Part 3: Managing leaky home liabilities

Final audits of Auckland's dissolved councils, and managing leaky home liabilities.

How local authorities have dealt with leaky home liabilities

Provisions amounting to $477 million were included in the 2009/10 financial statements of the six New Zealand local authorities most affected by leaky home claims. Four of those six local authorities, representing $454 million of the total $477 million of provisions, were former Auckland councils.26 Provisions for all the former Auckland councils amounted to $469 million at 31 October 2010 (see Appendix 5). Therefore, leaky home liabilities are a major issue for Auckland Council.

The six local authorities' increased total provisions for leaky home liabilities by $275.9 million, or 236%, on the amount disclosed a year earlier.

Disclosures in the 2009/10 financial statements are much improved on previous years, largely because of the co-ordinated approach taken to calculating these liabilities in the former Auckland councils' final annual reports. The work carried out to calculate Auckland Council's liability has led to more refined and accurate estimates and much more detailed and transparent disclosures in the financial statements. We consider that the disclosures fully meet applicable accounting standards.

Overall, the amount the six local authorities disclosed as contingent liabilities in their 2009/10 financial statements was less than in the previous year's statements. Four of the local authorities did not record any contingent liabilities because they had obtained information with a sufficient level of reliability, allowing the full identified liability to be disclosed as provisions in the financial statements. This led to increased provisions in the financial statements.

In its 2010 Budget, the Government indicated that it intended to establish a scheme to faster resolve leaky home claims. The scheme had yet to be confirmed at the time of writing. The former Auckland councils took the new scheme into consideration in calculating provisions for leaky home liabilities. They indicated that if the scheme did not go ahead the costs to settle leaky home claims would increase by an estimated $78.9 million.

Our review of how six councils accounted for leaky home liabilities

In 2007, we considered the annual reporting requirements of the local government sector in accounting for leaky home liabilities. We issued guidance to our auditors to help them assess leaky home liabilities for each stage of the claims process. Their appointed auditors gave the authorities the principles included in our guidance.

Liabilities arising from leaky home claims involve important issues of transparent reporting and accountability. Recording a leaky home liability as a provision is different from recording it as a contingent liability. The balance sheets of financial statements include provisions. Contingent liabilities are included in the notes to the financial statements. They are less obvious to the reader, and may not be quantified. The assumptions and estimation methods for provisions and any contingent liabilities must be clearly explained, so that readers of financial statements can understand how accurate the amounts might be.

In our reports to Parliament, we have 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.27 Here, we update our findings from the disclosures included in the 2009/10 financial statements.

In 2007, when we began 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. Four of these councils have been dissolved and replaced by the new Auckland Council.

Now, Manukau City Council and Tauranga City Council also face many claims.28 Other local authorities face fewer claims. However, to compare disclosures with our previous years of analysis, we have reviewed the same six local authorities we originally identified in 2007.

If we included Manukau City Council and Tauranga City Council, this would add $14.8 million to the total amount accounted for as provisions by the six local authorities listed in paragraph 3.9. Tauranga City Council has recorded an unquantified liability for future liabilities from leaky home claims. Manukau City Council did not record any contingent liabilities, because all categories of claims were estimated with sufficient reliability to be recorded as provisions in the 2009/10 financial statements.

The kinds of claims that local authorities face

We identified three categories of claims that local authorities must consider when assessing their current and future exposure to liability for leaky home claims:

  • category one – claims that have been investigated and reviewed, where the total claim amount and the local authority's share have been confirmed;
  • category two – claims still being investigated and confirmed, with work to assess whether other available parties will share the liability and work to assess the costs; and
  • category three – claims that might be made against local authorities between now and the end of the statutory limitation period but that have not yet been lodged, including issues that might not yet have been identified by home owners.

Categories two and three are of most concern to local authorities because of the associated high level of uncertainty.

Accounting for leaky home liabilities

The accounting standard that applies to leaky home liabilities is New Zealand Equivalent to International Accounting Standard 37: Provisions, Contingent Liabilities and Contingent Assets (NZ IAS 37). This standard provides the definitions and criteria to identify whether a liability should be accounted for as a provision or disclosed as a contingency. The most relevant element of the criteria for leaky home liabilities is assessing whether a liability that needs to be estimated can be calculated with enough reliability to meet the definition of a provision.

Our guidance to auditors on the appropriate accounting treatment 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.

