Part 1: The 2005/06 audited financial statements

Central government: Results of the 2005/06 audits.

The Auditor-General issued the audit report on the Financial Statements of the Government of New Zealand for the Year Ended 30 June 2006 (the Government financial statements) on 29 September 2006. This is the same date on which the Minister of Finance and the Secretary to the Treasury signed their Statement of Responsibility.

Unqualified opinion issued

The audit report appears on pages 24-25 of the Government financial statements. The report includes our unqualified opinion that those statements:

  • comply with generally accepted accounting practice in New Zealand; and
  • fairly reflect:
    • the Government of New Zealand's financial position as at 30 June 2006; and
    • the results of its operations and cash flows for the year ended on that date.

As in previous years, the Treasury has provided a comprehensive commentary on the financial statements, which is presented on pages 6-22 of the Government financial statements.

The significant matters that arose during the 2005/06 audit of the Government financial statements are listed below and discussed in this Part:

  • the Treasury and sector performance (paragraphs 1.105 to 1.111);
  • student loans (paragraphs 1.112 to 1.127);
  • tax revenue (paragraphs 1.128 to 1.135);
  • fair value of receivables portfolios (paragraphs 1.136 to 1.141);
  • the Kyoto Protocol provision (paragraphs 1.142 to 1.149);
  • valuation of rail assets and land (paragraphs 1.150 to 1.154);
  • Financial Reporting Standard No. 37: Consolidating Investments in Subsidiaries (FRS-37) (paragraphs 1.155 to 1.159);
  • New Zealand equivalents to International Financial Reporting Standards (NZ IFRS) (paragraphs 1.160 to 1.162);
  • funding of Alpurt B2 motorway extension (paragraphs 1.163 to 1.164);
  • related party disclosures (paragraphs 1.165 to 1.167); and
  • Public Finance Amendment Act 2004 (paragraph 1.168).

Significant matters arising from the 2005/06 audit

The Treasury and sector performance

Last year we raised concerns about the performance of the Treasury in preparing the draft Government financial statements – in particular, that the draft of the Government financial statements was not fully prepared by the statutory deadline and had not been subject to the level of quality assurance that we expected. We recognised that the Treasury's performance had been affected by the performance of some entities included in the Government reporting entity.1 We made a few recommendations to the Treasury. The recommendations were aimed at improving the process for 2005/06.

We are pleased to report that, overall, the audit of the Government financial statements went well this year. The close liaison between Treasury staff and our Government financial statements audit team, and changes to some procedures, have helped improve the process.

The Treasury produced the first draft of the Government financial statements on 31 August. We agreed with the Treasury that three important items should be omitted from that first draft, given that the auditors had not given clearance on the issues and that they were therefore still subject to change. The items omitted from the draft were Note 9 (on student loans), Note 10 (on disclosures on some receivables), and Note 15 (on the Kyoto Protocol provision).

The delay in finalisation largely reflects the complex nature of these issues and therefore the amount of effort required by both the entity and the auditor. Auditor clearance was subsequently given on all three areas, and the Government financial statements were amended to include the three notes. These three items are discussed below.

While we are satisfied with the Treasury's performance in producing the Government financial statements this year, the coming year will pose challenges, being the transitional year for implementation of NZ IFRS. The Treasury will need to continue to work closely with the entities within the Government reporting entity and our Office to ensure that the 2007 Government financial statements are prepared within the agreed deadlines and to the appropriate standard.

Date of audit sign-off

This year, the audit opinion on the Government financial statements was issued two weeks later than last year (29 September this year, compared to 16 September last year).2 The later date of sign-off this year allowed more time to consider some significant issues such as student loans valuation, tax revenue recognition changes, and Kyoto Protocol provision. The later date also meant that the audit sign-off of the Government financial statements was at the same time as some major entities within the Government reporting entity.3

We recognise that timely publication is important to users of the Government financial statements. We will discuss the timetable for next year with the Treasury, taking into consideration all these factors as well as the availability of the Minister of Finance.

Student loans

In November 2005, the Government agreed that (with effect from 1 April 2006) interest would not be charged on student loans if certain criteria, largely related to living in New Zealand, were met. To better reflect the value of student loans under this no-interest policy, the accounting policy for reporting student loans was changed in 2005/06.

The accounting policy is to initially recognise student loans at their fair value and to subsequently report them at amortised cost. This accounting policy applies from 2005/06 and is consistent with the "loans and receivables" designation under NZ IAS 39: Financial Instruments: Recognition and Measurement.

