Accounting and Disclosure

B. Financial Reports to State Supervisory Authorities

Objective

To protect and promote the financial integrity and efficiency of the State-based financial institutions system and to ensure that depositors are adequately protected from the risks that building societies incur in the process of financial intermediation. Towards this end, to ensure that financial information provided to SSAs is complete, timely and consistent with external reporting requirements and is adequate for supervisory purposes.

General Background

Supervision of building societies by SSAs is conducted, in part, through a review of financial data provided by societies. It is appropriate that this information should be more extensive than that provided in the public financial accounts. These data should form an extension of the information contained in the annual accounts and should be consistent with them.

It is the responsibility of directors and management to oversee the internal operating procedures of the society. Each society will, for its own purposes, be expected to have adequate accounting records, registers and supporting documentation. Normal budgets, monthly financial statements and reports on loans, liquidity, capital adequacy and investments should form an integral part of any management and control process.

Much of this information, prepared for internal purposes, will provide the data for reporting to SSAs.

C. Audit

Objective

To protect and promote the financial integrity and efficiency of the State-based financial institutions system and to ensure that depositors are adequately protected from the risks that building societies incur in the process of financial intermediation. Towards this end, to ensure that the auditors appointed by each building society are competent, adequately resourced and given sufficient scope to complete the duties imposed by the FI Code. Further, to ensure that societies are able to provide such reports of audit as are required by SSAs as part of their supervisory role.

General Background

Section 270 of the FI Code requires directors to ensure that the annual accounts and group accounts of building societies are audited. As well as the audit report attached to the published financial statements, auditors must provide to the directors and to the relevant SSA a report of compliance with respect to internal controls. Auditors are also required to provide a number of reports of compliance under the FI Code.

Sub-section 284(7) of the FI Code requires the auditors to report on the adequacy of systems adopted by the society:

" to ensure compliance with its primary objectives; and

" to monitor and manage the risks associated with its financial activities.

The intention of independent audit reviews is to lend credibility to the financial information presented in the annual report by the building society's directors. In carrying out their supervisory responsibilities, AFIC and the SSAs rely largely on information presented by societies. A properly planned and conducted audit should provide reasonable assurance that the financial statements are true and fair. In addition to the supervisory authorities, members and depositors should be able to place greater reliance on financial information where an audit has ascertained that the accounts are free of material misstatement and present a true and fair view of the entity.

It is important that a societys external auditor receives timely information concerning the prudential standing of the society. Accordingly, an SSA should provide to the societys external auditor a copy of any report following an inspection of the society and any other information the SSA may from time to time consider relevant to the auditors audit responsibilities in respect of the society. If the SSA considers the provision of the whole or part of the report or such other information unnecessary or undesirable in the circumstances, the SSA need not provide it to the external auditor.

Audit Standards

All audit work should be carried out in compliance with Auditing Standards and Auditing Guidance Statements prepared by the Auditing Standards Board of the Australian Accounting Research Foundation issued by the Australian Accounting Research Foundation on behalf of the Australian Society of Certified Practising Accountants and the Institute of Chartered Accountants in Australia. Particular notice should be taken of the requirements within the standard for proper planning and completion of audit techniques which take account of the nature and risks of building societies. Directors of societies should be satisfied that auditors have sufficient understanding of the industry to enable them to adequately plan the audit and assess audit risks.

The operations of societies involve a large number of transactions. The audit approach, therefore, must emphasize the importance of transaction testing. Adequate transaction testing is regarded as critical if audits are to satisfy the requirements of the FI Code.

The audit approach must set out how evidence will be gathered. Since that evidence is the basis of audit opinion, sufficient audit evidence must be obtained to enable an opinion to be properly formed.

The responsibility for appointing an auditor of proper ability is the responsibility of the society. Building societies can expect that SSAs will communicate with their auditors annually or more frequently if it is deemed necessary. The purpose of this contact will be to establish the efficacy of audit techniques. If a SSA is not satisfied with the quality of an audit it has the power, under Section 88(4) of the FI Code to appoint an additional auditor or remove an auditor and appoint another auditor in that auditor's place, as it sees fit.

Audit Committees

An Audit Committee should comprise a majority of non-executive directors to which has been assigned, amongst other functions, the oversight of the financial reporting and auditing process and formulation and periodic review of the disaster recovery plan. The main objectives of an appropriately established and effective independent Audit Committee include enhancing the credibility and objectivity of financial reporting and assisting the Board to discharge its responsibilities. All building societies shall, if they have not already done so, establish an Audit Committee. It is the responsibility of the directors to establish the Audit Committee and to develop clear guidelines for its operation, including its role, terms of reference, responsibilities and method of operation.

Internal Audit

The effectiveness of the internal audit function depends on the scope and objectives of the function, degree of independence and the technical competence of staff. As with any internal control, the cost of an internal audit function must be justified by the benefits. Usually, the size of the society will play a significant part in determining the nature, scope and objectives of the internal audit function. In general, internal audits will be most effective where they are directed towards the review and testing of internal controls and risk management systems. Societies should consider the standards for the professional practice of internal auditing issued by The Institute of Internal Auditors.

