Part 3: Our audit of the Government's 2010/11 financial statements

Central government: Results of the 2010/11 audits (Volume 1).

3.1
In this Part, we report the results of our audit of the Financial Statements of the Government of New Zealand for the year ended 30 June 2011 (the Government's financial statements) and discuss the significant matters arising from the audit.

Our audit report

3.2
The Auditor-General issued the audit report on the Government's financial statements on 30 September 2011.

3.3
The audit report appears on pages 26 to 28 of the Government's financial statements. It includes our audit opinion that those statements:

  • comply with generally accepted accounting practice in New Zealand; and
  • fairly reflect:
    • the Government's financial position as at 30 June 2011;
    • the results of the Government's operations and cash flows for the year ended 30 June 2011; and
    • the Government's borrowings as at 30 June 2011, and unappropriated expenditure, expenses, or capital expenditure incurred in emergencies, and trust money managed by the Government, for the year ended on that date.

3.4
This year, our audit report emphasised the uncertainties in the Government's financial statements because of the Canterbury earthquakes.

3.5
The most significant effects of the Canterbury earthquakes reflected in the Government's financial statements related to:

  • the Earthquake Commission (EQC);
  • the AMI Insurance Limited (AMI) support package;
  • the Canterbury residential red zone support package; and
  • the Government's share of local authority costs in immediate response to the earthquakes, and its share of costs for restoring local authority infrastructure damaged by the earthquakes.

3.6
We drew readers' attention to:

  • inherent uncertainties in estimating EQC's and AMI's earthquake-related outstanding claims liabilities and reinsurance receivables, using actuarial assumptions;
  • inherent uncertainties in estimating the provision resulting from the Government's offer to purchase properties in the Canterbury residential red zones, using actuarial assumptions; and
  • the high level of uncertainty associated with the Government's share of costs for restoring local authority infrastructure damaged by the earthquakes. The uncertainty was such that it was not possible to reliably estimate the costs, so a provision was not recognised for them. Instead, there is disclosure of a contingent liability for these unquantifiable costs.

3.7
In our view, the disclosures in the Government's financial statements about the uncertainties related to the Canterbury earthquakes are adequate.

3.8
For more information about the financial reporting and auditing implications arising from the Canterbury earthquakes, see Part 2.

Significant matters arising from the 2010/11 audit

Accounting for the effects of the Canterbury earthquakes

3.9
The costs associated with the Canterbury earthquakes were significant to the Government this financial year at a net amount of $9.1 billion.

3.10
We were satisfied:

  • that the effects of the Canterbury earthquakes had been appropriately recognised and disclosed; and
  • that the Government's financial statements provided a clear overview of the effects of the Canterbury earthquakes.

3.11
The most significant effects of the earthquakes related to:

  • EQC's insurance expenses;
  • the AMI support package costs;
  • the Canterbury residential red zone support package managed by the Canterbury Earthquake Recovery Authority (CERA); and
  • the Government's share of immediate local authority costs in response to the earthquakes, and its share of costs for restoring infrastructure damaged by the earthquakes. These costs are managed by the Department of Internal Affairs (DIA).

3.12
The Treasury disclosed the uncertainties as a result of the earthquakes in note 30 of the Government's financial statements, and disclosed details about assumptions and their sensitivities in the notes for the public entities referred to in paragraph 3.11. The Treasury has also completed an analysis to ensure that the main assumptions used by EQC, AMI, and CERA have been consistently applied and that the base data used is comparable.

3.13
Note 30 of the Government's financial statements describes:

  • the inherent uncertainties involved in estimating EQC's and AMI's earthquake-related outstanding claims liabilities and reinsurance receivables, using actuarial assumptions;
  • the inherent uncertainties involved in estimating the provision resulting from the Government's offer to purchase properties in the Canterbury residential red zones, using actuarial assumptions; and
  • the high level of uncertainty associated with the Government's share of costs for restoring local authority infrastructure damaged by the earthquakes. The uncertainty is such that it is not possible to reliably estimate the costs, so a provision has not been recognised for them. Instead, there is disclosure of a contingent liability for these unquantifiable costs.

3.14
We considered it essential to draw readers' attention to these uncertainties in the audit report that we issued, given the significance of the effects of the Canterbury earthquakes to the Government's financial statements.

3.15
EQC and AMI had actuarial valuations completed for their insurance liabilities. These were appropriately calculated and adjusted as new information became available, including the High Court declaratory judgment on 2 September 2011 about applying the Earthquake Commission Act 1993 in situations where full cover has been reinstated after an earthquake.