The major effects of the change in accounting policy were:

  • a one-off write-down of $1,415 million of the existing loan book to fair value;
  • recognition of a further $328 million as an expense, being the write-down to fair value of new loans made during 2005/06; and
  • a write-on of $358 million to income to recognise the interest "unwind" during the year.4

Note 9 of the Government financial statements shows the analysis of the movement in student loans during the 2005/06 year, and provides further information about the book value and fair value.

Last year, we recommended an external peer review of the methodology used to determine the fair value, given the complexity of the calculation and the sensitivity to the key assumptions. This review was completed by independent actuarial consultants during 2005/06. We acknowledge the significant amount of effort applied this year in determining the closing balance of student loans at 30 June 2006.

We are satisfied with the work done to determine the value of student loans. However, despite the significant effort, there are still three uncertainties that could significantly affect the student loans valuation. These are:

  • the age of data;
  • forecast future cash flows; and
  • voluntary repayments.

Age of data

The data used for the initial fair value (calculated at 31 October 2005) was 39 months old as at 30 June 2006,5 and the same data was used for the valuation in 2004/05. We understand that, for 2006/07, integrated student data to 2005 and 31 March 2006 tax data will be available. This will reduce the time gap between the age of the dataset and the year-end valuation date to 15 months, which we consider will improve the soundness of the valuation.

Forecast future cash flows

The student loans valuation model uses the "minimum obligation" repayments placed on the borrower to assess the future cash flows, and therefore assess the fair value (and amortised cost).

An independent actuary has analysed the forecast future repayments used in the model for years up to and including 2005/06 and compared these to the actual repayments made in those years. This comparison has indicated that the actual repayments could be lower than forecast for more than 17% of borrowers (in the dataset used by the actuaries valuing the scheme).

A conservative approach would treat these differences as "real" and adjust the valuation accordingly. However, the valuation has not been adjusted, because the actual level of underpayments, if any, is not at this stage fully understood.

The student loans valuation model is currently based on data with a short time horizon, and as such the fair value is sensitive to changes in the underlying assumptions.

The Inland Revenue Department (IRD) is currently investigating this matter by reviewing the data. This work is part of the integration and data testing required under the Memorandum of Understanding between the agencies involved in the collection of the dataset.

The Ministry of Education considers it valid to assume that the IRD will ensure that all borrowers meet their minimum obligations. We agree with the approach being taken.

Voluntary repayments

The no-interest policy change will affect the level of voluntary repayments received. Before the policy change, about 30% of all repayments were voluntary. It has been assumed that, because of the policy of not charging interest on student loans for New Zealand residents, the percentage of voluntary repayments will reduce steadily over time.

As there is a lack of history about the level of voluntary repayments under the new policy, there is a degree of risk about the soundness of this assumption. We note that, since the new policy took effect on 1 April 2006, the actual decrease in repayments is consistent with the assumption that voluntary repayments will reduce.

We have recommended that the Treasury work closely with the IRD during the coming months to ensure that the work on student loans progresses as planned, and that the effect of any changes to the valuation as a result of the three uncertainties discussed above are thoroughly tested. The Treasury has also advised us that it is working with agencies to devise a reporting protocol that will address issues such as frequency of recalculation of the discount rate.

Tax revenue

Last year we recommended that the IRD and the Treasury review the tax revenue recognition policies for provisional tax payments in two particular areas – revenue recognition and provisional tax pooling accounts – to ensure that they remained appropriate and in accordance with New Zealand generally accepted accounting practice (NZ GAAP).

Revenue recognition

Our main concern about tax revenue recognition was that the practice of recognising provisional tax when "payment is due" was, in substance, cash accounting rather than accrual accounting.

After a review of the provisional tax estimation method, the IRD formed the view that provisional tax revenue can be reliably estimated when it is incurred or earned (accruals basis), rather than when payment is due. The transition to the new estimation method has resulted in a significant one-off adjustment to the Government financial statements for taxation revenue and taxes receivable of $1.8 billion. We concurred with this treatment.

Tax pooling

Tax pooling was introduced in 1 April 2003 to allow taxpayers to manage provisional tax payment risk by reducing interest payable on underpaid tax and increasing interest receivable on overpaid tax.

