Should an auditor qualify the audit of an SMSF that lends money to an unrelated party?

Welcome to episode 2 of That's a good Question. 

A question that regularly pops up on Knowledge Shop's help desk is the boundary lines for qualifying an SMSF audit - often a controversial issue for accountants working with auditors, clients, and the auditors themselves! This is particularly true when the decision made by the trustees is arguable but is at odds with other elements of the SMSF rules.

Here's the question...

An SMSF lends $100,000, unsecured, to an unrelated party. The SMSF deed and investment strategy allow for this. A loan agreement is signed by the trustee and unrelated party. The repayment schedule outlines a 5 year term with principal and interest repayments. The interest rate is 10% per annum, payable monthly. As the auditor, do I need to qualify this audit?

So, what's your answer? See what Hayes Knight Director Ray Itaoui has to say on the issue and the decision making process.

Knowledge Shop's help desk is just one of the benefits of Knowledge Shop membership. Find out how we make professional life less of a hassle for thousands of accountants and advisers across Australia.

For SMSF auditors and those working with SMSF clients, join Ray Itaoui for the SMSF Audit & Compliance Online Workshop -  12, 19 & 26 October 2022. The workshop will bring you up to speed with recent developments and what they mean to SMSF auditors and advisers right now, what you can expect to see, and what to do about it.

Edited transcript

In today's session of That's A Good Question we work through a common dilemma facing SMSF auditors – where they have to work through whether to qualify an audit report or to issue an unqualified opinion.

I'll be taking you through an example of a Knowledge Shop help desk question. We will work through exactly how to approach this type of situation.

The situation we have is:

An SMSF lends $100,000, unsecured, to an unrelated party. The SMSF deed and investment strategy allow for this. A loan agreement is signed by the trustee and unrelated party. The repayment schedule outlines a 5 year term with principal and interest repayments. The interest rate is 10% per annum, payable monthly. So the question is, as the auditor, do I need to qualify this audit?

And that's a really good question.

The first thing I do in this situation is have a bit of a think about what would unrelated parties do. If I was to ask you to lend me $100,000 to my self managed super fund, what would you think? Would you allow me to borrow money from you unsecured? Or, would you look to have some sort of security over that asset?

What concerns me about this this question, and if I was completing this audit, is the fact that there's $100,000 being lent with no security over any underlying assets. What would happen if the borrower was to default on the loan? The super fund has no recourse over any asset and, as a result, it could lose the $100,000.

Now, in the real world, again if I was to ask you to lend me that money, I doubt that you would lend me the money unless we had some sort of agreement in place or you had some sort of security over that asset. So, as an auditor, you need to step back and have a bit of a think about what would the unrelated parties do? In this situation a 10% interest rate for an unsecured loan, in my opinion, is low.

Now, I know a lot of accountants, a lot of auditors, would suggest that the trustee is free to make this investment if that's what they want to do. And, you need to have a think about what's best for the fund. The sole purpose test for a self-managed super fund states that every decision that's made by the trustee should be in the best interest of the fund and the members of the fund. Is lending $100,000 to an unrelated party, unsecured with 10% payable every year, is that is acceptable? Is that in the best interest of the fund?

I have seen this example in the real world. I have audited a fund that had this exact same scenario and we asked questions to the trustee. The trustee kept coming back and saying that they can only get a 5% return in the market, a 10% return is much better, and they know that the borrower is good for it, and as a result, they want to invest. In that situation, if the trust deed allows for it, the investment strategy allows for it, it's very difficult for the auditor to come back and say this is a breach of the SIS Act. Section 109 is breached, they're not dealing with unrelated parties at arm's length terms. It becomes very subjective.

I would have concerns about signing off on this audit report without a qualification. I think the fact that 10% unsecured is so far removed from what you would get in the market. I think an unsecured loan in the market from one of the big banks, you might be looking at 20% to 25%. To have a 10% return on an unsecured investment, in my opinion, is a qualification and I would raise that with the trustee. If the ATO wants to review that and the trustee has a defendable position that's okay. As the auditor, at least we have completed our role and signed off the audit report accordingly.