Part 4: Local authority exposure to liabilities from leaky home claims
4.1
The exposure to liabilities from leaky home claims continues to be a significant issue for the local government sector. Liabilities amounting to $167.9 million have been included in the 2007/08 financial statements of six of the most significantly affected local authorities. This is an increase of $50.7 million, or 43%, on the amount disclosed in their 2006/07 financial statements. These liabilities cover claims that have been confirmed, and claims that have been notified to local authorities where investigation and confirmation of their validity is still in progress. Methods of quantifying the notified but unconfirmed claims vary between each local authority.
4.2
In addition, $410.4 million has been disclosed as contingent liabilities in the 2007/08 financial statements of these local authorities. This is an increase of $166.7 million on the amounts disclosed in 2006/07 and reflects further assessment of the estimated future liability by all six of these significantly affected local authorities during the past year. In particular, we note that one local authority has recognised for the first time an estimate of the liability for claims not yet lodged.
4.3
It is important to note that the estimate of future claims is not the complete future liability, because four of these local authorities have not quantified and disclosed in their annual reports an estimate for claims yet to be made. The extent of liability recognised by these local authorities is already significant. The full extent of the liability to the local government sector is potentially much greater.
Background
4.4
In 2007 we considered the annual reporting requirements of local authorities in accounting for liabilities from leaky home claims. We gave guidance to our auditors to help them assess leaky home liabilities for each stage of the claims process. The principles included in our guidance were given to local authorities by their appointed auditor.
4.5
In our previous report, Local government: Results of the 2006/07 audits,1 we considered the disclosures made by the six most significantly affected local authorities and assessed how well their disclosures were aligned with the guidance we had issued. In our current report, our objective is to update our findings from the disclosures in the 2007/08 financial statements.
4.6
In 2007, when we started monitoring the leaky home liability issue, the six most significantly affected local authorities were Auckland City Council, Christchurch City Council, North Shore City Council, Rodney District Council, Waitakere City Council, and Wellington City Council.
4.7
Manukau City Council and Tauranga City Council now also face a high level of claims.2 Other local authorities have some claims against them but the number and value of these claims is much lower. However, to compare disclosures with last year, we have reviewed the same six local authorities as last year.
Categories of claims facing local authorities
4.8
We identified three categories of claims that local authorities need to consider when assessing their current and future exposure to liability for leaky homes. Each category represents a progressively increasing level of uncertainty about the extent of a local authority's financial obligations:
- category one - claims notified to local authorities where investigation and review has taken place and the amount of the total claim and the local authority's share has been confirmed;
- category two - claims that have been notified to local authorities where investigation and confirmation of validity is still in progress, which includes work to assess the other available parties to share the liability and to assess the costs; and
- category three - claims that may be made against local authorities between now and the end of the statutory limitation period but that have not yet been lodged, which includes issues that may not yet have been identified by the home owner.
4.9
Categories two and three are of greatest concern to local authorities because of the associated high level of uncertainty. These categories reflect the "tail" of the leaky home liability issue facing the country.
Accounting treatment
4.10
The accounting standard that applies to accounting for leaky home liabilities is NZ IAS 37 - Provisions, Contingent Liabilities and Contingent Assets. This standard provides the definitions and criteria to identify whether a liability should be accounted for as a provision, and therefore included within the balance sheet of the local authority, or as a contingency, and therefore included only in the notes to the financial statements. The most relevant element of the criteria for leaky home liabilities is the assessment of whether a liability, which requires estimation, can be calculated with enough reliability to meet the definition of a provision.
4.11
Our guidance to auditors on the appropriate accounting treatment based on the categories of claims was:
- category one - a provision for the confirmed amount should be recorded in the financial statements;
- category two - a provision for the estimated amount should be recorded in the financial statements; and
- category three - a provision should be recorded in the financial statements if an actuarial assessment has been obtained and is reliable; otherwise it should be disclosed as a contingent liability.
