Auditor-General's overview

I am pleased to present my annual report for 2007/08.

During the year we began preparing a new strategic plan for the period 2009-12 to serve as a basis for the term of the next Auditor-General after my term concludes in May 2009. While an incoming Auditor-General will bring their own priorities, I want to ensure that the Office’s strategies, intentions, and risks are clearly laid out as a basis on which they can chart the course for their own term of office.

In 2007, I also commissioned a peer review of the Office by a team of our international counterparts. The purpose of the review was to let us know whether we are operating effectively and efficiently, and in keeping with good practice. The peer review team’s report was published on 15 April 2008. It covers the governance and general management of the Office, including the allocation of audits, and setting and monitoring of audit fees, the carrying out of annual audits, performance audits and inquiries; the operation of quality control systems; and the Office’s relationships with its primary stakeholders.

I am very pleased with the report of the peer review team which noted, among other things, that “the Office would rate highly both absolutely and relatively in any international comparison.” The full report of the peer review team is available on the Office’s website.

The year in review - New Zealand equivalents to International Financial Reporting Standards and the impact for the public sector and us as auditors

Significant changes in the accounting and auditing profession and in the legislative and operating environments of public entities continue to have a major effect on our work, as they have done in recent years.

Carrying out audits under NZ IFRS

A significant change in the accounting and auditing profession has been the adoption by the Accounting Standards Review Board (ASRB) of New Zealand equivalents to International Financial Reporting Standards (NZ IFRS) for periods starting on or after 1 January 2007.

For most public entities, 2007/08 was the first year their audits were carried out under NZ IFRS. Therefore, during 2007/08, we turned our attention from preparing our auditors to audit in an NZ IFRS environment to actually carrying out audits under NZ IFRS. We continued to assist the public sector to prepare for their transition to NZ IFRS with a range of initiatives, including developing model annual reports for reporting under NZ IFRS.

The impact of NZ IFRS for public sector financial management

The change to NZ IFRS has increased complexity for those preparing financial reports and those auditing them and contributed to a public sector environment in which financial and audit expertise are in high demand. Overall, I believe the change to NZ IFRS is beginning to impact on the public sector as a whole - as well as on my own Office, resulting in pressure on both the quality and the cost of the audit work carried out. For example, arrears in issuing public entities’ audit reports at 30 June increased from 312 in 2006 to 362 in 2007 to 453 in 2008. Fees overall, including work associated with NZ IFRS, increased by approximately 9% for 2007/08, and we experienced greater overruns of audit hours against those anticipated.

In my liaison with those involved in the accounting and auditing of public entities, I have been told that financial reporting standards are now so complex that many entities’ finance teams can no longer prepare their financial statements and associated information without specialist external expertise. If the need for external expertise is now the norm for public entities, this raises serious questions about both the reasonableness of financial reporting standards and the financial management capability of the public sector. I understand that the Treasury is currently carrying out work to assess financial capability within government departments, and I look forward to the results of this analysis.

I believe that the ASRB, when it decided to base New Zealand standards on IFRS (which were written to be applied by large profit-oriented entities), acknowledged that the needs of the public sector are different and would therefore require different treatment. As I have publicly stated before, the new standards will be credible only if they are seen to:

• specifically consider public sector issues;
• incorporate appropriate changes to IFRS so that the public sector is able to apply them sensibly; and
• incorporate appropriate guidance to assist the public sector to apply the standards.

However, this is not happening in all cases. I am becoming increasingly concerned about the credibility of the new standards and have begun to voice my concerns publicly. If New Zealand is to remain at the forefront of public sector management, it is vital that accounting standards are sensible in the context of the New Zealand public sector. I expect that some of the standards my Office has been concerned about will create issues and begin affecting our reporting over the next year. For example, I expect the requirements for capitalisation of borrowing costs to be a problem as we undertake our 2009 Long-Term Council Community Plan audits over the next few months.

The impact of financial reporting requirements for the work of the Office

I have also been concerned that the demands created by changes within the accounting and auditing profession have meant that my Office’s audit work has had to focus more heavily on entities’ financial statements. That focus has been at the expense of public-interest audit work based on fuller consideration of the risks and challenges that entities face in their strategic, governance, and operational contexts.

