Part 1: Matters arising from the audit of the 2006/07 Financial Statements of the Government

Central government: Results of the 2006/07 audits.


The Auditor-General issued the audit report on the Financial Statements of the Government of New Zealand for the Year Ended 30 June 2007 (the FSG or the financial statements) on 28 September 2007. This is the same date on which the Minister of Finance and the Secretary to the Treasury signed their Statement of Responsibility.

The audit report appears on pages 26-27 of the 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 2007; 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 6-23 of the financial statements.

Significant matters arising from the 2006/07 audit

The significant matters that arose during the 2006/07 audit of the financial statements are listed below and discussed in this Part:

  • the Treasury and sector performance (paragraphs 1.05-1.16);
  • valuation of student loans (paragraphs 1.17-1.28);
  • the Kyoto Protocol provision (paragraphs 1.29-1.37);
  • recognition of income tax revenue (paragraphs 1.38-1.44);
  • Accident Compensation Corporation - future claims liability valuation assumptions (paragraphs 1.45-1.50);
  • Statement of Borrowings - derivative movements (paragraphs 1.51-1.57);
  • valuation of rail network assets (paragraphs 1.58-1.60);
  • an audit committee for the FSG (paragraphs 1.61-1.67); and
  • Financial Reporting Standard No. 37: Consolidating Investments in Subsidiaries (paragraphs 1.68-1.70).

The Treasury and sector performance

Under section 30(1) of the Public Finance Act 1989, the Treasury is required to provide the annual FSG to the Auditor-General by the end of August. This year, the Treasury provided us the draft of the FSG, which was substantially complete, on 31 August.

Matters arising from the audit of the 2006/07 Financial Statements of the Government

However, there were a number of material audit issues that were not resolved until late September. These issues put at risk our ability to achieve the statutory requirement under section 30(2) of the Public Finance Act 1989 to issue our audit opinion within 30 days of receiving the FSG from the Treasury.

We are concerned about the performance of some entities in providing financial information to the Treasury for consolidation into the FSG. Some of these entities reported crucial financial information to the Treasury well outside the agreed time frames and did not address important issues in a timely manner.

The departments and Crown entities that provided information significantly late to the Treasury or that had significant delays in achieving audit clearance on their consolidation information for the FSG included:

  • Inland Revenue Department (IRD) - Audit clearance on all aspects of IRD’s reporting to the Treasury was achieved only in late September. A number of significant issues arose in the audit of the student loans valuation. Material correcting adjustments were necessary, and audit clearance for consolidation was achieved on 27 September (see our discussion on student loans in paragraphs 1.17-1.28).
  • Ministry for the Environment (MfE) - MfE is responsible for reporting the Government’s liability under the Kyoto Protocol. Final audit clearance on the Kyoto Protocol provision was achieved only in late September due to delays in providing the net position to the auditors and the complexity of the issues to consider (see our discussion on the Kyoto Protocol provision in paragraphs 1.29-1.37).
  • Ministry of Education (MOE) - The MOE audit clearance was delayed significantly due to late completion of the revaluation of school land and buildings and the time taken to resolve issues identified by our auditor.
  • ONTRACK - The audit clearance on the valuation of the rail network assets was delayed due to a number of late adjustments (see our discussion on valuation of rail network assets in paragraphs 1.58-1.60).
  • Ministry of Social Development (MSD) - MSD administers benefit recovery debt. Audit clearance on the fair value of benefit debt was obtained on 18 September because of the late delivery of workpapers to the auditors.

The performance of these entities put at risk the timely completion and publication of the audited FSG.

We recognise that these entities are dealing with very complex public sector accounting issues or complex physical asset valuations. Applying commercially based accounting standards to these issues can be very challenging, and for a number of the issues external experts were engaged to perform valuations or provide advice.

Determining the fair value of non-commercial financial assets has caused particular challenges. With the Government reporting entity’s transition to reporting in accordance with the New Zealand equivalents to International Financial Reporting Standards (NZ IFRS) for the year to 30 June 2008 (see Part 2 of this report), fair value determinations will become increasingly important.