4.12
In practice, identifying category two and category three claims has proved more complex than anticipated when we wrote our guidance paper. In our guidance, we assumed that an actuarial assessment, particularly if carried out by professional actuaries, would be sufficient to meet the requirements of the accounting standards and facilitate accounting for the liability within the financial statements. However, the estimation processes used to assess category two and category three liabilities, whether performed in-house or by a professional actuary, has, in most cases, not been reliable enough to enable the resulting estimation to be accounted for as a provision in the financial statements.
Approach taken by local authorities
4.13
The six local authorities made few changes in their 2007/08 financial statement disclosures compared with those included in 2006/07 financial statements, other than the reassessment, and in all cases there were increases in the values of the liabilities faced by local authorities.
4.14
All six local authorities continued, as they did in 2006/07 and earlier years, to appropriately provide for notified and confirmed claims (category one).
4.15
For category two claims, one local authority did not change the amount from that provided in 2006/07 but did split the provision into current and non-current portions. Another local authority improved its approach to accounting for leaky home liabilities by making provision for category one and category two claims, where it had previously provided for only category one claims and treated the remainder of the liability as a contingency. These changes were an improvement in the quality of the information disclosed in the local authorities' financial statements.
4.16
As we noted last year, the treatment of claims that had been notified but were yet to be investigated and confirmed (category two) continues to vary across the sector. In many cases, based on the information disclosed in the financial statements, it is not clear what approach local authorities have taken to accounting for this category of claims. In some cases, the local authority has divided category two claims into two parts. The part where a higher level of certainty has been obtained has been accounted for as a provision, while the remainder has been treated as a contingent liability. None of the local authorities following this approach included in their disclosures an explanation of the basis that they had used to make such a distinction.
4.17
There appears to be an increasing use of actuaries and other professional expertise to assess these liabilities. However, as we noted last year, the reliability of the estimate can be uncertain even when an actuarial assessment has been completed. This situation has continued this year and, in many cases, still prevents the local authority from meeting the requirements of the accounting standard. The standard requires the estimate to be reliable. The disclosure of the assumptions and uncertainties surrounding the estimate should enable the liability to be treated as a provision and not a contingent liability. On this basis, four out of the six local authorities have continued to disclose category two claims as contingent liabilities rather than accounting for them as provisions in the balance sheet.
4.18
With future claims, all six local authorities included some disclosure in their financial statements and have acknowledged the issue as a contingent liability. Two of the six local authorities have included a quantified contingent liability for leaky home claims in their 2007/08 financial statements. The remaining four local authorities have all recorded the issue as part of their contingent liability disclosures. Two of these local authorities have included an estimate of the total liability for all parties involved, and two have disclosed their use of an actuarial assessment to gain an understanding of the extent of the liability they face in the future. However, much uncertainty remains despite the actuaries' review.
4.19
We had hoped the use of actuaries would clarify the extent of leaky home liability for the sector. However, we accept that the uncertainties linked with the assumptions that the actuary is required to make do not provide the desired level of clarity. Nevertheless, the increased involvement of actuaries in the assessment of these liabilities has contributed to improved disclosure in the financial statements of these six significantly affected local authorities in the past two years.
Conclusion
4.20
There has been an incremental improvement in reporting by local authorities about leaky home liabilities in the past year. The uncertainties associated with assessing future liabilities because of leaky home claims has not been significantly reduced by increased actuarial assessments. However, overall the information disclosed in local authority financial statements is more extensive and informative than in the past. It is clearly evident, from the large increase in the value of the liabilities disclosed by the six local authorities in their 2007/08 financial statements, compared with 2006/07, that leaky home liabilities remain a significant issue for these local authorities in particular, and for the local government sector as a whole.
1: Published June 2008, and available on our website at www.oag.govt.nz.
2: Manukau City Council and Tauranga City Council had claim levels that were significantly below the six councils listed in paragraph 4.6 at the time of our original analysis in 2007. Rodney District Council currently has a lower level of claims than the five other councils listed in paragraph 4.6 and Manukau and Tauranga city councils.