In 2007/08 we began development work to rebalance our audit effort so that our audits of public entities take this fuller perspective into account. This work is expected to form a key element of our 2009-12 strategy and is expected to result in a stronger emphasis on non-financial reporting, waste, probity, and accountability across many of the sectors within our mandate.

Over time, providing this broader and more useful assurance to Parliament, public entities, and the public may well result in some increases in audit costs. I am not yet sure of the extent of such increases, and will discuss these with Parliament and others before I make any decisions. Nonetheless, I am committed to ensuring that the annual audits address the Auditor-General’s statutory mandate, while meeting stakeholder expectations.

Monitoring and managing the reasonableness of audit fees

To ensure that our annual audits comply with changing financial reporting and auditing standards, public sector audit fees have been increasing to keep pace with the wider international demand for assurance services. That fee pressure is likely to continue for the foreseeable future, given the prevailing market conditions.

I have systems in place to ensure that audit services are provided at a reasonable cost to public entities. In doing so, I must ensure that audits are performed well, both now and in the future, which means my audit service providers must be fairly remunerated.

I again sought independent assurance that our audit appointments and fee monitoring processes are working effectively. The report from the independent reviewer, David Gascoigne, is on pages 37-39.

I also sought an internal review of the audit allocation method, which we have used for contracting audits since 2005 to ensure that the wider pressure on audit fees is managed as well as it can be. The results of this review were positive. The review report suggested a number of refinements to the allocation processes as follows:

• Continuing to build on existing sector clusters by ensuring sufficient critical mass is achieved and maintained for each audit service provider;
• Continuing to fine tune fee monitoring processes so that public sector entities can have confidence that their audit fees represent value for money;
• Providing more education and dissemination of ‘good practice’ advice for Boards and officers of public sector entities so that there is wider and better understanding of the reasons for changed audit processes;
• Examining ways to simplify the administration of audits - especially for smaller entities.

The year in review - public entities’ legislative and operating environment and their impact on our audits

Auditing Long-Term Council Community Plans

The next round of the three-yearly audits of Long-Term Council Community Plans (LTCCPs), required by the Local Government Act 2002 and first undertaken in 2006 is due to be undertaken during the 2008/09 year. During 2007/08, we carried out extensive work to review and improve our LTCCP audit methodology and we reviewed the basis of estimating audit fees. In particular, we focused on enhancing our methodology around the following key areas of concern arising out of our 2006 LTCCP audits:

• implementation of the local government principle to take a sustainable development approach;
• the provision of clear information to the public on key issues, choices and implications and the associated financial management strategies;
• performance frameworks and information to allow the public to meaningfully assess council services and progress toward community outcomes; and
• the adequacy of underlying information - in particular, about asset management.

As we prepare to enter our second round of LTCCP audits, there is now no question in my mind that the Office’s LTCCP and associated amendment audit responsibilities are having a significant impact on the Office and its resourcing. Some of this has been extremely beneficial, providing a platform for collaborative work between our audit service providers and a basis for the development work I referred to earlier to rebalance our audit effort. However, the effort and resource involved in gearing up to perform a demanding audit that occurs only once every three years is high.

At present, based on the results of the 2006 LTCCP audits and the issues that we identified, my view is that our audit work is warranted. Local authorities manage long-lived assets and services of critical importance to communities across New Zealand. Public confidence that these assets and services will continue to be available and will meet changing community needs is vital. However, I would like to think that over time, local authorities themselves will build the integrity of their information, decision-making, and service management such that our LTCCP audits would no longer be necessary.

Performance audits and good practice guidelines

Most work we do to ensure quality in our performance audit work confirmed that it is of high quality and remained on a par with previous years. We also equalled our success of 2005/06 in completing the highest number of reports on performance audits, special studies, and inquiries in the history of the Office. The International Peer Review Team also commented favourably on our performance audit work, reporting that:

Overall we found a robust performance audit framework, with thorough processes and quality assurance arrangements complementing the findings of other external quality assurance reviews in recent years. The reports themselves were clearly written and easy to follow.

