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Report of the Securities Commission on Aspects of the Affairs of Max Resources Limited

4
AUDIT ISSUES

The audit of Max's financial statements

4.1

Max's financial statements were audited by Sinclair & Wood, Chartered Accountants, of Tauranga. The audit partner responsible was Peter Morris Wood.

4.2

Max's financial statements for the year ended 30 June 1997 received an unqualified audit report. The financial statements disclosed that the cost of the audit for the year had been $3,762.

4.3

In conducting their audit Sinclair & Wood were obliged to comply with, and said in their audit report that they had complied with, generally accepted auditing standards.

4.4

Auditing Standard 6 B Planning, issued by the Institute of Chartered Accountants of New Zealand's predecessor, the New Zealand Society of Accountants, in March 1994 says:

The auditor's work should be planned so as to enable an effective audit to be conducted in an efficient and timely manner. Plans should be based on a knowledge of the client's business and should be further developed and revised as necessary during the course of the audit.

4.5

In developing an overall plan paragraph 6.9 of the standard says:

The auditor should consider the following matters in developing the overall plan for the expected scope and conduct of the audit:

the terms of the engagement and any statutory responsibilities;

conditions requiring special attention, such as the possibility of material error or fraud;

the degree of reliance expected to be able to be placed on accounting systems and internal control;

the nature and extent of audit evidence to be obtained.

4.6

In relation to accounting systems and internal control Auditing Standard No 7 B Accounting Systems and Internal Control, says:

The auditor should gain a preliminary understanding of the principal features of the accounting system and related internal controls to assist in determining the nature, timing and extent of audit procedures. The auditor should study, evaluate and test, as appropriate, the operation of those internal controls upon which reliance is to be placed. Where the auditor concludes that reliance can be placed on certain internal controls, substantive procedures would normally be less extensive than would otherwise be required and may also differ as to their nature and timing.

4.7

Max was a publicly listed company and the audit approach should have reflected that fact.

4.8

From our review of Sinclair & Wood's audit file, and from discussions with Wood, we observed:

There appeared to be a lack of up-front planning of the audit. We would have expected to see documentation on file in the first half of the financial year discussing the approach to be taken in the audit. This would have referred to the client's business, changes in that business, and changes in the environment in which the business operates. It would have noted: that Max had a history of trading losses; that there were liquidity concerns; that operating cash flows were negative; that a number of the Company's creditors had taken, or had threatened to take, action to enforce repayment of amounts due; that Max had changed its business direction and had acquired new ventures. The strategy paper would have discussed how much reliance could be placed on internal controls and the extent to which a substantive audit would have to be undertaken. There would have been an assessment of the level of materiality to be applied in undertaking the audit. There was no such documentation ⁷.

The audit programs were not specific to the client. They appeared to be based on a standard approach for a small business. Wood has told us he believed his approach was fit for the purpose. We think there was insufficient recognition that Max was a New Zealand listed company operating outside New Zealand.

Wood did not seem to obtain adequate audit evidence. There does not appear to have been any review of the originals of the Company's books and records. Most information was faxed to Wood from Western Australia. This included vouchers for payments and the cashbook. In respect of major transactions Wood appears to have relied on copies of directors' resolutions and, in some cases, copies of key letters and principal contracts. As we understand Wood's practices he did not review complete files relating to particular transactions. The file did not include audit evidence for all the asset revaluations that had been undertaken at balance date. Wood did not visit the offices of the Company in Perth for the purposes of conduct of the audit ⁸;

Wood told us he audited several mining companies operating in Perth and that where those companies carried out real mining activities there (as compared with paper transactions) he would get a Perth accounting firm to carry out audit responsibilities. He had not done this for Max;

There appeared to be no engagement letter on the audit file. Wood has told us that, while sending an engagement letter represents best practice, it is not a requirement of auditing standards. Wood considers that the purpose of an engagement letter was substantively met by the terms of the representation letter ⁹ received from Max on 30 October 1997;

The audit report is dated 30 October 1997 but did not appear to have been signed until at least 20 November 1997. Wood says it is common practice for there to be short gaps between the release date of the audit report and the date it is signed;

There are no financial statements on the audit file for Max's subsidiary companies, just a consolidation workpaper. Wood says he was not engaged to undertake statutory audits of the subsidiaries;

Wood did not review the substantial security holder disclosure in the Annual Report to ensure consistency with any published information and his audit report excluded reference to this information. He did not know where the Company's file of substantial security holder notices had been kept, assuming it to be in Perth.