Prudential Standards

Public Reporting

3.3.2 Accounting Standards Specific to Building Societies

Provisions

3.3.2.a Statutory Provisions for Doubtful Debts

Each society shall provide for, and show in the body of its accounts, a provision for doubtful debts covering all loan advances, including revolving credit arrangements. Directors should ensure that all problem loans are reviewed regularly and that provisions are appropriate. The minimum provisions shall be the amounts specified below.

Loan Provisions

The minimum loan provisions required depend on the type of loan. Three categories of loans are distinguished.

(i) " A loan which is secured by a registered first mortgage against residential building and/or development (defined in Prudential Standard 3.2.4.d) and is insured by an authorised(a) insurer for 100 per cent of the outstanding balance;

" A loan which is secured by a registered first mortgage against residential building and/or development, where the ratio of the outstanding balance, less the amount of mortgage insurance, to the valuation of the security is no more than 80 per cent (where the loan is 6 months or more in arrears, the valuation must be no older than 12 months);

" A loan which is secured by a qualifying registered second mortgage. (A qualifying second mortgage is one which satisfies the conditions spelled out in Prudential Standard 3.2.4.d.)

No minimum provision is required for this type of loan.

(ii) A loan which is secured by a registered first mortgage against residential building and/or development, where the ratio of the outstanding balance, less the amount of mortgage insurance, to the valuation of the security is greater than 80 per cent but no more than 100 per cent (where the loan is 6 months or more in arrears, the valuation must be no older than 12 months).

For these loans, the minimum provision required is a percentage of the balance outstanding, where the percentage depends upon the loan arrears period, as shown below.

Loan Arrears Provision (%)

up to 3 months 0

3 months and less than 6 months 5

6 months and less than 9 months 10

9 months and less than 12 months 15

12 months and over 20

Where the provision calculated under this category (ii) is greater than the provision which would have been calculated under category (iii) then the category (iii) is the minimum required.

(iii) All other loans

For all loans which do not fall into categories (i) and (ii) above, including unsecured and commercial loans, and mortgage loans where the ratio of the outstanding balance, less the amount of mortgage insurance, to the valuation of the security is greater than 100 per cent, the minimum required provision is a percentage of the balance outstanding, where the percentage depends upon the loan arrears period, as shown below.

Loan Arrears Provision (%)

up to 3 months 0

3 months and less than 6 months 40

6 months and less than 9 months 60

9 months and less than 12 months 80

12 months and over 100

Where these loans are secured by a mortgage over real property, the provision may be adjusted to reflect a part of the collateral value. In this case, the minimum provision percentage in the table above will be applied to the difference between the outstanding balance (less any loan insurance) and 70 per cent of the security value (where the loan is 6 months or more in arrears, the valuation must be no older than 12 months).

The minimum total provision required under loan provisions is the sum of the provisions made with respect to the different types of loans.

Where a loan is otherwise secured by equivalent or better security arrangements, the society may on application to its SSA, seek to have the provision adjusted to reflect the whole or part of the collateral value. After consideration of all relevant circumstances pertaining to the loan and security the SSA may reject or may, with the consent of AFIC, agree to the application.

Revolving Credit Provisions

Unless a variation is approved by its SSA, a society will be required to provide an amount equal to 1.0 per cent of the total unsecured(a) balances outstanding for line of credit advances, credit cards, overdrafts and any other revolving credit facilities. These provisions will be in addition to any provisions required under (iii) above.

After consideration of a societys loss experience and the level of non-statutory provisions available to cover potential losses on revolving credit facilities, an SSA may reduce the 1% requirement set out above. The SSA is to notify AFIC of any variation issued.

For overdrawn savings and overdrawn limits on credit cards, overdrafts and line of credit advances, the minimum required provision is a percentage of the balance outstanding, as shown below. Secured loans should be provisioned in accordance with Loan Provisions (i), (ii) and (iii). In calculating the minimum provision for each revolving credit facility, except overdrawn savings, the full amount of the credit drawn is to be included in the balance outstanding.

Period of Irregularity Provision (%)

14 days less than 3 months 40

3 months and less than 6 months 75

6 months and over 100

Where a revolving credit facility is both overdue (in terms of contractual repayments) and has a balance in excess of its authorised limit, the minimum provision required will be that calculated from the table above.

3.3.2.b Restructured Loans

1. Restructured loans are loans and other similar facilities where the original contractual terms have been modified to provide for concessions of interest, principal or repayment for reasons related to financial difficulties of the member or group of members. The following concessions are examples that would lead to a loan being classified as restructured:

• a reduction in the principal amount of the loan;

• a rate of interest lower than the society applies to a similar loan;

• reduction of accrued interest;

• a deferral or extension of interest or principal payments including interest capitalisation; or

• Extension of the maturity date or dates at a stated interest rate lower than the current market rate for new debt with a similar risk.