3.16
Because CERA was established in March 2011, it needed a lot of support from the Treasury to be able to report on its non-departmental activities for consolidation into the Government's financial statements. The Treasury led the work to ensure that a liability valuation was carried out. As CERA builds its capability, we would expect CERA to be able to carry out this work, with support from the Treasury as needed.

3.17
DIA had a challenge trying to obtain adequate information to be able to reliably estimate the Government's liability for contributing to the restoration of essential infrastructure (wastewater, stormwater, and freshwater systems) and river management systems. When the Government's financial statements were signed, the underground infrastructure assets had not yet been adequately inspected for damage. The estimate was not considered reliable enough to be formally recorded as a liability. The Government's financial statements disclosed an estimated contingent liability of between $348 million and $610 million, to provide some indication to readers of the size of the liability – albeit with a high level of uncertainty. We were satisfied that the accounting treatment adopted and the disclosures were appropriate.

3.18
DIA was able to recognise a liability for the Government's share of response costs, such as Christchurch City Council's costs associated with caring for displaced people, temporary repairs to essential infrastructure, and other precautionary measures to reduce immediate danger after the earthquakes.

3.19
As well as the earthquake liabilities, the $9.1 billion net cost includes wage subsidies, temporary accommodation, community and trauma support, and other support assistance. It does not include costs yet to be incurred by the Government, such as the Government's contribution to repairing local roads, which is expected to be recognised when claims are made to the National Land Transport Fund.

Accounting for the support package for AMI Insurance Limited

3.20
We were satisfied that AMI had been appropriately accounted for at 30 June 2011, including the accounting treatment and disclosures relating to the Government's acquisition of AMI.

3.21
On 7 April 2011, the Government agreed a "support package" in response to AMI's concerns that its reserves and reinsurance might not be enough to cover all claims resulting from the Canterbury earthquakes.

3.22
We worked closely with the Treasury and our auditor of the Treasury. All parties agreed that the Government controls AMI and should consolidate it. This is based on the Government having the capacity to direct the operating and financing policies of AMI (through its option to make a partial payment and take control of the Board) and that it is directly affected by the risks, or benefits, from AMI's operations.

Accounting for the scheme for repairing leaky homes

3.23
We were satisfied that the provision of $567 million recognised for the Government's financial assistance package (FAP) for the owners of leaky homes has been appropriately recognised and disclosed.

3.24
Our auditor of the Department of Building and Housing (DBH) experienced challenges and delays in auditing the provision because the quality of information initially provided for audit to support the measurement of the liability was not satisfactory. We were disappointed with the time taken to resolve the various issues about measuring the provision and the late change to the liability amount. These problems were caused because DBH did not have robust systems and processes in place to calculate the liability.

3.25
In our view, many of the problems we experienced this year in auditing the provision were avoidable. We expect the systems and processes to measure the provision to be significantly improved to enable a timely audit of the liability for the year ended 30 June 2012.

3.26
The FAP became available to homeowners from 29 July 2011. The Government has agreed to contribute 25% of agreed repair costs to owners of leaky homes who qualify for the FAP (affected local authorities also contribute the same amount where private certifiers are not involved). The Government will also provide assistance to homeowners to access bank finance for the remaining agreed repair costs, through loan guarantees under a loss-sharing model with banks.

3.27
We agreed that the Government is required to recognise a provision in the 2011 financial statements for the estimated cost of the Crown's 25% contribution under the FAP because of the commitments made to owners of leaky homes before 30 June 2011.

3.28
There is considerable uncertainty about the assumptions used in measuring the provision because of the limited claims experience to date. We were satisfied that the nature of the uncertainties and the sensitivities of the assumptions had been satisfactorily disclosed. These uncertainties were drawn to readers' attention in our audit report on DBH's financial statements. However, we did not consider it necessary to draw attention to these uncertainties in our audit report on the Government's financial statements because the provision is not as significant to the Government as it is to DBH.

3.29
The three most critical assumptions used in measuring the provision are the number of eligible homes, the take-up rate for the FAP, and the average cost of repairs. Although we were satisfied with the assumptions used, the assumed FAP take-up rate of 70% is at the higher end of the range. In particular, the rate is higher than that used by local authorities in estimating their leaky home liabilities. These critical assumptions will need to be closely reviewed and updated, taking into account the claims experience, when measuring the provision as at 30 June 2012.