However, despite consultation with Select Committees showing considerable support for our work programme, including the proposed performance audits, our 2007/08 stakeholder survey showed significant reductions in satisfaction for our performance audit work. The stakeholder survey report noted that the survey results:

... show that the Office is continuing to perform at a high level and that Where the scores are reduced, this is primarily because of the smaller number of interviews conducted this year compared to last.

Relative to our international counterparts, the Office audits a very large number of public entities and comparatively has very limited discretionary resources to carry out the in-depth work that performance audit allows. This limited discretion means that our performance audits are carried out with significantly lesser resource and costs than those of many of our peers - but also means that, at times, we are not able to do as much in-depth work as we would like.

Nevertheless, our performance audit programme has built up a useful body of work in important areas of public administration. These areas include funds management, grants administration, debt management, “joined-up” government, asset management, defence acquisitions, transport safety and strategy implementation. As a result there has been growing effort on good practice guides on issues commonly emerging from our annual audits.

However, determining how to best use our discretionary resources - primarily our performance audit resource - requires careful balancing. Topics for performance audits must not only be of interest to stakeholders, but must also, given our limited discretionary resources, produce results that can be useful to as many entities as possible. We therefore continue to consider how we can both develop our performance audit and good practice guide programme and carry out this work to balance the different interests and needs of our stakeholders and entities.

Auditing performance information - Implications of new public sector management legislation

One of the significant areas of strategic focus which we continue to pursue is performance information prepared by public entities - particularly where the auditor is required to attest to entities’ Statements of Service Performance. The work in this area is intended to enhance the effectiveness of annual audit work on service performance information - an area of particular interest to me.

These enhancements are also needed to address issues arising as a result of statutory change (for example, the Crown Entities Act 2004 and the changes to the Public Finance Act 1989 and the Local Government Act 2002), as well as general improvements that I consider to be long overdue.

The work we carry out in this area will better position us to contribute to improving the quality of service performance information reported by public entities. It also takes account of our focus on sustainable development.

I have recently decided that audit opinions should provide assurance that we have assessed whether the entity’s performance framework will allow its actual output performance to be fairly presented. For the local government sector, this is already part of the assurance that the audit opinion on the LTCCP provides. My staff are revising my auditing standard AG-4 The Audit of Service Performance Reports, which I will consult on later this year prior to issuing it. I intend the revised AG-4 to take effect for future reporting periods.

During 2007/08 we completed our in-depth reviews of the 2007/08 forecast performance information of government departments and most Crown entities and began in-depth reviews of 2008/09 forecast information. Our intention through these in-depth reviews was to provide entity-focused feedback that set out our expectations of forecast information (which are based on relevant legislation and accounting standards) and clearly identified areas for improvement. My expectation is that our in-depth reviews will help entities understand and improve their information in anticipation of the changes I expect to make to my auditing standard AG-4.

For the 2009 financial year-end audits, our letters to Ministers and select committees will provide gradings of government departments and Crown entities on the Service Performance Information and Associated Systems and Controls.

This will be the first time we have graded this aspect since the introduction of our revised grading approach in 2007.

Our 2009 LTCCP methodology review also included lessons learned from our work in relation to auditing performance information. Our revised LTCCP methodology gives greater emphasis to performance frameworks rather than detailed performance measures. Ultimately all our work on improving the audit of performance information will be incorporated into the rebalancing of our audit effort and the development and training of our audit service providers.

Main risks and issues

For several years, we have identified our key strategic risks as being the loss of our independence and audit failure. We have recently included two additional strategic risks - loss of capability and loss of reputation. During 2007/08, we maintained risk management systems around our key risks and worked to improve recruitment and retention. However the changes in the public sector and the accounting and auditing professions, together with the continuing difficulty in finding and retaining suitably qualified and experienced staff, mean that our main strategic risks remain.

I have a high standard for independence for my employees and the auditors whom I appoint from chartered accounting firms. My independence standard is based on a standard issued by the New Zealand Institute of Chartered Accountants. Compliance with my independence standard, by statutory officers, employees, and all appointed auditors, is monitored through regular declarations of interest and, as necessary, measures to manage conflicts of interest.

