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Lessons about how not to meet SMSF professional standards

Lessons about how not to meet SMSF professional standards

Shelley Banton
26 October 2018 — 5 minute read

One of the most critical aspects of the Ryan Wealth Holdings Pty Ltd vs Baumgartner [2018] NSWSC 1502 case was the auditor failing to confirm that the fund’s investment strategy had given appropriate consideration to risk, return, liquidity and diversification and that the fund’s investments were made in line with that investment strategy.

The consequences of this omission not only saw the SMSF auditor liable for $1.62 million of the total $7.2 million losses incurred by the trustee but also has critical implications for those SMSF auditors who give the investment strategy a cursory glance during the audit.

The impact of the Ryan case provides a lesson for all SMSF auditors and advisers to meet their professional standards or face potential litigation from trustees when their investments go to custard.

SIS Regulation 4.09

Regulation 4.09 of the Superannuation Industry (Supervision) Regulations 1994 (“SIS”) covers the requirement to have an investment strategy.

SMSF trustees must consider all of the fund’s circumstances before any investments are made that include:

  1. The risk involved in making, holding and disposing of fund investments taking into account the fund’s objectives and its cash flow requirements
  2. The likely return form fund investments taking into account the fund’s objectives and its cash flow needs
  3. The composition of the fund’s investments taking account of the fund’s exposure to risks from inadequate investment diversification
  4. The liquidity of the fund’s investments to make sure that the fund’s cash flow needs can be met
  5. The fund’s ability to discharge its existing and future liabilities (for example, paying pensions)
  6. Whether the trustees of the fund should hold a contract of insurance for one or more members of the fund

The trustees must ensure that the fund’s investment strategy is used as a blueprint for all investment decisions and regularly reviewed; usually on an annual basis and noted in the year-end minutes. 

What Should Happen At Audit

An investment strategy is not just a superficial compliance document. It is, in fact, an integral part of the audit process as evidenced by the following statement signed by the auditor in Part B of the audit report:

‘My procedures included testing that the fund has an investment strategy that complies with the SISA and that the trustees make investments in line with that strategy, however, no opinion is made on its appropriateness to the fund members’.

An SMSF auditor must review the investment strategy from a compliance perspective only. There is no scope for a qualitative review or to judge its’ effectiveness and, indeed, that is not the point of the auditor’s obligations to the fund’s trustees.

Whether the investment strategy is good, bad or indifferent, the SMSF auditor looks no further than whether the trustees have formulated an investment strategy that has regard to the whole of the circumstances of the fund.

The main components as outlined in SIS r4.09 must be present for the fund to comply with its trustee requirements. 

What Happens in Practice

Some SMSF auditors lump the investment strategy in the same bucket as annual minutes: they are given a quick once-over to ensure the document contain keywords such as ‘risk’, ‘diversification’, ‘liquidity’, ‘cash flow’, ‘insurance’ and the audit marches on.

(Note that Ryan covered the 2007 – 2009 audit years and the amendments to the SIS Regulations in respect to life insurance commenced from August 2012).

One of the main reasons for this “quickie” approach by SMSF auditors is that the majority of trustees appear to put very little thought into formulating and revising their investment strategies.

Standard templates are used to create many investment strategies that get tweaked in line with the investments held by the fund at balance date. The preparation of the financial statements is usually the catalyst to get these changes made.

In reality, some SMSF trustees never review their investment strategy even though their annual minutes state otherwise.

Back to Basics

An SMSF auditor must read the investment strategy and “report accurately as to whether each investment by the Super Fund as recorded in the financial statements was made in accordance with an investment strategy that had regard to all of the circumstances of the fund”.

The 2007 investment strategy presented in the Ryan case contained more complex conditions than usual, for example: 

            Liquidity and Cash Flow

Access to substantial amounts of cash or cash type investments is not required. However, investments shall normally be of the type convertible to cash within 90 days. The trustees will also maintain a minimum cash reserve sufficient to pay the expenses of the firm as they fall due.

Where some assets are not readily converted to cash then at least 50% of the fund assets shall be invested in assets which are convertible to cash within 90 days, unless certain assets represent particular direction from the members.

The fund had invested in high-risk unsecured loans, and unit trusts worth $7.2 million that were effectively worthless. The auditor failed to advise the trustee that the fund’s investments did not meet the requirements of the investment strategy.

As a result, SMSF auditors are at significant risk when they don’t scrutinise the investment strategy more closely and query the trustee when the fund’s asset allocation and investments differ materially.

The auditor must document the trustee’s response, which means the trustee should provide either a revised investment strategy or advise the auditor when the asset allocation, or the investments of the fund, will be returned to meet the conditions of the original investment strategy.

Asset allocation % ranges aren’t a legislative requirement in an SMSF investment strategy, but most trustees have them included in their signed investment strategies.

Unfortunately, investment strategy ranges are often too restrictive and cause unnecessary review points, which can be frustrating for everyone as it delays audit completion. SMSF advisers should, therefore, consider whether it’s appropriate to include these ranges in the fund’s investment strategy.

The requirement for the auditor to undertake a thorough review of the investment strategy in line with r4.09 SIS has always been part of the audit process.

The fine art of performing this audit task, however, has been largely lost in the cloud of technological development and low-cost audit fees.

Conclusion

The Ryan case demonstrates that the court can put any aspect of the audit under the microscope and make SMSF auditors accountable, especially when they are the last person standing with PI insurance in a long line of SMSF professionals.

SMSF trustees will continue to lose money from poor investment choices and fraud, while SMSF auditors now have 1.6 million reasons to stop cutting corners in a race to the bottom.

The real lesson from the Ryan case, however, is that any SMSF advisor not meeting their professional standards should expect future litigation from trustees looking to recoup losses when their investments go south.

There’s no doubt that most SMSF trustees would prefer to be made aware of potential compliance issues rather than spending the time, money and emotional energy going to court. They may just have to accept that this peace of mind comes with a slightly higher price tag.

Shelley Banton, executive general manager, technical services, ASF Audits 

Lessons about how not to meet SMSF professional standards
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