The balance of the pooling account has increased significantly again this year to $2.3 billion as at 30 June 2006 ($1.2 billion in 30 June 2005 and $0.6 billion in 30 June 2004). This increase is because more taxpayers are now using the pooling account for provisional tax payments.

The IRD has sought independent advice as to the correct accounting treatment of payments to the pooling account. That advice is that these payments do not meet the revenue recognition criteria and that they should be treated as taxes refundable. We have reviewed this advice and concur with the treatment.

However, we note that provisional tax payments into the pooling account are not recognised in the taxpayer's account. As a result, provisional tax payments are not recognised as revenue, as they would have been if they had been paid into the taxpayer's account. When the pooling account is used, revenue is only recognised based on a provisional tax assessment. Therefore, tax revenue will be recognised later in the year if a taxpayer uses tax pooling. However, provided that an appropriate tax assessment is made by the IRD before the end of the year, the amount of tax revenue recognised by the IRD is the same, regardless of whether the taxpayer uses tax pooling or not.

We have recommended that the IRD conduct an exercise comparing payments into the pooling account with the corresponding provisional tax assessments in the individual taxpayers' accounts and consider the implication of the results for monthly and year-end financial reporting. This will provide further understanding of the materiality of the timing difference caused by the tax pooling recognition treatment of provisional tax.

Fair value of receivables portfolios

The Government financial statements include $14,474 million of receivables debt. As disclosed in Note 10 of the Government financial statements, the balance includes $8,720 million of taxes receivable administered by the IRD, $424 million of debt administered by the Ministry of Justice and $413 million administered by the Ministry of Social Development (MSD).6

The Ministry of Justice and the MSD debt have lengthy collection periods and do not accrue interest. The fair value of these receivables is likely to be less than the carrying value. We have therefore, in previous years, recommended that the fair value of these receivables be disclosed in the Government financial statements (like student loans), and that the Treasury provide some guidance to departments on this matter.

The Ministry of Justice engaged an external provider to carry out a calculation of fair value as at 30 June 2006. The fair value figure was initially disclosed in the draft Government financial statements. However, on closer scrutiny, it was decided that further work was required on the fair value. The fair value disclosure was therefore removed from the Government financial statements. It is disappointing that work had not progressed as far as planned to allow this receivable to be disclosed in a note.

The fair value of the MSD receivable was determined but not disclosed in the Government financial statements, as it would have been the only receivable for which fair value was disclosed.

The fair value of all debt portfolios will need to be determined for the Government financial statements opening NZ IFRS balance sheet as at 1 July 2006. This includes the $8,720 million tax receivable debt.

We have recommended that the Treasury work closely with the departments to ensure that fair values will be available for the opening NZ IFRS balance sheet. Our auditors will also need to be closely involved at a sufficiently early stage (see Part 9).

The Kyoto Protocol provision

New Zealand ratified the Kyoto Protocol in December 2002. The protocol came into force on 16 February 2005, as a result of Russia's decision to ratify. This international agreement commits New Zealand to reducing its net emissions of greenhouse gases during 2008-12 (the first commitment period, otherwise called CP1) to 1990 levels or take responsibility for the difference.

A provision for New Zealand's net deficit position under the Kyoto Protocol for CP1 was first recognised in the 2005 Government financial statements. This year a provision of $656 million ($310 million in 2005) has been recognised. Detailed disclosure about the Kyoto Protocol provision is provided in Note 15 of the 2006 Government financial statements. The Treasury has not recognised any provision or contingent liability for periods beyond 2012, as New Zealand currently has no specific obligations beyond CP1.

The provision is the Treasury's best estimate at this time. However, provisions by their nature are more uncertain than most other items in the statement of financial position. It is likely that successive estimates will change as updated information becomes available, better systems are implemented, or some uncertainties are reduced. Some of the main aspects of the Kyoto Protocol provision that are subject to fluctuation through time include:

  • the price for a tonne of carbon;
  • the exchange rate with the United States dollar; and
  • the various assumptions underlying the calculation of the emissions and sinks (for example, forecasts of gross domestic product, oil prices, and availability of more updated statistics).

The provision in the Government financial statements is based on 21 million tonnes for estimated deforestation. This estimate assumes policy interventions to implement the Government's policy to cap its liability at this amount. This estimate was made in the knowledge that there was likely to be a policy decision on the deforestation cap by the Government in the near future and policy interventions designed to achieve that cap.

We note that, without such policy interventions (and assuming current market conditions prevail), a deforestation intentions survey carried out in 2005 indicated likely deforestation to be around 38.5 million tonnes, which would increase the provision by around $279 million.

