing for this change as it felt that the executive directors might wish to influence or even, in some instances, ignore some parts of internal audit reports. To prevent this possibility, the audit committee wanted to assess the real issues regarding internal audit and internal controls and present reasonable recommendations directly to the board of executive directors to act upon.
Required:
Explain why internal audit is important at SBF.
Importance of internal audit at SBF
Internal audit is important at SBF for many reasons, especially given its recent performance. Internal audit measures and monitors internal compliance issues and is therefore important for shareholders, especially those concerned about the going concern problems at SBF.
Internal audit ensures compliance with regulatory norms in the interests of stakeholders (including the regulators and the shareholders). For example, the rule on capital adequacy cannot be ignored and it is very important to the bank’s stakeholders, including shareholders. Compliance is also expected by the stock exchange. Non-compliance might affect SBF’s credit rating, which is also very important to the shareholders.
Internal audit is integral to the organisation’s internal control system. Accordingly, it helps directors set the tone for the internal environment and will become part of the culture of the organisation. The effective functioning of the audit committee and the internal audit process leads staff to expect certain organisational norms. Internal audit signals the tone from the top and what is expected from staff in terms of performance and the types of behaviour which are acceptable and which are not.
Internal audit monitoring activities involve inspecting the internal processes used to determine the quality of the organisational systems and the robustness of the organisation’s outcomes. Once SBF employees expect monitoring to take place, it becomes a normal part of the work culture. Their behaviour is influenced, and good behaviour becomes embedded in SBF’s organisational culture and procedures.
Internal auditing should also ensure that risks are regularly assessed, meaning that risks are monitored and then assessed in terms of probability and impact. This is very important in terms of SBF management being aware of all business risks and ensuring their assessment is up-to-date. It also means that all risks are theoretically understood and there should be nothing which comes as a surprise to management. Once risks are assessed, strategies can be selected for the management of those risks, depending upon how each one is assessed.
Internal auditing of control activities as they relate to issues of capital adequacy are important to SBF shareholders. Control activities may underpin the confidence of shareholders concerned about the value of their holdings and the ability of the bank to meet its short-term liquidity needs. Adequate reporting should provide them with reassurance about the going concern status of the bank and the value of their investment within it. A robust internal audit function can assure shareholders that there are control activities in place, which safeguard the bank’s assets and sources of value, including controls on transactions and anything else which ensures that management directives are actually carried out.
Finally, and more generally, internal audit also provides SBF shareholders with a robust assessment of the internal processes of the business. The efficiency and effectiveness of internal control systems are material considerations to shareholders when deciding on their investments.
Explain why it would be more appropriate for the audit committee to review the internal audit report before it goes to the executive board.
Audit committee receiving the internal audit report before the board
SBF’s audit committee would need to receive the internal audit report before the board for the following reasons:
Most importantly, the primary reason why the audit committee receives the internal audit report first is so the audit committee can see the quality (or not) of the bank’s internal systems. The reason SBF’s audit committee would not want the internal audit report to go to the main board first is to allow them to assess the robustness of internal systems without having comments from the board to deal with at the same time. Comments from SBF’s board might try to put critical reports in a positive light, which would be unfair to the shareholders. Shareholders have a right to know about anything which affects the long-term value of their shares, and any limitation on this right is not what they (the shareholders) would want.
SBF’s audit committee would also need to see the true state of external compliance within the organisation, including compliance with the reporting, capital adequacy and other statutory provisions, as imposed by the regulator, the national parliament, and the stock exchange. This information is important for the shareholders and therefore, as the representatives of the shareholders, the audit committee must review it, and report on it, as necessary to the shareholders. This information may affect how shareholders value and price SBF, and accordingly, shareholders should be informed as necessary, without the board trying to influence the findings of such reports to protect themselves.