Our monitoring of the sector up to 2009/10 found that identifying category two and category three claims was more difficult for local authorities than we had anticipated when we wrote our guidance. In our guidance, we assumed that an actuarial assessment, particularly if carried out by professional actuaries, would be enough to meet the requirements of NZ IAS 37 and allow accounting for the liability in the financial statements. We found that, in many instances, the estimation processes used to assess liabilities for category two and category three claims, whether done in-house or by a professional actuary, were not reliable enough to allow the resulting estimation to be accounted for as a provision in the financial statements. The argument presented to support this approach has been that the estimation processes were not reliable enough because too many variables apply to each leaky home case.

How councils approached leaky home liabilities

Of the six local authorities included in this review, five made significant improvements to the disclosures in their 2009/10 financial statements compared with those in their 2006/07, 2007/08, and 2008/09 financial statements. The former Auckland councils aligned their approach before being amalgamated into the new Auckland Council. This meant a much more consistent approach to accounting for these liabilities, and clearer disclosures.

A changing approach to leaky home liabilities

During the transition to Auckland's new local government structure, it was important that accounting policies of all the former councils were aligned. Each former council carried out a detailed, consistent assessment of potential leaky home liabilities to prepare for Auckland Council taking these over. With minor exceptions, all the former councils accounted for the liabilities for leaky home claims in the same way in their annual reports.

Because of the differences in approach applied by these local authorities in previous years, and their unique circumstances, the effects on each of aligning the accounting approach varied. In some instances, there were large increases in provisions for leaky home liabilities. One local authority's provision increased by more than 4000% compared to 2008/09.

In 2009/10, the approach taken to completing the actuarial assessments of the future liabilities for the Auckland councils was significantly refined. As a result, the actuarial assessments were deemed reliable enough to allow all categories of liabilities to be disclosed as provisions in 2009/10. This meant $378.2 million previously classified as contingent liabilities was reclassified as provisions.

When comparing liabilities of the former councils as disclosed in 2008/09 with those disclosed in 2009/10, it is appropriate to consider the total liabilities in the 2008/09 annual reports – both the provisions and the quantified contingent liabilities. For each council, these movements range from a total increase of 660% to a total decrease of 64%. Overall, the sum of total potential liabilities for the four Auckland councils decreased by $114.7 million compared with 2008/09.

Wellington City Council significantly changed its approach to accounting for the liabilities for leaky home claims. In the 2009/10 year, the Council accounted for the legal costs associated with settling leaky home claims, and refined the basis of its actuarial assessment. Previously, the liability was assessed in relation to the repair-related costs only without including an assessment of the other costs incurred by the local authority to settle a claim. The total movement in the provision compared to the 2008/09 year is $12.2 million. This actuarial assessment relates only to category two claims. This part of Wellington City Council's leaky home liability has been treated as an unquantified contingent liability.

Accounting for category one claims

All six local authorities continued to appropriately provide for notified and confirmed category one claims.

Accounting for category two claims

For category two claims, all six local authorities increased provisioning in 2009/10, compared with 2008/09. The primary drivers of the increases are explained in paragraphs 3.17 to 3.21. We note that, in the case of the four former Auckland councils, the disclosures supporting the amounts provided for in the financial statements are extensive and clearly identify the part of the provision that is for category two claims and the part that is for category three claims. The provisions made by the other two local authorities most affected by this issue relate only to category two claims.

The extensive and informative disclosures included by the former Auckland councils reflect a large improvement in the quality of the information disclosed in these local authorities' financial statements. The disclosures meet the requirements of NZ IAS 37 to provide disclosure related to the assumptions applied in calculating the estimated liability, and to provide information about the effect on the calculations of changes to the assumptions. We are pleased to see this information set out clearly in the financial statements, and consider that this approach should be considered by all other local authorities facing potential liabilities for leaky home claims.

Accounting for category three claims

The approach to disclosing category three claims has been more consistent than in previous years because of the aligned approach of the former Auckland councils. Paragraph 3.18 describes the approach taken by these local authorities. For these local authorities, the full extent of the estimated liability has been included as provisions within the financial statements. In their 2009/10 financial statements, the remaining two of the six councils recorded being exposed to contingent liabilities for future leaky home claims, but did not quantify the estimated future cost to the local authority.

Given the former Auckland councils' extensive disclosures, we consider that other local authorities need to work with their actuaries to improve the accuracy and transparency of their disclosures related to category three claims.