4.9

We have already noted (see para 3.32) that Sinclair & Wood's audit report was not qualified for the Company's non-compliance with its obligations to provide a comparison with previously published prospective financial information.

4.10

As also noted earlier (see para 3.39), in January 1996 Wood had written to the Company's Audit Committee pointing out to them the impossibility of providing adequate internal controls in respect of the cash affairs of the Company because of the nature of its administration. Wood had recommended implementation of some steps that would have improved the directors' control over the day to day operations of the Company. Wood's audit approach for dealing with these internal control problems should have been outlined in his audit strategy document. However there was no such document.

4.11

Because of the size and nature of the Company's operations it was difficult to maintain effective internal controls. In our view this required more extensive substantive year-end audit procedures than those carried out by Sinclair & Wood.

4.12

We do not believe it was possible to carry out the audit of Max to the standard required by generally accepted auditing standards without the auditor examining at first hand the records of the Company.

4.13

Max's registered office is at the offices of Sinclair & Wood in Tauranga. While there is no prohibition on a company having its registered office at the offices of its auditor, we think, for two reasons, this is undesirable, particularly in the case of a listed company with a diversity of shareholders. First, the independence of the auditor is crucial. We think the perception of independence is likely to be compromised when the company has its offices at the auditor's office. Secondly, there is a risk that in such a situation the auditor will be considered to be an officer of the company. Having said this we note that we have seen no evidence to suggest that Wood did not act independently in relation to the audit of Max.

Approval of the Company's 1997 Annual Report

4.14

As we have already noted (see para 1.14 above) at the Company's Annual General Meeting in December 1997 Johnson drew the shareholders' attention to an allegedly incorrect statement in the Annual Report concerning the Audit Committee.

4.15

That statement, on page 10 of the Annual Report, said:
The Company has a formally constituted Audit Committee comprising Messrs McShane and Johnson which has discussed the results of the audit with the auditor.

4.16

A letter dated 24 November 1997 from Bate Hallett, Barristers and Solicitors of Hastings (acting for Johnson and McShane) to Sinclair & Wood, said:
Of concern to both Messrs McShane and Johnson is the statement contained in the Directors report to the company accounts as at 30 June 1997 that they discussed the result of the audit of the company's financial accounts with you as auditor. This statement is incorrect as no such discussions took place. Mr Johnson and Mr McShane have recorded their objection to the incorporation of that statement in the Directors report with the other two directors and wish to draw your attention to their concerns.¹⁰

4.17

Sinclair & Wood's audit file showed that Wood received several drafts of the final text of the Annual Report prior to its completion. All these versions had included the offending words. On a draft dated 29 October 1997 Wood had actually corrected the preceding paragraph of the statement but had not amended the complained of words.

4.18

Wood acknowledged to us that he had seen the text of the Annual Report prior to its completion. He also acknowledged that there had been no discussion with the Audit Committee about the Company's results.

4.19

Auditing Guideline 8 ("AG-8") Other Information in Documents Containing Audited Financial Statements, issued by the New Zealand Society of Accountants in March 1986, was applicable in 1997. AG-8 deals with the obligations of the auditor to review information contained in a company's annual report or similar document but on which the auditor is not legally obliged to specifically report.

4.20

In relation to a "Material Misstatement of Fact" AG-8 says:

If on reading other information the auditor becomes aware that the other information, although not inconsistent with the financial statements, nevertheless appears to include a material misstatement of fact, the auditor should discuss the matter with the client.