Given the complexity of the issues involved and the apparent difficulties in meeting established time frames, we are of the view that the timetable for these key financial or physical asset (or liability) valuation exercises needs to be reviewed. Earlier completion of these valuations would provide more time to properly resolve any issues arising without risking the timetable for completing the FSG.

In most if not all cases, we believe that the valuation can be substantially performed at a date earlier than 30 June (for example, 31 March or 31 May), with a subsequent roll forward to 30 June.

These issues also raise some concerns about the capacity of, and capability in, the finance functions of central government agencies. As we have noted, the issues have been very complex. In a number of cases, the agencies have realised that they need external expert assistance to enable them to complete their reporting obligations. However, the sector needs to have the capability to understand and adequately review and challenge the experts’ work.

With the transition to NZ IFRS, the complexity of accounting will increase, and the capacity and capability of central government finance functions will continue to be tested.

We have recommended that the Treasury engage further with chief executives and boards (where relevant) about:

  • the need to meet the set timetables for reporting financial information to the Treasury for consolidation and for providing this information and supporting information to auditors;
  • the capacity of, and capability in, departmental finance teams to deal with complex financial reporting issues; and
  • the need to bring forward the timetables for the valuation of key financial and physical assets (and liabilities).

Valuation of student loans

Student loans are recognised in the 2007 FSG at a carrying value of $6.01 billion (2006: $5.56 billion). Note 9 to the FSG provides detailed disclosures about student loans.

A number of significant issues arose in the audit of the student loans balance, and our auditor was not able to sign off on the accuracy of the student loan book value and disclosures until 27 September, the day before the audit report on the FSG was signed.

The accounting policy for student loans is to account for them as “loans and receivables” under NZ IAS1 39: Financial Instruments: Recognition and Measurement. This policy was adopted in the year ended 30 June 2006 because of the introduction of the interest-free policy for student loans and concerns that the fair value of student loans would drop significantly below their carrying value. This accounting policy requires initial recognition at fair value followed by subsequent measurement at amortised cost using the effective interest rate method.

The student loans book value and fair value (for disclosure) are generated using complex actuarial models. The actuary for the three departments jointly responsible for student loans administration developed these models. The departments are:

  • the Ministry of Education (MOE), which provides policy advice and tertiary education data for the valuation models, and manages the contract with the actuary;
  • the Ministry of Social Development (MSD), which assesses applications, makes student loan payments, and provides data on borrowing for the actuarial models; and
  • the Inland Revenue Department (IRD), which manages the collection of loan repayments and provides data on loan repayments and balances for the actuarial models.

The accounting for student loans is split between MSD and IRD. MSD records all new borrowings and then transfers the accounts to IRD annually in February. This means that, as at 30 June, both MSD and IRD have student loan balances to account for. The complexity of the institutional arrangements for administering student loans provides an additional complication to our audit.

The most significant audit issue arose when we considered the Treasury’s and IRD’s explanations for the difference between the proposed student loan book value and proposed fair value. The fair value was $1.468 billion lower than the book value in the initial valuation reports from the actuary. Most of this difference was because revised risk margins were applied to the discount rate used to calculate the fair value to reflect the payment volatility of borrowers repaying less than their payment obligations (based on their income).

The way the actuary’s methodology for the fair value model determines the premiums for expected default loss and the risk premium that are applied to the risk free discount rate has changed this year. The actuary’s report highlighted that the changed methodologies were necessary because the data analysis during the year demonstrated that actual “repayments made by many borrowers are significantly less than their repayment obligations”. The issue of borrowers repaying less than their repayment obligations (for example, because of supplying incorrect tax codes) was an issue that our management report identified and reported after the 2006 audit.

Our view was that the identified underpayments by borrowers that affected the fair value so significantly should also raise concern about the appropriateness of the book value.

At our request, the Treasury, with IRD and the actuary, investigated these issues further. This resulted in the Treasury proposing adjustments to decrease the book value of student loans by $300 million and to increase the disclosed fair value of student loans by $600 million.

These adjustments reduced the difference between book value and fair value to $568 million (with book value being higher). This remaining difference is due to the increase in market risk-free interest rates (which have reduced the fair value but do not affect the book value) and revised assessments of expected future credit losses (which are allowed for in the fair value model, but are not accounted for in the book value model).