Additionally, SBF’s audit committee needs to consider internal compliance issues including internal requirements relating to SBF’s asset portfolio. The robustness of SBF’s asset portfolio is very important to shareholders because it can affect the future income shareholders are likely to receive. A key area of concern for SBF’s audit committee is what the internal audit report says about the bank’s overall approach to internal compliance issues. If the internal audit report shows any problems with internal compliance, then that would be a negative signal to shareholders. The audit committee might decide to probe further and to challenge the executive directors on the laxity of the internal processes.
Explain why it was in SBF shareholders’ interests for the bank to put the external audit contract out to tender and allow other audit firms to bid for the audit contract.
Putting the external audit out to tender
There was a manifest lack of independence in the relationship between SBF and its auditor. Private briefings between the audit partner and the finance director, which raised serious issues about ‘going concern’ which were then not reported or acted upon, was highly improper behaviour. Any material information should be reported to the shareholders, especially if it concerns the capital structure of the bank and if it affects the going concern status of the bank.
The fact that the finance director of the bank and the engagement partner were old friends is an obvious threat to independence and this relationship in itself compromised the shareholder value of the business. The number of private briefings without referring the issues to shareholders in the annual report is a manifestation of the lack of independence, and this was not in the interests of the shareholders.
The former audit partner was ‘captured’ by SBF’s executive directors and as a result was unable to bring concerns to SBF’s shareholders, especially those which were material to shareholder value. In particular, auditor concerns over capital adequacy and the valuation of the bank’s asset portfolio are all price-sensitive information to shareholders. These should all be disclosed to shareholders, possibly in a statement by the chairman to the shareholders. Certainly, this information should not have been the subject of private briefings between the bank’s audit partner and finance director, and then be left unresolved. In this situation, it was imperative that SBF should put the audit out to tender as a matter of urgency.
A new auditor would also serve to reassure shareholders that all of the material concerns would be reported to them. In corporate governance, it is vital that shareholders can rely on the external auditor to adequately serve their needs and insist that all material disclosures are made to furnish the shareholders with all relevant and material information.
As chairman of the board, draft a statement to the shareholders, for inclusion on the bank’s website, which contains the following:
(i) An explanation of the board’s fiduciary duty and how the bank failed its shareholders in respect of the board’s fiduciary duty.(8 marks)
(ii) A discussion of the importance of making a reliable going concern statement to shareholders and to the stock exchange.(6 marks)
(iii) A discussion of the main risks which the SBF is exposed to, and how these can be managed to make SBF a more stable and sustainable bank in the future.(8 marks)
Professional marks will be awarded in part (d) for flow, tone, persuasiveness and structure of the statement.(4 marks)
(i) Bank’s fiduciary duty
Dear shareholders
The board is acutely aware of the duty to ensure that every decision it makes is in the interests of shareholders. The bank has a duty of care and trust to the shareholders, and this is the fiduciary duty it owes to those who fund the bank. It should be said that the board takes this responsibility very seriously. In respect of this, there are several points we would want to make.
On reflection, our relationship with our previous auditors became too close which was perhaps inevitable after such a long period. This situation was potentially a threat to objectivity and this, in turn, raises independence issues. Apparently auditors had privately expressed doubts about the capital adequacy of the bank and highlighted issues relating to our asset portfolio. This information is highly price sensitive and should have been reported to the shareholders.
The bank’s audit committee also had doubts over the independence of the previous external auditors. This is a serious issue and it should have been reported. We regret that we did not put the audit contract out to tender sooner. The audit partner gave the bank a clean bill of health (reporting there were no issues relating to going concern), when it has now become evident that there were some doubts in this regard.
The value of SBF’s asset portfolio was heavily dependent on the value of its derivative loan instruments and there was some question over the long-term viability of these instruments. There was also a high dependence on the intrinsic value of these instruments. The derivatives have subsequently reduced in value and, accordingly, shareholders should have been informed of these value reductions.
(ii) Reliable going concern reporting
Shareholders have a right to know all values which relate to their investment and to be informed about any reasonable doubts as to the reliability of these values. The concealment of relevant information (such as capital adequacy) would represent a failure of the agency relationship between shareholders and directors.