The determination of the net position is an extremely complex process involving a number of models across a range of government departments. An independent expert has assessed the reasonableness of the assumptions and methodologies underpinning the emissions projections and found them to be sound and reasonable.

We have reviewed the work done (including the annual Kyoto stocktake undertaken in May 2006) to estimate the provision, and are satisfied that it represents the best estimate of New Zealand's liability.

We have recommended that the Treasury continue to work with the relevant agencies to develop their methodologies, models, and data for determining the net Kyoto position and to ensure that the recommendations in the 2005 experts' report are addressed. We have also recommended that a follow-up independent report be commissioned in 2007 to give assurance for the 2007 Government financial statements that there have been no significant changes in the environment, good practice, or international thinking that would change the overall approach.

Valuation of rail assets and land

The Crown purchased the national rail infrastructure and related assets from Toll Holdings Limited (Toll) for $1 in 2004 and entered into a track access agreement with Toll to the year 2070. On 1 September 2004, the rail assets were transferred from the Treasury to ONTRACK (New Zealand Railways Corporation).

In the 2004 and 2005 Government financial statements, the Treasury assessed the track access agreement as a finance lease and accounted for the rail infrastructure as a lessor's interest in a finance lease. Under this accounting treatment, the Treasury expensed, rather than capitalised, the expenditure the Crown incurred on replacing and upgrading the national rail network and the Auckland commuter network. We disagreed with this accounting treatment as, in our view, the agreements with Toll did not amount to a finance lease.

We are pleased to report that the Treasury has reconsidered the accounting treatment for rail assets. The 2006 Government financial statements do not account for the rail agreements as a finance lease. Expenditure of $119 million on upgrade and renewals work has been capitalised.

As we reported last year, in our view, more meaningful information would be provided if the rail assets were revalued to depreciated replacement cost (DRC). This would be consistent with the approach taken in the Government financial statements for other major infrastructural assets, such as the state highway network.

The determination of the DRC would also provide useful information for asset management. However, we have agreed with the Treasury and ONTRACK that, because of the complex nature of the valuation, it would not be possible to complete a valuation of rail assets at 30 June 2006. However, the valuation has been completed for the NZ IFRS opening balance sheet at 1 July 2006 (see Part 9).

Financial Reporting Standard No. 37: Consolidating Investments in Subsidiaries (FRS-37)

Since 2003, the Treasury has used equity accounting for tertiary education institutions (TEIs) in the Government financial statements based on a 100% interest, rather than consolidating on a line-by-line basis. This approach is based on a view that the control test in FRS-37 is not satisfied, as the Crown does not have the ability to determine the financing and operating policies of TEIs, but that the Crown's relationship meets the "significant influence" test necessary for equity accounting. The approach and the reasons for it are set out in Note 13 to the Government financial statements.

Since 2003, we have expressed our view that line-by-line consolidation remains the treatment that best reflects the substance of the relationship between the Crown and TEIs, and the intent of FRS-37. However, we have accepted equity accounting for TEIs, as the treatment does arguably comply with a strict interpretation of the mandatory elements within FRS-37, and because of the additional disclosures provided in Note 13. With these additional disclosures, we have accepted that the Government financial statements remain fairly stated.

Last year we recommended that the Treasury continue discussions with accounting standard-setters on the application of the control test in the Crown context where entities have some autonomy and independence.

The Treasury has communicated with the standard-setters to clarify the treatment. In August 2005, the Financial Reporting Standards Board (FRSB) issued a discussion paper on control of public benefit entities that have autonomy and independence. The Treasury completed a joint submission, with the New Zealand Vice-Chancellor's Committee, on the discussion paper to the FRSB recommending criteria for defining when autonomous public benefit entities should be consolidated.

In July 2006, Exposure Draft 1097 was issued, which proposed that TEIs should be consolidated into the Government financial statements as if they were wholly owned subsidiaries of the Government for the purposes of FRS-37. However, the FRSB has decided not to adopt the changes proposed in the exposure draft. We will be discussing the consequences of that decision with the Treasury. At this stage, it is likely that equity accounting for TEIs, based on a 100% interest, will continue.

New Zealand equivalents to International Financial Reporting Standards (NZ IFRS)

The Government will be implementing NZ IFRS in the Government financial statements as part of Budget 2007. This means that the first audited Government financial statements under NZ IFRS will be for the year ending 30 June 2008.