When discussing the matter with the client, the auditor should consider personal competence to evaluate the validity of the other information or management's responses to the enquiries and that there may be valid differences of judgement or opinion.

If after discussion with the client the auditor still believes there is a basis for concern as to the validity of the other information, the auditor should request the client to consult with some other party, such as the entity's legal counsel and the auditor should consider the opinion received.

If the auditor concludes that there exists a material misstatement of fact which the client refuses to correct, the auditor should consider such steps as notifying the client in writing of the concern regarding the other information and obtaining legal advice as to further appropriate action.

4.21

We are not aware that Wood had any discussions with the directors of Max concerning this misstatement. While we recognise that the primary responsibility for statements in the Annual Report lies with the directors, we think Wood should have asked for the erroneous statement in the Annual Report concerning discussions he was purported to have had with the Audit Committee to be corrected. He did not do so.¹¹

The Audit Committee

4.22

Wood advised that as far as he was aware the Audit Committee of Max had no charter and had never formally met. There are no minutes of any meetings of the Audit Committee.

4.23

Johnson has told us that the Audit Committee met by telephone several times a year and that notes of discussions were provided to the Company. The Audit Committee does not appear to have reported formally to the board of Max before early 1998. Langoulant says that the Company's office in Perth never received any notes of these meetings.

4.24

Wood said that he had spoken to Johnson and McShane after the conclusion of the 1997 audit and had encouraged them to become properly constituted with a specific role and functions. Wood said he had sent them material about the operation of Audit Committees although there were no copies on Wood's audit file and Johnson has no recollection of receiving any such material.

4.25

We would have expected the Audit Committee's activities to have been more formally recognised by the Company. Shareholders could reasonably have had higher expectations of the Committee than actually eventuated.¹²

4.26

We note, however, that there are wider questions of corporate governance. We also note that efforts were made by the then non-executive directors, McShane and Johnson, from the latter part of 1997, in relation to these wider questions.

Referral

4.27

We are referring this report to the Registrar of Companies, the Institute of Chartered Accountants of New Zealand and the Institute of Directors of New Zealand.

4.28

We are aware that the Institute of Chartered Accountants has already considered some of the matters raised in this report.

4.29

We invite the Institute of Chartered Accountants to review its findings in the light of the matters contained in our report.

Footnote(s):

Wood, through his legal advisers, acknowledges that he should have better documented his audit and planning. However Wood submits that he did plan the audit adequately. He says this is evidenced by the tests he undertook as part of the audit. Return

Wood concedes that accepting photocopies and faxes as audit evidence will not always be appropriate, particularly if there is evidence of fraud. However Wood says he was unaware of any indications of fraud or evidence to suggest that the audit evidence had been falsified. In Wood's view no harm has come from his reliance on accepting copies of documents. Return

A representation letter is a letter from the Company's board and management to the auditor outlining their responsibilities in relation to the accounting records and financial statements. Return

Langoulant has told us that McShane and Johnson saw several drafts of the Annual Report containing the offending words but had not mentioned, during discussions on the Report, that the statement was incorrect. Johnson has told us that he and McShane did not approve the final form of the Annual Report. Return

Wood notes that the Annual Report was adopted at the Annual General Meeting even though Johnson had raised his concerns about the misstatement about the results having been discussed with the Audit Committee. Wood considered he could rely on this matter being brought to the attention of shareholders by Johnson since Johnson had told him he would be raising the matter. Wood considers that no harm or loss flowed from this misstatement. Return

The Institute of Directors of New Zealand issued a statement on 2 October 1996 on "Audit Committees - Best Practice for New Zealand Directors." The Introduction says "An audit committee is a committee of the board whose principal function is to assist the board in producing accurate financial statements in compliance with all applicable legal requirements and accounting standards. In fulfilling this role audit committees should be expected to: oversee, review and enhance the company's external financial reporting procedures; and monitor and enhance the company's internal financial systems and controls." The statement goes on to detail the expectations of an audit committee in terms of establishment, terms of reference, composition, meetings, and access to records and personnel. Return