Policies for recognising tax revenue

3.30
We were satisfied that the recognition of taxation revenue under current policies materially complies with generally accepted accounting practice. However, in previous years, we suggested that a thorough review of taxation revenue recognition policies be carried out with a view to fine-tuning the recognition of taxation revenue, where appropriate. The Inland Revenue Department expects to complete its revenue recognition project in 2011/12. This is an important project because of the complexities involved and the potential effect on the way the Government recognises its tax revenue.

3.31
The Department is currently part-way through reviewing its Crown revenue accounting policies and methodologies for each of the main tax types it administers; that is, PAYE, GST, and income tax (for individuals and companies). There have been no changes to the tax revenue accounting policies for 30 June 2011.

3.32
During 2010/11, we commented on the draft discussion document on PAYE. The Department subsequently produced a draft decision document setting out an agreed approach and proposal for changes, which includes a range of specific recommendations for consideration and agreement.

3.33
We recently commented on the draft GST discussion document, and we expect an income tax discussion document to be provided soon. All three discussion documents will need to be considered together to ensure consistency of approach across the different tax types.

3.34
We expect that there will be accounting issues likely to span these three documents. The approach and proposals for change for all three tax types will need to be considered after the release of the income tax document.

3.35
We have recommended that the Treasury closely monitor the progress of the project. It will be important that the project is completed on schedule to enable early consideration of any potential changes to revenue recognition policies, their financial reporting effect, and disclosure requirements (if any) in the Government's financial statements for 2012.

Accounting for the Emissions Trading Scheme

3.36
We were satisfied with the accounting treatment and disclosures for the Emissions Trading Scheme (ETS), with a provision of $612 million.

3.37
Accounting for the ETS will become more significant to the Government's financial statements as the ETS is extended into new sectors. There were several refinements and developments required this year, including preparing an accounting policy for revenue and expenditure recognition and agreeing the approach to valuing transactions in New Zealand Units (NZUs).

3.38
The ETS has been operating since 1 January 2008. The forestry sector has been in the scheme since this time, and activity has been increasing during the past few years. Obligations under the ETS began for the following sectors on 1 July 2010:

  • liquid fossil fuels (transport);
  • stationary energy; and
  • industrial processes.

3.39
The first emissions returns and surrender obligations for these sectors and for pre-1990 foresters fell within the 2010/11 financial year.

3.40
During 2010/11, the Government incurred ETS expenditure for the industrial allocation to emissions-intensive and trade-exposed industry, the compensatory allocations to pre-1990 foresters and fishing quota owners, and for claims for carbon sequestration by post-1989 foresters.

3.41
Under the Government's accounting policy for ETS, the Government recognises a liability and expense for the NZUs issued and recognises a reduction in the liability and revenue for NZUs surrendered.

3.42
ETS returns are submitted for a calendar year (in arrears). This year, the Ministry for the Environment has forecast the revenue from emissions produced by participants during the period 1 January 2011 to 30 June 2011. The Ministry has included the forecast revenue for this six-month period, as well as the actual revenue for the six-month period July 2010 to December 2010, in its financial statements.

3.43
The carbon price used to calculate the ETS provision is EUR 11.63 per unit. This is based on the market price of Certified Emission Reduction units (CERs) traded on the European carbon market. We agreed that CER pricing is the best proxy to market values for the NZUs issued under the ETS.

Accounting for the Crown Retail Deposit Guarantee Scheme

3.44
The provision at 30 June 2010 for payments under the Crown Retail Deposit Guarantee Scheme (the Scheme) of $748 million was fully utilised during 2010/11 as payments were made to depositors of finance companies that failed while under the Scheme. As at 30 June 2011, there were only four finance companies in the extended scheme. These companies are not expected to fail within the remaining period of the Scheme so the Treasury has not made a provision for further losses.

3.45
The Government's financial statements for 2011 recorded a receivable of $739 million. The receivable is the amount that the Government expects to recover from realising the assets of the failed finance companies that were part of the Scheme.

3.46
We were satisfied that the accounting for the Crown Retail Deposit Guarantee Scheme was appropriate and based on reasonable analysis and assumptions, and that the disclosures are adequate for the Government's financial statements. In particular, we were satisfied that the receivable is based on the most recently available reports from the receivers for the failed finance companies. However, we note that a range of outcomes is possible for the eventual recovery to the Government.