The going concern statement is a validation by the auditors on behalf of the directors that the bank’s financial and economic position is sound and sustainable into the foreseeable future. That would involve giving an assurance to shareholders that the bank is not at risk of insolvency and the value of the bank’s assets are reliable and reasonably secure. The confidence in going concern raises a number of agency issues. The first is that if there is any doubt about the going concern of a business such as SBF, the shareholders have a right to know this so they can adjust their share portfolio accordingly, perhaps by selling their shares in SBF.
Shareholders may also want to question the board about the disclosures in the annual report, including the going concern statement. This is an important element of the board’s accountability to shareholders and these meetings exist for this very purpose: to hold boards to account. In SBF’s general meetings, shareholders can ask any question and expect the board to provide convincing answers. These meetings are also important to satisfy the shareholders that no information has been withheld.
(iii) Risks which might face SBF
Because of the unfortunate events which have faced SBF in recent months, there are a number of risks which the bank faces and we must now address these urgently.
The most significant risk is liquidity risk. It was this risk, which created the problems at the time when the government intervened and these must be continually monitored and reported upon. Because this matters to the shareholders, it matters to the board, and we fully intend to ensure our internal controls will help prevent this in future. Were this risk to be realised (again), it would represent a serious going concern threat to SBF, so by continual monitoring, we intend to control this risk. Since the government has passed a law requiring SBF and other Forenian banks to report this risk, we will obviously do so in future. This risk will be considerably mitigated by our new, more transparent reporting system where the findings of internal control risk monitoring at the bank are reported to the audit committee to consider before recommendations are passed to the main board of directors to act upon.
The next most serious risk is investment risk. It is likely that if there is any repetition of the recent events, investors will lose confidence in the bank and reduce the number of SBF shares in their portfolios. Again, we need to communicate directly with shareholders, and to tell them what they need to know in order for them to make informed choices about their investments in SBF. I would suggest that open reporting to shareholders is imperative if confidence is to be restored. We also need to review our business model to ensure that we invest in more sustainable assets whose value can be more readily guaranteed and verified.
Another risk associated with failure to control the above risks is reputation risk. The bank has been severely criticised in the press and our investors and customers have rightly reacted negatively. Management of this risk requires a demonstration of competence and ongoing trust, and we must not waver in this regard. SBF has faced an unprecedented loss of reputation and this must be met head on with continued integrity and probity, ensuring full disclosure of capital adequacy and any problems we might be having with capital values and the security of assets and any potential deterioration in their value over time.
There is also the issue of strategic risk. It is very important that the bank fits in with its environment and strategic risks can affect the future of the bank. Strategic risks can affect the going concern status of SBF and must be taken seriously. Strategic risks include positioning risks, an inability to attract resources and to add value to those resources. Strategic risks can affect the going concern for shareholders, and so must be avoided or minimised as far as possible, for example, by having contingency plans to attract resources. To manage these risks, the bank should gradually strengthen its statement of financial position around a more sustainable portfolio of assets and liabilities and have greater controls around ensuring that the lending it makes, or the securitised assets it purchases are more dependable in economic terms. We also need to ensure we hold an adequate reserve of readily available liquid assets and to increase our capital adequacy ratio to meet our short-term needs and any contingencies we may face in the future.
To conclude, SBF recognises it has failed its shareholders in the past, has had a closer than usual relationship with the previous auditors and failed to properly uphold its fiduciary responsibilities to the shareholders, its customers, the government and to the wider public. We have now addressed this failing with the appointment of our new external auditors, with whom nobody in the company has any previous connection.
Looking to the future, our primary objective is to strengthen our financial performance and position by reviewing our asset base, considering more carefully to whom we lend and borrow from and gradually increasing our asset base through sustainable lending and trading within a formal framework of internal controls, reporting and risk management. We must also manage our major risks more effectively.
Yours faithfully
Amy Tan
Chairman of the board