We noted in previous years that home owners were filing increasingly more accurate claims. This, along with the knowledge acquired from the increasing number of settled claims, is helping actuaries to refine their estimation process. These reasons have been specifically noted in the disclosures made by the former Auckland councils as leading to the estimated future liabilities being assessed with sufficient reliability to be included as provisions rather than contingent liabilities.

Insurance matters related to leaky home liabilities

Local Government Mutual Funds Trustee Limited (RiskPool), a mutual fund created by local authorities to provide liability protection, is the main insurer for local authorities. Because of the extremely high value of the claims related to leaky homes, RiskPool has progressively reduced the extent of insurance cover for leaky home claims in recent years. The specific limits and parameters of insurance cover for claims before June 2009 vary for each local authority and for each year. The specific level of coverage is related to the number and value of claims for each local authority. From June 2009, RiskPool has completely excluded leaky home claims from its insurance cover, leaving local authorities with no insurance cover for this costly type of liability.

In June 2009, because of high deficits in the fund, RiskPool asked its members for capital funding. A further call was made on 1 July 2010. RiskPool indicated that further calls would be required and would be made on 1 July 2011 and 1 July 2012 to address the shortfall for claims from 2002 to the time when leaky home coverage was withdrawn. RiskPool was not fully reinsured for all years of the fund because full reinsurance for leaky home claims was not available.

Tentative details of the future calls were provided to members during 2009/10. On 1 July 2010, Auckland City Council and Christchurch City Council paid the full amount of their share of the calls signalled to be made between 1 July 2010 and 1 July 2012.

The costs of the calls for funding already made, the expected future calls, and the withdrawal of insurance cover, add to the burden that leaky home claims place on local authorities.

In completing our review of the disclosures made in the financial statements of the six most significantly affected local authorities, we noted some inconsistencies in how insurance recoveries are treated. In line with accounting standards, local authorities should calculate provisions for liabilities for leaky home claims and separately account for the proceeds of insurance recoveries. We noted that, in the few instances where disclosure covered this issue in previous years, insurance recoveries had been offset against total liabilities.

In considering the six councils' annual reports for 2009/10, we noted that the practice of offsetting insurance recoveries:

  • has continued in some instances;
  • has been resolved for 2009/10 in others; and
  • in other instances has been resolved both for the 2009/10 year and by adjustment of the previous year's comparative figures.

The amounts involved are below our audit materiality thresholds. However, because of the inconsistencies identified, particularly among the former Auckland councils, we encourage local authorities, including Auckland Council, to address this matter.

The Government's financial assistance scheme

In May 2010, the Government proposed a financial assistance scheme for homeowners with leaky homes. The scheme provides for the local authority and the Crown to each pay 25% of the agreed repair costs. We understand that all of the local authorities significantly affected by the leaky home liability issue have agreed to participate in the scheme. All but one of the local authorities in this review noted in their 2009/10 financial statement disclosures that they intended to participate in the scheme. Christchurch City Council has made no specific disclosure on the matter.

The scheme is designed to speed up the resolution of leaky home matters for the homeowner and to reduce the extent of associated costs such as legal and other professional fees for all parties. In participating in the scheme, the homeowner will obtain a 25% contribution to repair costs, from both the local authority and the Crown, as full and final payment. The scheme places no limits on the right of the homeowner to pursue other remedies with third parties.

The Government indicated that the scheme would become operational in the first quarter of the 2011 calendar year. However, as of May 2011, the scheme was yet to be confirmed.

The former Auckland councils have made clear disclosures about the scheme and the implications it is assumed to have for their estimated liabilities. Auckland City Council, North Shore City Council, Rodney District Council, and Waitakere City Council disclosed that, if the scheme did not go ahead, their total provisions would increase by $78.9 million. Manukau City Council indicated that its provisions would increase by $4.2 million if the scheme were not to go ahead. The increases would reflect a combination of increased settlement costs and increased professional fees. Because the new scheme is expected to speed up the settlement process, it would reduce the costs associated with discounting for the changing value of money over time.

It does not appear that the new scheme has been factored into the provisions of the other two non-Auckland councils most affected by the leaky home liability issue.

26: Auckland City Council, North Shore City Council, Rodney District Council, and Waitakere City Council.

27: Local government: Results of the 2006/07 audits, Local government: Results of the 2007/08 audits, and Local government: Results of the 2008/09 audits.

28: In 2007, Manukau City Council and Tauranga City Council had claim levels that were significantly below the six most affected local authorities. Now, both have claims volumes higher than those of Rodney District Council.

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