Reporting of commitments

3.47
The reporting of commitments continues to be a challenge, and is now an area of concern. This year, many adjustments to commitments were required as a result of the information we received in our audit returns. Two very significant prior-period errors were identified.

3.48
There was an understatement of $3.996 billion for gas contract commitments and an overstatement of $1.742 billion for inter-entity grants that were not eliminated in the Government's financial statements. Both prior-period errors have been corrected and a disclosure made about the nature and extent of the errors, as required by financial reporting standards.

3.49
We have recommended that the Treasury provide guidance to public entities about expectations for the disclosure of commitments and emphasised the need for accuracy in the disclosure of commitments. We are pleased that the Treasury intends to do some work on commitments and contingent liabilities in 2012. We expect to see improvements in the quality and the accuracy of the information reported in the Government's 2011/12 financial statements.

Accounting for the Kyoto Protocol net position

3.50
New Zealand ratified the Kyoto Protocol in December 2002. This international agreement commits New Zealand to reducing its average net emissions of greenhouse gases during 2008-12 (the first commitment period of the Kyoto Protocol, or CP1) to 1990 levels or to take responsibility for the difference.

3.51
The best estimate of New Zealand's net position at 30 June 2011 is an asset of $291 million. This net asset position is based on a surplus of 21.8 million tonnes of carbon equivalents measured using an exchange rate of EUR 0.57335 = NZ$1 and a carbon price of EUR 7.63 per unit. This compares with a net surplus of 11.2 million tonnes of carbon equivalents last year, which was then measured at a carbon price of EUR 10.75 per unit.

3.52
The major factors behind the forecast decreased emissions were:

  • a decrease of 7.5 million tonnes in expected agricultural emissions, as a result of updated scientific data for agricultural emissions; and
  • the level of expected deforestation has fallen as a result of further mapping of New Zealand's land use. This resulted in an increase of 2.9 million tonnes in expected removals of carbon through forests.

3.53
The forecast decreased emissions have been offset by a decrease in the carbon price used to value the net position, mainly because of a change in the carbon pricing methodology. The carbon price is now based on the actual transactions in Kyoto Protocol units in international markets.

3.54
We were satisfied that the estimated asset of $291 million had been recognised in keeping with accounting standards. There is a degree of uncertainty with the asset because fluctuations in the asset value can occur as a result of changes in the underlying assumptions, movements in carbon prices, and the exchange rate of the Euro.

3.55
The movement in the projected balance of Kyoto Protocol units during the first commitment period is set out in a 2011 report, New Zealand's net position under the Kyoto Protocol, which is available on the Ministry for the Environment's website (www.mfe.govt.nz).

Using appropriate discount rates for long-term liabilities

3.56
We were satisfied with the discount rates and assumptions about the Consumer Price Index (CPI) used to value the significant long-term liabilities of the Government.

3.57
We have concluded that the Treasury's table of risk-free discount rates and CPI assumptions as at 30 June 2011 has been determined in keeping with the Methodology for Risk-free Discount Rates and CPI Assumptions for Accounting Valuation Purposes (the Methodology), and are appropriate for the Government to use.

3.58
We followed up our observations from the previous year's discount rate review and were satisfied with the outcome. We will continue to monitor these observations next year, because these matters may be subject to future technical developments or different market conditions.

3.59
However, there is one new matter to note this year. In setting the discount rates for long durations, there was no regard given to bank swap rates with 15- and 20-year durations because it was not clear that those rates represented the long-term fixed rate that would be earned in the market. Although we accepted the approach this year, we recommended that further work be done to identify the main factors that indicate that the decision to disregard those bank swap rates for future valuations continues to be reasonable.

Collecting information about related party transactions

3.60
Overall, we were satisfied with the process used to record information about related party transactions and the disclosures made. Returns were received from all Ministers who held office during 2010/11. There were no relevant matters noted by Ministers that required disclosure.

3.61
However, we are aware that the financial reporting standard covering related party transactions is likely to change as part of the general change in financial reporting standards affecting the public sector (see Part 8). We expect that the Treasury will monitor these changes and consider their effect on the Government's financial statements.

Valuing the state highway network

3.62
Last year, we recommended that the New Zealand Transport Agency (NZTA) review the reasonableness and validity of the assumptions used in the methodology to value state highways and that it update the valuation methodology to incorporate "Brownfields" costs.8

3.63
NZTA has made progress with those recommendations by engaging an external specialist to carry out a review of the valuation methodology. This review concluded "that there is nothing to suggest that the depreciated replacement cost (‘DRC') methodology being used to value the state highway network is inappropriate. The methodology is broadly consistent with the approach used elsewhere". Therefore, there were no changes to the valuation methodology for 30 June 2011.