The late adjustments were determined outside the complex actuarial models and are estimations of the correcting entries required to ensure that the amounts recognised are in accordance with accounting standards. The written representations that we received from the actuary and the Treasury and our detailed audit work provided us with enough audit evidence to conclude that the book value and fair value are materially correctly stated and that the difference between the two values does not represent an impairment of the student loan asset. However, significant further work will be required on the models to ensure that they are robust and can be relied on for future financial reporting.

Given the significance and complexity of the student loan receivable valuation and to ensure that we avoid similar issues in 2008, we have recommended that:

  • the Treasury and the three departments jointly responsible for student loans administration review the timing of the actuarial valuation processes that determine the book value and fair value of student loans - completing the valuations before 30 June and then rolling them forward to year-end may provide more time to resolve the complex issues that may arise in the valuations; and
  • another actuary carry out quality assurance review of the actuarial models and valuations on an annual basis, because of the complexity of the models and the significant effect on the values from changes in actuarial assumptions.

The Kyoto Protocol provision

New Zealand is a signatory to the Kyoto Protocol, which imposes binding emission reduction targets on New Zealand during the First Commitment Period (CP1) from 2008 to 2012.

A provision for New Zealand’s net deficit position under the Kyoto Protocol for CP1 was first recognised in the 2005 FSG with a provision of $310 million. The provision was revised to $656 million in 2006, and increased to $704 million in the 2007 FSG. Note 15 of the 2007 FSG provides detailed disclosure about the Kyoto Protocol provision. The Treasury has not recognised any provision or contingent liability for periods beyond 2012, because 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 more updated information becomes available, better systems are implemented, or some uncertainties are reduced. Some of the aspects of the Kyoto Protocol provision that are subject to fluctuation over time include:

  • the price for each tonne of carbon;
  • the exchange rate with the US dollar; and
  • the various assumptions underlying the calculation of the emissions and sinks (for example, forecasts of GDP, oil prices, availability of updated statistics).

Net removals of carbon through forest sinks are deducted from the projected emissions. The net removals through forests is reported after deducting 21 million tonnes for estimated deforestation. This estimate assumes policy interventions to give effect to the Government’s policy to cap its liability at this amount. The FSG disclose that, without policy interventions and assuming current market conditions prevail, a deforestation intentions survey conducted in 2006 indicated likely deforestation of 41 million tonnes, which would result in an increase in the provision of $310 million.

The Ministry for the Environment had an independent expert assess the reasonableness of the assumptions and methodologies underpinning the 2007 projections. The expert concluded that they were sound and reasonable, while making a number of recommendations and highlighting areas of risk.

The Government has agreed in principle that an Emissions Trading Scheme (ETS) will be implemented after 30 June 2007 as part of the Government’s climate change response. The Treasury had stated that, at that stage, it was unable to quantify the likely effect of the ETS on the Government’s Kyoto Protocol liability as the final decisions had not been made.

As discussed in paragraph 1.08, the audit of the Kyoto Protocol liability was completed later than expected due in part to the complexities of the issues under consideration, but also due to delays in providing the net Kyoto stocktake position to our auditor. The release of the stocktake position was delayed this year to enable officials to consider the effect on forecast agricultural emissions of the announcement in May 2007 by Fonterra Co-operative Group Limited of a significant increase in its forecast milk solids payout.

We have recommended that the Treasury and other relevant government agencies review the timetable for the annual Kyoto stocktake, with a view to providing the net position for audit by the end of June each year at the latest. This will ensure that enough time is available for audit assurance.

We have also recommended that the Ministry for the Environment and the Treasury take action on the recommendations from the independent expert’s review, and carry out the work to quantify the effect of the ETS on the Kyoto Protocol liability.

Recognition of income tax revenue

Direct income tax revenue for the year to 30 June 2007 totalled $36.89 billion. In recent years, we have raised a number of issues about revenue recognition policies for income tax, particularly the revenue recognition point for provisional tax and the treatment of payments into provisional tax pooling accounts.

Generally we have been pleased with the responses to the issues that we have raised, but there remain areas where revenue recognition policies need to be considered further. Given the large amounts involved, any change in revenue recognition policies can have significant effects on the FSG.

