1.6 Small controlled entities

Local government: Results of the 2003-04 audits.

In our 2002 report, we discussed the impact on the local government sector of the extended definition of “public entity” in section 5 of the Public Audit Act 2001.37 We noted that the Public Audit Act extended the mandate of the Auditor-General in the sector, by making the Auditor-General the auditor of any entity “controlled” by one or more local authorities as well as local authorities themselves. We outlined the “control” test in the Public Audit Act, which uses both legal and accounting definitions of control.38

In our 2003 report, we noted that the definition of “council-controlled organisation” in the 2002 Act is slightly wider than the definition of controlled “public entity” under the Public Audit Act, as it uses a threshold of 50% for control.39 We noted too that the definition of “council-controlled organisation” in the 2002 Act is wider than the definition of a local authority trading enterprise under the 1974 Act, as it includes both profit and non-profit entities.

The impact of these definitions is that the Auditor-General is the auditor of about 150 trusts and incorporated societies associated with local authorities, that were not previously subject to our audit. A large number of these entities are charitable trusts.

Since 1 July 2003, these entities have had to comply with the accountability and reporting requirements for council-controlled organisations under the Local Government Act 2002, which are generally more complex and onerous than those that applied under their trust deeds or rules. The enactment of the Charities Act 2005 and changes arising from the review of the Financial Reporting Act 1993 will impact further on the accountability of charitable entities in the local government sector.

This article comments on the issues and developments that may impact on the accountability of trusts in the local government sector, including:

  • audit arrangements for entities exempted from the accountability regime in the 2002 Act;
  • the Charities Act 2005; and
  • review of the Financial Reporting Act 1993.

Audit arrangements for exempt council-controlled organisations

Section 7 of the 2002 Act provides for certain entities to be exempted from being a council-controlled organisation (CCO). There are 2 means by which exemption may be given:

  • By the Governor-General, on a recommendation from the Minister of Local Government – This provision is aimed at entities that are already subject to appropriate accountability under their own Acts. Therefore, the Minister must be satisfied that the entity’s accountability under its own Act is appropriate for the purposes of the 2002 Act. The Governor-General has recently exempted the Otago Museum Trust Board and the Museum of Transport and Technology Trust Board from being CCOs.
  • By the council, for “small” organisations – This provision addresses concerns about compliance costs for small non-profit trusts. The 2002 Act does not define “small”, but a local authority cannot exempt a council-controlled trading organisation and, in exempting a non-profit entity, must have regard to:
    • the nature and scope of the activities provided by the organisation; and
    • the costs and benefits, if an exemption is granted, to the local authority, the entity and the community.

Once exempted under section 7 of the 2002 Act, an entity is not subject to any of the requirements of that Act, including the requirement to prepare financial statements for audit by the Auditor-General. However, in the majority of cases an entity that is within the definition of “council-controlled organisation” is likely to also be a controlled “public entity” under the Public Audit Act. Where that is the case, the Auditor-General must still audit the entity’s financial statements where an audit is required.40

An entity such as a trust or incorporated society may be required to prepare financial statements and have them audited under its trust deed or rules. An exemption given by a local authority from the accountability regime for CCOs under the 2002 Act does not negate such a requirement.

Therefore, where an exempted CCO is a public entity by virtue of the control test in section 5 of the Public Audit Act, the Auditor-General will continue to be the exempted CCO’s auditor. The audit will be conducted under the authority of the Public Audit Act, rather than the 2002 Act. Where the CCO’s trust deed or rules contain no audit requirement, we would no longer need to audit an exempt CCO’s financial statements (but would remain its auditor for any other purposes).

Audit fees for small non-profit CCOs

In 2004, Local Government New Zealand (LGNZ) asked the Government to support an amendment to the Public Audit Act to provide that the Auditor-General would not be the auditor of “small” entities exempted from being CCOs under the 2002 Act. The background to the request was a concern about small non-profit entities, not previously audited by the Auditor-General, whose audit fees had increased following enactment of the Public Audit Act 2001 and the 2002 Act.

LGNZ noted that the 2002 Act allows certain non-profit CCOs to be exempted from accountability requirements if the criteria in section 7 are met, and believed that such entities should also be exempt from public audit under the Public Audit Act in order to reduce compliance costs. We are not aware that the Government has responded to LGNZ on this issue.

