Fonterra illustrates audit-law weakness

By ALAN J. ROBB*

The $34 million discrepancy in Fonterra's accounts disclosed by the Herald last week cannot be dismissed simply as one of the first-year problems of the mega-merger.

The explanations from Fonterra and its auditors have been contradictory and confusing. They will undoubtedly prompt the Shareholders Council to ask some pointed questions. They should also alert investors in other companies that the coverage of group audits has weakened since the Companies Act 1993 came into effect.

On July 19, Fonterra reported its audited results to the Stock Exchange. It also gave a media briefing. The details were posted on its website. One good news item announced that Fonterra's subsidiary, NZ Milk, had recorded earnings before interest and tax of $336.2 million, up 28 per cent, on sales of $5.604 billion.

When the annual report was posted to farmers last week, the earnings were seen to be only $302 million. Turnover too had dropped, by $21 million. No change occurred in the overall group result.

The Herald questioned the reason for the changes. Here began the contradictory explanations which should concern the Shareholders Council.

Fonterra's explanation was that the audit of NZ Milk was completed "later than Fonterra's". This is most confusing and scarcely credible. Group accounts comprise those of a parent and its subsidiaries. It would be extremely irregular for an auditor to sign off the group accounts until the subsidiaries' accounts themselves had been completed.

The confusion was compounded by the further statement that the changes arose from two items. First, the cost of restructuring Fonterra's United Kingdom operations for the joint venture with Arla Foods had been treated as a cost to Fonterra, "but should have been attributed to NZ Milk." Most farmers would know that while this would result in additional costs to NZ Milk, it could hardly alter its turnover.

Secondly, "other adjustments were made to inventory valuations between Fonterra and NZ Milk". A little thought shows that this too would affect only costs and not turnover. Why then was the turnover of NZ Milk down by $21 million?

The Shareholders Council should be asking for better explanations than were given early last week.

Then came the contradictions.

The auditor said NZ Milk had not been audited. And this was because Fonterra "chose not to".

It should be a matter of concern if a senior executive of Fonterra believes the subsidiaries are being audited but the auditor understands that an audit is not required.

Fonterra has an internal audit department, as would be expected in any large organisation. Internal auditors can be cost effective in maintaining internal control. They often can detect errors and frauds more promptly than external auditors. They can supplement, but never replace, external auditors.

M ISTAKES, and ultimately frauds, can occur anywhere within any organisation. They are more likely to occur in organisations which are unaudited or in which parts of the organisation are "off-limits" to the auditor.

The Shareholders Council should ask why the board chose to exclude any subsidiary from the audit and should demand that it cease forthwith. They should reject any suggestions that this is a minor issue or an acceptable practice.

Investors will be surprised at the comment that companies can choose whether to have subsidiaries audited, but it is correct.

Before the passing of the Companies Act 1993 companies were classified as either public or private companies. Private companies could resolve unanimously not to appoint an auditor except where they were subsidiaries of a public company.

In 1993, the Companies Act and the Financial Reporting Act abolished the public/private distinction. The obligation to appoint an auditor became applicable only to "issuers", effectively those who had raised finance from the public. Their subsidiaries need not be audited unless they too are issuers.

There is no obligation to tell shareholders that any subsidiaries have been excluded from the audit. There should be.

An auditor of an issuer which has subsidiaries is required to report on both the issuer's and the group's figures. In Fonterra's case, 40 per cent of the group turnover was earned by NZ Milk and 55 per cent of the group turnover is generated in the subsidiaries in total.

So how does the auditor deal with financial data from a subsidiary which is excluded from an audit?

An audit partner, who wished not to be identified, explained it to me thus. The subsidiary's information entering the group's figures will be reviewed, but not audited, to an appropriate level of materiality.

In other words, the auditor does not accept the figures at face value. An attempt is made to assess their reliability. While this is responsible and professional, something less than a full audit is taking place.

Auditors should not be put in a position where a material part of the group's activities are excluded from full audit scrutiny. Nor should they agree to such restrictions.

Another auditor commented that some boards saw this as a way of reducing the cost of the group. The downside was that the board implicitly increased its own risk as it no longer received an audit report covering the particular subsidiaries. It also increased the risk that Fonterra's shareholders received less reliable information.

How many shareholders knew that they were receiving a Claytons audit - the audit you have when you are not having an audit - because of a loophole in company legislation?

* Alan Robb is a senior lecturer in accountancy at the University of Canterbury. He has been called as an expert witness by major auditing firms and is a regular commentator on financial issues.