My employees and appointed auditors are required to adhere to professional auditing standards. There are external peer review and substantiation procedures across annual audits, performance audits and inquiries. Although there were updates to the Auditor-General’s Auditing Standards (as is required to be done every three years) during 2007/08, the adoption of New Zealand equivalents to International Standards on Auditing will mean further changes to my auditing standards during 2008/09.

We continued to implement the New Zealand Institute of Chartered Accountants’ revised quality control standard PS-1. We have interpreted the new quality control standard as requiring quality control processes to be in place throughout the operations of the Office (that is, the Office of the Auditor-General, Audit New Zealand, and other audit service providers) and to all the Office’s outputs. Our work to implement the standard means I can be confident that the Office gives appropriate emphasis to quality for all my auditing and assurance work.

My independent Audit and Risk Committee, comprising three external members and the Deputy Controller and Auditor-General continues to meet on a quarterly basis. The report from the Chairman of the Audit and Risk Committee is included at pages 75-76.

However, we continue to face challenges in recruiting and retaining suitably qualified and experienced senior staff because of industry and labour market shortages. This in turn adds pressure on salaries, audit charge-out rates, and ultimately audit fees paid by public entities. Therefore, recruiting and retaining good staff and continuing to invest in developing our staff is a core component of our strategic plan. This is becoming increasingly critical in the current tight and international labour market.

Our “future business model” project has provided a planning tool for better forecasting our audit staff requirements in future years. As a result we know that we need to maintain a consistent level of recruitment for both graduate and qualified audit staff. We also know that we need to supplement our staff with secondments from within New Zealand and internationally to help us through peak periods.

We were fortunate in 2007/08 to have had several successful Audit New Zealand recruitment initiatives, which saw the Office’s total staff boosted from 288 to 311 full-time equivalents. Initiatives included our accounting graduate recruitment programme and recruitment programmes targeted at qualified accountants in the United Kingdom and South Africa.

However, we must also focus on retaining our skilled staff. Despite our success in recruitment, staff turnover, particularly of qualified auditors, remains of concern. Auditing is a knowledge industry and therefore retaining knowledge and expertise is as important as recruiting new people and skills. Initiatives to address this include more targeted development programmes, more flexible work arrangements, and potential secondment programmes to our equivalent organisations in the United Kingdom.

Further discussion on our organisational health and capability is set out in Part 3.

The year ahead

I was grateful for the feedback I received from Parliament on my 2008/09 draft work programme. I appreciate the opportunity to operate transparently in setting out my annual work programme, including seeking feedback from members of Parliament as part of our annual plan preparation.

Members of Parliament mainly supported the approach we have taken to determining the Office’s work programme, and neither the Speaker nor any committee of the House requested any change to our work programme priorities. As a result, I am confident that the performance audits we intend to carry out in 2008/09 are relevant and likely to be useful to Parliament, public entities, and the public.

The feedback included:

• guidance on the scope and relative emphasis we should place on some studies and other areas of concern - I will ensure that this feedback is incorporated into our scoping of the respective studies; and
• suggestions for projects in future years including to consider more work on procurement across the public sector - I will ensure that this feedback is incorporated into development of our 2009/10 work programme.

Concluding remarks

I would like to extend my thanks to the Deputy Controller and Auditor-General and my Audit and Risk Committee for their guidance and support. I would like to acknowledge the contribution of Terry McLaughlin who recently left his role of Executive Director of Audit New Zealand (after a long period in a range of roles with the Office) to become Chief Executive of the New Zealand Institute of Chartered Accountants. Finally, I thank my staff and appointed auditors for their efforts and their achievements and for their commitment to integrity, honesty, and independence.

We have another challenging year ahead as we continue to contribute to trust in the effectiveness and efficiency of the public sector. I am proud of the contribution we have made in 2007/08, and am confident that we have a strong basis on which to continue to make that contribution.

K B Brady
Controller and Auditor-General

30 September 2008

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