In order to comply with the requirements of NZ IFRS 1: First-time Adoption of New Zealand Equivalents to International Financial Reporting Standards, the 2008 Government financial statements will need to include comparative figures as at 30 June 2007 restated in accordance with NZ IFRS, and some detailed reconciliations explaining the effect of the transition to NZ IFRS. To meet these requirements, the Treasury will need to produce an opening balance sheet at 1 July 2006 in accordance with NZ IFRS.

We will be providing assurance on the NZ IFRS provisional opening balance sheet as at 1 July 2006 and NZ IFRS accounting policies. We have discussed with the Treasury its progress towards the adoption of NZ IFRS and how it is dealing with key NZ IFRS issues, and monitoring progress of significant entities within the Government reporting entity to ensure that timetables will be met (see Part 9).

Funding of Alpurt B2 motorway extension

The motorway extension north of Auckland (Alpurt B2) is planned to be built by 2009. Transit NZ will fund the construction of the motorway partly from the national land transport fund and partly through funds raised from infrastructure bonds issued by the New Zealand Debt Management Office.

The financing arrangements for Alpurt B2 have now largely been finalised. The accounting treatment of the arrangements is expected to be complex. We have recommended that the Treasury, in conjunction with Transit NZ, consider the appropriate accounting treatment and discuss it with us, so that the accounting treatment can be agreed.

Related party disclosures

Related party disclosures in the Government financial statements have historically been limited to aggregate information on salaries and allowances paid to Ministers of the Crown.

Last year, we raised the issue of related party transactions in the context of the change from the Crown to the Government reporting entity from 1 July 2005 arising from the Public Finance Amendment Act 2004. We recommended that the Treasury consider further the application to the Government financial statements of SSAP-22: Related Party Disclosures, and whether present systems and processes are enough to identify and allow all related party transactions to be reported on. While this work has not been completed, we accept that, given the introduction of NZ IFRS, the focus should be on compliance with NZ IAS 24: Related Party Disclosures together with any changes that result as a consequence of Exposure Draft 108.8

We have recommended that the Treasury consider this issue further when the requirements under the new standard are known, to ensure that appropriate systems and processes are in place to comply with the NZ IFRS reporting requirements.

Public Finance Amendment Act 2004

Last year we referred to the changes that would be needed to the Government financial statements as a result of the Public Finance Amendment Act 2004. We mentioned two specific changes. The first was the need to reincorporate the Offices of Parliament into the 2006 Government financial statements because of the change in the reporting entity. The second was that the Government financial statements would no longer have to disclose all guarantees and indemnities entered into by the Minster of Finance, but only those that met the definition of a contingent liability under NZ GAAP. The Treasury made both these changes in the 2006 Government financial statements.

1: From 1 July 2005, the Public Finance Amendment Act 2004 changed the reporting entity from "the Crown" to the "Government reporting entity". The Government reporting entity is defined to include the Sovereign and the legislative, executive, and judicial branches of the Government. The revised definition clarifies that all three branches of government are to be included within the Government financial statements. Section 27(3) of the amended Public Finance Act 1989 requires the annual financial statements of the Government to include the Government reporting entity's interests in various entities, including Offices of Parliament.

2: Under section 30 of the Public Finance Act 1989, the Auditor-General has 30 days after receiving the Government financial statements from the Treasury to issue the audit opinion. However, in recent years we have generally agreed an earlier date for audit sign-off in the interests of timely reporting.

3: The earlier date of sign-off of the Government financial statements does pose some risks, as the statutory audit opinions for some major entities have not been issued at that time. However, audit sign-off for consolidation audit purposes has been received.

4: The initial fair value write-down will be unwound (that is, recognised as income) over the maturity of the loan. The value will be adjusted for any impairment (for example, non-repayments caused by death or bankruptcy of the borrowers).

5: The data is up to 31 March 2003.

6: These amounts are net of provisions for doubtful debts. The Ministry of Justice receivables largely relate to outstanding court and enforcement fines, and associated filing and enforcement fees. The MSD receivables largely relate to benefit overpayments, advances on benefits, and recoverable special needs grants.

7: Exposure Draft 109 proposed amendments to FRS-37 and NZ IAS 27: Consolidated and Separate Financial Statements.

8: Exposure Draft 108: Omnibus Amendments addressed minor matters relating to a number of standards, including NZ IAS 24: Related Party Disclosures.

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