3.64
The review supported the remedial work NZTA is doing with data quality and "Brownfields" costs. It also raised for consideration the "discounting" of the valuation of land under the state highway network.

3.65
It has been agreed that these discussions will continue in relation to "Brownfields" costs and the discounting of land values to determine the appropriateness of making any adjustments to future state highway valuations.

Accounting for relativity obligations in Treaty of Waitangi claims

3.66
We are satisfied that the Crown's obligations as a result of relativity clauses in two previous Treaty of Waitangi settlements have been appropriately accounted for and disclosed. That includes disclosure of an unquantifiable contingent liability for payments that may be required under the relativity clauses.

3.67
The deeds of settlement negotiated with Waikato-Tainui and Ngai Tahu included relativity clauses. The clauses provide that, where the total redress amount for all historical Treaty settlements exceeds $1 billion in 1994 present-value terms, the Crown is liable to make payments to maintain the real value of Waikato-Tainui and Ngai Tahu's settlements as a proportion of all Treaty settlements.

3.68
We will continue to work with the Ministry of Justice and the Treasury on this.

Impairment testing of goodwill arising from the acquisition of Air New Zealand Limited

3.69
We were satisfied that the balance of goodwill from the Government's acquisition of Air New Zealand Limited (Air New Zealand) has not been impaired this year.

3.70
The Crown recognised goodwill of $258 million from the Air New Zealand acquisition, which is tested for impairment annually. An impairment loss must be recognised if the recoverable amount of the Air New Zealand investment (the higher of value-in-use and fair value less costs to sell) is less than its carrying amount, including goodwill.

3.71
The Treasury prepared a model to calculate value-in-use, using inputs (such as revenue growth rates) provided by Air New Zealand. The value-in-use model produced a valuation that showed goodwill was not impaired.

3.72
The difference between the value-in-use valuation and the market capitalisation of Air New Zealand was significant. The Treasury provided an explanation for this difference, and we also obtained comfort that there was no impairment of goodwill by rationalising that there would be a control premium over and above the share price for the Crown's investment in Air New Zealand.

3.73
We have recommended that the Treasury continue to monitor Air New Zealand's value-in-use and market capitalisation, and the rationale for differences, for future impairment tests.

Observations about the consolidation process

3.74
It has been a challenging year for preparing and auditing the Government's financial statements, largely because of the complexity and uncertainties involved in accounting for the effects of the Canterbury earthquakes. Other challenging matters have included accounting for the acquisition of AMI during the year, and measuring the provision recognised for the obligations arising under the Government's FAP for repairing leaky homes.

3.75
The Treasury had to deal with late adjustments to the financial statements and had to work more closely than usual with some public entities to help them account for the effects of the earthquakes.

3.76
Apart from these late adjustments and the leaky homes matter, the Treasury prepared the draft financial statements to a good standard by the statutory deadline. The Treasury's staff provided support and information to the audit team, including keeping clear and detailed work papers and having an audit file available for our audit team on the first day of our final audit visit.

3.77
In recent years, we have raised concerns about the performance of some public entities in preparing timely and accurate financial information for consolidation. This year, we saw an improvement in the receipt and accuracy of the returns received. However, we continue to be disappointed in the number of "except for" audit clearances received (in other words, clearance of most but not all of the information provided for consolidation) and the number of late audit clearances as a result of entity non-performance.

3.78
We will continue to work with the Treasury to ensure that public entities that have not performed or met the required deadlines this year work with us actively to meet the deadline next year, with no "except for" audit clearances. In particular, it is expected that both we and the Treasury will work with the public entities that had significant late adjustments to their submissions this year.

3.79
We were particularly concerned with the quality and accuracy of the information on commitments submitted for consolidation. There were a number of errors identified through the consolidation and audit process, including two significant prior period errors. We recommended that the Treasury work with public entities to ensure that they accurately report their commitments (discussed in paragraphs 3.47–3.49).

8: "Brownfields" costs include: traffic management, environmental compliance, utilities, generic increase in construction costs because of restrictions imposed by the built environment, and costs associated with re-establishing the interface with adjacent properties that have been excluded from the current valuation based on recent urban projects.

page top