We have asked our auditors to advise us of any exemptions granted by local authorities for small CCOs as part of the 2005 audit, so that we can assess any impact on audit arrangements and gain an understanding of the number of entities involved. Since LGNZ raised the issue, the Charities Act has been enacted and the review of the Financial Reporting Act 1993 has progressed. These developments impact on financial reporting and audit of charities. We intend to have further discussions with LGNZ on the issue.

Charities Act 2005

Many non-profit CCOs are incorporated charitable trusts or incorporated societies with charitable purposes. They are subject to the Charities Act 2005, which was enacted in April 2005 with staggered commencement provisions. The broad intention of the Act is to enhance the accountability of the charitable sector.

The Charities Act establishes a new Crown entity, the Charities Commission, which is responsible for running a registration, reporting and monitoring system for charities. Those charities that wish to retain or gain income tax-exempt status from the Inland Revenue Department will be required to register with the Commission.

One of the accountability requirements in the Charities Act is a requirement for charitable entities to prepare an annual return within 6 months of balance date and forward it to the Charities Commission. The content of the annual return is to be determined by regulations made under the Act, but is likely to include certain financial information. On receipt of the annual return, the Commission is required to examine the entity’s activities to determine that the entity continues to qualify for registration as a charitable entity.

The Charities Act will add to the legislative compliance obligations for CCOs that wish to register as charitable entities, regardless of whether an entity is exempted from being a CCO under the 2002 Act.

Review of the Financial Reporting Act 1993

The Ministry of Economic Development is undertaking a review of the Financial Reporting Act 1993.41 The Ministry consulted on a discussion paper on phase 2 of the review between November 2004 and February 2005. The discussion paper proposes that the Financial Reporting Act would determine only the content of financial reporting standards (i.e. what must be reported and how). In other words, the Act would set generally accepted accounting practice (GAAP). The obligation to produce financial reports in accordance with the Financial Reporting Act (i.e. who must report) would be left to other specific pieces of legislation, such as the Companies Act and the Charities Act.

In line with this general approach, the discussion paper proposes that reporting obligations of charitable entities registered under the Charities Act would be determined by that Act. It proposes that all registered charitable entities should be required to produce financial reports in accordance with a 3-tier reporting framework differentiated on level of income (see table below). The reporting obligations, including audit, would differ depending on the size of the entity – small charitable entities would be required to comply with only very simple reporting requirements. The required content for financial reports would be determined by financial reporting standards.

Income Possible reporting requirements Audit requirement
Small Less than $100,000 Receipts and payments None
Medium From $100,000 to $2,500,000 Accrual accounting Independent review
Large Greater than $2,500,000 Requirements based on IFRS42 Full audit

Significantly for non-profit charitable CCOs, the discussion paper proposes that there would be no duplication of financial reporting requirements, and that financial reporting requirements in the Charities Act would over-ride any requirements in other Acts (unless the CCO is established under a specific Act, in which case the specific Act would apply).

This may impact on the accountability regime for charitable trusts that are CCOs under the 2002 Act, as it would mean that small charitable CCOs would not need to comply with GAAP and would either not need to be audited or would not be subject to a full audit. While this would reduce compliance costs for small entities, and may go some way to addressing the concerns raised by LGNZ about audit costs, the “higher standard” should always apply.

However, the review does not propose that non-financial reporting requirements in other Acts will be affected. Charitable entities that are CCOs would therefore still need to report on their non-financial performance against their statement of intent (unless exempted under section 7).

In the case of charitable CCOs, we consider that a CCO that is a registered charity under the Charities Act should meet the accountability requirements of the 2002 Act, even though it would not need to meet any of those requirements if covered by the Charities Act only.

We will monitor developments in this area and report further on these issues as appropriate.

37: Local Government: Results of the 2000-01 Audits, parliamentary paper B.29[02c], pages 65-67.

38: The relevant approved financial reporting standard, for the purpose of the Public Audit Act, is FRS-37: Consolidating Investments in Subsidiaries.

39: Local Government: Results of the 2001-02 Audits, parliamentary paper B.29[03b], pages 31-37.

40: Section 15, Public Audit Act 2001.

41: See the Ministry’s discussion paper Review of Financial Reporting Act Part II at http://www.med.govt.nz/buslt/bus_pol/bus_law/corporate-governance/financial-reporting/part-two/discussion/ discussion-10.html.

42: International Financial Reporting Standards.

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