A loan extended or renewed on terms similar to those available for debt with similar risks where the member has met the originally contracted terms, is not considered a restructured loan.

Restructuring required under the provisions of the Consumer Credit Code which satisfy the above definition are not excluded from the definition of restructured loans.

4. Each society must develop policies to identify, monitor and manage restructured loans. Any restructuring of a loan or similar facility must be supported by a current, well documented credit assessment of the members financial condition and prospects for repayment under the modified terms.

5. Renegotiation of a loan must not be used to "hide" the poor quality of loan performance. Before any concession is made to a member, a restructure of the members loan should receive prior approval of the board of directors or its delegate. If there has been no prior approval, the restructured loan must be ratified by the society's board or their committee within 30 days of approval.

6. A restructured loan may only be returned to performing status, if it was not fully performing when restructured, for both the purposes of accrual and provisioning, when:

• it has been formally restructured ie. at a minimum the customer is provided with a written agreement, signed by the society, which outlines the new terms and is complying with these terms;

• there are no concessional terms applying to the facility, that is, the loan operates under the terms and conditions comparable to those applied by the society to a similar new facility; and

• the member's financial condition and prospects for full repayment have improved such that the facility has been operating in accordance with the new terms and conditions for a period of at least six months.

Provisioning requirements for a loan that has been formally restructured but is yet to be considered as performing should generally be based on the arrears period as at the time of the restructure. A society may, however, take into account additional security provided under the agreement which would result in a reduction of the provisioning requirement.

5. A single facility cannot be split into a performing and non performing part to avoid the total facility being classed as restructured.

6. For the purposes of reporting under AASB1032 only formally restructured loans may be included in the restructured category. Informally restructured loans are to be reported as non-accrual loans as appropriate. If, following a restructure, the yield on a facility is less than the societys average cost of funds, it should be reported as non-accrual.

3.3.5 Required Returns

3.3.5.a Each building society will complete the following returns for the purposes of section 290 of the FI Code as required by notice from its SSA.

(i) Quarterly:

A general return containing the information contained in Attachment B to the Prudential Standards.

In addition to this quarterly general return, other returns on:

" Loans

" Directors' Interests

" Primary Objects

" Assets

3.3.5.b A SSA may, by notice, vary the reporting interval for any or all of the returns included in Prudential Standard 3.3.5.a for any or all societies under its jurisdiction.

3.3.5.c Any society which fails to comply with the notice of lodgement of returns by the due date will be in breach of the Prudential Standards under Section 402 of the FI Code.

Prudential Standards

Audit

3.3.6 Audit Standards

3.3.6.a A building society is to be audited in accordance with Auditing Standards and Auditing Guidance Statements and any additional requirements considered necessary by the auditor in satisfying the various requirements of the FI Code.

3.3.6.b Directors of a building society are to satisfy themselves that the auditor has sufficient relevant expertise to audit the society properly and that the auditor maintains appropriate levels of professional indemnity insurance.

3.3.6.c Directors of a building society are to satisfy themselves that the auditor has adequate computer audit support to be able to access any and every transaction within the society, as the auditor determines.

3.3.6.d A building society is to obtain from its auditor, an engagement letter which confirms acceptance of the appointment, the objectives and scope of the audit, the extent of the auditors responsibilities and the form of reports and any other matters identified in AUS204 - Terms of Audit Engagements.

3.3.6.e A building society is to maintain an audit committee whose members comprise at least half non executive directors.

3.3.6.f An internal audit function should be considered by each societys directors as part of the societys system of internal control.

3.3.6.g Audit reports are to be forwarded directly to the audit committee in addition to any other recipients required by the society.

3.3.6.h Pursuant to section 284(7) and (8) and section 285(10) of the FI Code, an external auditor is to provide to the SSA, reports on the compliance and adequacy of the following risk management systems and internal controls:

" operational liquidity risk management systems (annually) - Prudential Standard 3.1.2.a;

" market risk management systems (annually) - Prudential Standard 3.1.3.a;

" credit risk management systems (annually) - Prudential Standard 3.1.4.a;

" data risk management systems (annually) - Prudential Standard 3.1.5.a;

" operations risk management systems (annually) - Prudential Standard 3.1.6.a; and

" internal controls within the above risk management systems.

3.3.6.i Pursuant to section 285(10) of the FI Code, an external auditor is to provide to the SSA, reports on the security for Emergency Liquidity Support Scheme (6 monthly) - Prudential Standard 3.4.6.l.

3.3.6.j An SSA is to provide to a societys external auditor a copy of any report following an inspection of the society and any other information the SSA from time to time considers relevant to the auditors audit responsibilities in respect of the society. If the SSA considers the provision of the whole or part of the report or such other information to be unnecessary or undesirable, the report or the information need not be provided to the external auditor.