Time for action on audit procedures

Recent case law should serve as a reminder to auditors to review their processes when it comes to SMSFs, writes Belinda Aisbett.

A number of interesting cases recently have put the spotlight on auditor risk and the ever-increasing concern of litigation when advising or being involved with SMSFs, especially as the auditor of a fund.

To ensure this litigation risk is managed by the auditor, consideration must be given to the increased risks arising from case law. As a result, auditors must allocate some time in their audit testing to ensure these risks are identified, communicated and, where relevant, rectified.

Montgomery Wools

The Montgomery Wools case resulted in the fund being made non-complying for transactions undertaken in a trust the fund had invested in. The trust in question was a pre-August 1999 fund investment that owned property. The trust allowed a mortgage to be placed on the property, even though the mortgage was not associated with any loan the trust had. The loan related to the business of the family members. The family business also leased the property and had failed to pay rent for a period of around two years. The property was sold and the proceeds were used to repay debts of the family business. As a result, the trust investments were simply related-party loans, where originally the investment had been the commercial property.

The Australian Taxation Office (ATO) concluded the trustee failed the sole purpose test by allowing the property in the trust to be used as security for a loan that was unrelated to the fund or the trust, and in essence placed the interest of the business ahead of the interests of the fund.

Auditors should consider the implications of this on their audit. It has been accepted practice that an SMSF audit doesn’t need to extend to the transactions inside a pre-August 1999 trust in any great detail, as the trust (assuming exempt) is not governed by the Superannuation Industry (Supervision) (SIS) Act. This should now change to reflect the increased risks to fund trustees and their auditors, and auditors should be ensuring their audit programs and procedures incorporate some additional testing.

Given the results of the Montgomery Wools case, we are now performing title searches on properties inside pre-August 1999 trusts to ascertain if mortgages exist, and if they do, we confirm whether they relate to debt in the trust or not. We are also using the title search information to confirm the titleholder is correctly noted. Where the auditor identifies title issues or the inappropriate use of assets as security external to the trust, these matters can be dealt with in a timely manner and corrected, well before the ATO becomes involved.


The ZDDD case again concerns a pre-August 1999 trust, and the use of assets within the trust to the detriment of the fund. In this particular case the trust owned a number of properties. These properties were sold and the proceeds were used to provide financial assistance to the members and the members’ business operations. The loans were not documented in loan agreements and interest was not charged on the amounts lent. After many years passing without the issues being corrected, the fund was made non-complying by the ATO.

In light of this, audit procedures should be extended to include the requirements that auditors review the financials of fund investments in trusts and private companies in detail, and that auditors be required to request and review documentation on loans to confirm the loans comply with the SIS requirements. Interest received should be compared to commercial rates of interest to ascertain if interest, assuming some has been charged, has been done so at arm’s-length.

This assessment will also assist the auditor’s review of non-arm’s-length income in the trust, when determining if trust distributions are ordinary income of the fund or non-arm’s-length income of the fund.

Ali Superannuation Fund

A similar fate was handed down to the Ali Superannuation Fund as a result of loans made to family members from a trust the fund had invested in. The ATO formed the opinion that the loans from the trust were made purely to provide financial assistance to a member prior to retirement. The auditor should be able to identify these compliance issues by reviewing the interest income being reported by the trust and by requesting loan documentation for review.

Other potential litigation risks

There are of course any number of issues that might end up in litigation, and some issues are more common than others. One particular risk area that auditors should be aware of is the exempt pension deduction claim. Where a fund has not satisfied the minimum pension obligations for pension members, the fund is not entitled to claim the deduction. Auditors should ensure their audit work papers adequately review the eligibility of claims made by superannuation funds, otherwise the financials may be materially misstated. And in the event the auditor signs the audit report that all balances are fairly stated, where the fund is audited by the ATO and the deduction is denied, the auditor may face claims of negligence and be liable for any losses suffered by the fund.

Allens Asphalt

In the Allens Asphalt case the distribution from this trust to the superannuation fund investor seemed okay, until it was identified that the fund had invested in a hybrid trust, rather than a unit trust. The fund received a distribution of capital gains to the tune of $2.5 million and the fund taxed these as ordinary income. Given the trust was a hybrid trust, the distribution should have been taxed as non-arm’s-length income.

This case should remind all auditors to review trust investments to ascertain if the trust is a true unit trust or if there are elements of discretion embedded in the trust deed. This is essential to ensure income is allocated between ordinary and non-arm’s-length for tax calculation purposes.

The auditor can review the deed of the trust to obtain the audit evidence, or perhaps obtain representations from the tax agent to confirm the nature of the trust structure.

Henfarm Superannuation Fund

This case again involves the assessment of income and determining whether the amount is ordinary income or special income. The fund invested in a private company and dividends paid to the fund were in line with the dividends paid to other, unrelated shareholders of the company, and were in fact based on ordinary income. The reason the dividends should have been classified as non-arm’s-length income of the fund was because the fund initially acquired the investment at 10 per cent of the market value of the shares.

On the assumption that the acquisition was material, the auditor should be able to identify this issue by obtaining audit evidence to confirm the acquisition was made at arm’s-length, and ascertained if the party disposing of the shares was a related party of the fund. Had this issue been identified and corrected in the year the shares were acquired, the circumstances resulting in non-arm’s-length income would not have eventuated.

Bad auditors

On occasion we receive requests for advice from auditors who in the current year notice a compliance issue that has been present in the fund for an extended period of time. Unfortunately it was never reviewed by the auditor in detail, and as a result the matter looms large at year end when they do finally notice it.

This should be a significant reminder to all auditors who sign off on SMSFs to ensure their review of balances is thorough, and that they have a good understanding of the transactions and activity of the fund. All material balances should be adequately audited and there really are no excuses for having gaps in an audit file.

The ATO has commented previously that a fund with a good auditor will reduce the risk of non-compliance penalties as those auditors pick up issues in a timely manner and ensure they work with the fund to resolve the compliance issues identified. On the flip side, those funds that have auditors who don’t perform a professional and thorough audit increase the fund’s risk of penalties. This is because compliance issues typically exist for extended periods of time, and given the trustees are unaware in most cases of the problems, make no attempts to correct them. Where the ATO sees the history of issues with no moves by the trustee to correct the problems, these funds are more likely to be penalised. It is not a sufficient excuse for the trustee to simply blame their auditor. The ATO has advised the trustee is ultimately responsible for compliance, and where penalties are handed down, the only option for the trustee is to seek legal recourse against their auditor if the auditor has been negligent.

In summary, where a fund has invested in a trust or private company, the auditor should peruse the balances in these entities in an attempt to identify related-party transactions. These transactions, once identified, should be reviewed in light of SIS compliance. Property leases should be covered by a lease agreement and be reflective of commercial terms, such as timing of rental payments, and the value of rental. Rent should not be received by the trust, for example, from the tenant annually in arrears. Rent should, in most cases, be received monthly in advance.  The auditor should be checking the timing of rental receipts to ensure these risks are identified and managed. Loans should be covered by formal loan agreement and terms should be reflective of commercial arrangements, in interest rate, payment frequency and repayment terms.

Where an auditor identifies any related-party transactions that fail the sole purpose test, the financial assistance test or the arm’s-length test, immediate action should be taken to communicate the matter to the trustee of the fund, including suggested rectification plans. Given the penalties being handed down by the ATO for mischief inside entities a fund has invested in, the auditor should be ensuring these matters are dealt with seriously so as to avoid any risks of being caught up in litigation.

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