We have recommended that the Treasury and IRD consider two important issues further.

We recommended that the Treasury and IRD consider the potential for payments into provisional tax pooling accounts (which at 30 June 2007 total $2.8 billion) to delay the recognition of provisional tax revenue in the monthly and annual FSG. Payments into pooling accounts are not recognised as revenue, whereas the same payments would be recognised as revenue if made into the individual taxpayers’ accounts. Conceptually, provisional tax revenue should be recognised in the same period, regardless of whether the taxpayer uses tax pooling or not.

We also recommended that the Treasury and IRD consider whether provisional tax payments by taxpayers are a better indication of tax revenue for recognition purposes than provisional tax assessments, given that there are strong incentives (in terms of interest costs) for taxpayers to make accurate payments, but fewer incentives for taxpayers to make accurate self-assessments of provisional tax or to update assessments for income changes. Currently provisional tax payments are recognised as revenue only up to the time that a provisional tax assessment is issued. After the provisional tax assessment is issued, the tax assessed (less provisional tax payments made previously) is accrued as revenue, and payments made subsequently do not affect revenue recognition.

In addition, we note that, due to the planned alignment of provisional tax and GST, provisional tax will generally be paid later, may be paid more frequently, and could be paid in unequal instalments based on turnover. As a result, the calculation of the accrual for provisional tax revenue will need to be modified for next year.

We have recommended that the Treasury work with IRD to review provisional tax revenue recognition policies to ensure that they remain in line with generally accepted accounting practice and international best practice.

Accident Compensation Corporation - Future claims liability valuation assumptions

The claims liability of the Accident Compensation Corporation (ACC) represents the present value of future costs for accidents that have occurred before balance date and that are covered by ACC. The liability is valued each year by actuaries. As at 30 June 2007, the ACC claims liability was $13.7 billion (2006: $12.7 billion). Note 17 of the FSG provides detailed disclosure about the ACC claims liability.

In valuing the claims liability, the actuaries need to make a number of assumptions about future costs. One of these assumptions is referred to as the superimposed inflation rate, which is the increase in the cost of claims above the general inflation rate.

In determining the ACC claims liability at 30 June 2007, ACC adopted a long-term superimposed inflation assumption of 1% each year after five years for social rehabilitation for serious injury claims. The adequacy of the superimposed inflation assumption was subject to discussion between relevant parties, including the valuing actuary, the peer review actuary, and the actuary advising our auditor.

There is limited evidence to authoritatively support any particular level of superimposed inflation. Given the limited evidence, there was discussion among the various actuaries involved about the adequacy of this level. We have nevertheless accepted the 1% level because of the written representations that we have received from the valuing actuary and from the ACC Board who, between them, have the most detailed knowledge of ACC’s rehabilitation costs.

However, we requested that the Treasury include some sensitivity analysis on superimposed inflation in Note 17 to the FSG. This discloses that a 1% movement in the superimposed inflation figure will affect the liability and the surplus by about $450 million.

We have recommended that the Treasury work with ACC to improve the quality of information to support key actuarial assumptions in the ACC claims liability model.

Statement of Borrowings - derivative movements

Section 27 of the Public Finance Act 1989 requires the Treasury to include a Statement of Borrowings in the FSG. This statement is on page 37 of the FSG.

There are some large movements in the Statement of Borrowings between the 2006 and 2007 figures. These include US dollar debt moving from $14.4 billion to negative $3.9 billion, and US dollar securities moving from $11.1 billion to negative $10.9 billion.

These significant movements arise because derivative financial instruments (such as cross-currency interest rate swaps and forward foreign exchange contracts) are included within the statement balances. The New Zealand Debt Management Office manages derivative financial instruments. To give an accurate representation of debt by currency, the currency flows under these derivatives have been separated out and allocated to the relevant part of the statement.

There is no financial reporting standard that sets out how a Statement of Borrowings should be presented. The construction and presentation of the statement is consistent with previous years. The movements and negative balances arise from the effect of foreign exchange derivatives and the significant changes in foreign exchange rates between the two years and the appreciation of the NZ dollar at the end of the financial year.

We have confirmed the accuracy of the figures presented in the statement. However, we do not believe that the statement as it is currently constructed is clear or informative to users.

We recommended that the Treasury reconsider the presentation of the Statement of Borrowings and particularly how to treat foreign exchange derivatives associated with borrowings in the statement, with a view to ensuring that the statement provides a clear and informative presentation of government borrowings, while meeting the requirements of the Public Finance Act.

We note that the Treasury has revised the presentation of the Statement of Borrowings in the FSG for the quarter ended 30 September 2007 (the first interim FSG reported under NZ IFRS). The revised format presents derivative balances separately from borrowings and financial assets, and no longer presents an analysis by currency.

Valuation of rail network assets

The accounting policy for rail network assets was changed to measurement at fair value rather than cost from 1 July 2006. This was done to provide a more current value of the rail network and to be more consistent with the approach taken for other significant items of property, plant, and equipment. The rail network assets were valued by an independent valuer on a depreciated replacement cost basis for the rail infrastructure and on a fair value of adjoining land basis for the land under the network. The revaluation was a complex exercise and resulted in an increase in the carrying value of rail network assets of $10.3 billion.

Our auditor of ONTRACK audited the new valuation of rail network assets and confirmed that it is materially correct. The audit clearance for the FSG audit was delayed due to a number of late adjustments to the carrying value of the assets resulting from uncertainties about the ownership of some assets, impairment considerations, and additional assets being identified. The audit identified a number of weaknesses in ONTRACK’s fixed asset records, and we have recommended that ONTRACK implement comprehensive fixed asset information and accounting systems.

As ONTRACK develops its knowledge of the assets it has taken over, and as its fixed asset information systems improve, the asset carrying values will probably be adjusted further.

An audit committee for the FSG

The FSG is an important document that provides a record of the Government’s financial performance and position, and performance against the fiscal forecasts. As auditor of the FSG, we need to work with Treasury officials on many issues that arise. Mostly we work with officials within the Treasury’s Fiscal Management and Reporting Cluster, although we raise significant issues about the FSG with the Secretary to the Treasury.

Most large public entities have set up an audit committee that has the function, among other things, of dealing with the auditor about the audit and any issues that arise. There is currently no audit committee providing oversight of the preparation and audit of the FSG.

In our view, some of the discussions that we have with Treasury staff about, for example, appropriate accounting policy choices for the Government or significant issues arising during the course of the audit would benefit from wider consideration through an audit committee.

As is best practice in public sector governance, we expect such an audit committee to include suitably experienced members independent of the Treasury.

An audit committee could also support the Secretary to the Treasury and the Minister of Finance in their statutory obligations under the Public Finance Act to sign the Statement of Responsibility for the FSG.

We note that some other jurisdictions have set up audit committees for their equivalents to the FSG, such as the Australian Government Financial Statements Audit Committee.

We have recommended that the Treasury investigate setting up an audit committee for the FSG.

Financial Reporting Standard No. 37: Consolidating Investments in Subsidiaries

Since 2003, the Treasury has equity accounted for tertiary education institutions (TEIs) in the FSG based on a 100% interest, rather than line-by-line, consolidation. This approach is based on a view that the control test in Financial Reporting Standard No. 37: Consolidating Investments in Subsidiaries (FRS-37) is not satisfied because the Crown does not have the ability to determine the financing and operating policies of TEIs, and that the Crown’s relationship does meet the “significant influence” test necessary for equity accounting. Note 13 to the FSG sets out the approach and the reasons for it.

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 because the Crown arguably does not control TEIs according to a strict interpretation of the definition of control within FRS-37, and because of the additional disclosures provided in Note 13. With those additional disclosures, we have accepted that the financial statements remain fairly stated.

In July 2006, the Financial Reporting Standards Board (FRSB) issued Exposure Draft 109, which proposed that TEIs should be consolidated into the FSG as if they were wholly owned subsidiaries of the Government for the purposes of FRS-37. After considering submissions on the Exposure Draft, the FRSB decided not to proceed with the proposed amendments, but noted that it will consider the issue further during its consideration of the International Accounting Standards Board’s proposals on consolidation. At this point in time, the status quo continues and is likely to do so for the 2008 financial year.

1: New Zealand equivalent to International Accounting Standard.

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