Part 2: Our audit of the Government's 2011/12 financial statements

Central government: Results of the 2011/12 audits.

2.1
In this Part, we report the results of our audit of the Government's financial statements and discuss the significant matters arising from this audit. These matters relate to:

Our audit report

2.2
The Auditor-General issued the audit report on the Government's financial statements on 28 September 2012.

2.3
The audit report appears on pages 30 to 32 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 2012;
    • the results of the Government's operations and cash flows for the year ended 30 June 2012; and
    • the Government's borrowings as at 30 June 2012, and unappropriated expenditure, expenses, or capital expenditure incurred in emergencies, and trust money managed by the Government, for the year ended on that date.

2.4
As was the case in 2010/11, our audit report emphasised the uncertainties in the Government's financial statements because of the Canterbury earthquakes.

2.5
The most significant effects of the earthquakes related to:

  • EQC;
  • the support package for Southern Response;
  • the Canterbury residential red zone support package; and
  • the Government's share of local authority costs in response to the earthquakes and its share for restoring local authority infrastructure damaged by the earthquakes.

2.6
We drew readers' attention to:

  • the inherent uncertainties involved in estimating EQC's and Southern Response's earthquake-related outstanding claims liabilities and reinsurance receivables, using actuarial assumptions;
  • the inherent uncertainties involved in estimating the provision and associated insurance recoveries resulting from the Government's offer to purchase properties in the Canterbury residential red zone, using actuarial assumptions; and
  • the high level of uncertainty associated with the Government's share of costs for restoring local authority water infrastructure damaged by the earthquakes.

2.7
In our view, the disclosures in the Government's financial statements about the uncertainties related to the Canterbury earthquakes are adequate.

Significant matters arising from the 2011/12 audit

Continuing uncertainties because of the Canterbury earthquakes

2.8
The costs associated with the Canterbury earthquakes are again significant to the Government this financial year, and there is still a lot of uncertainty associated with many of the cost estimates included in the Government's financial statements.

2.9
We were satisfied that:

  • the effects of the Canterbury earthquakes have been appropriately recognised and disclosed in the Government's financial statements; and
  • the Government's financial statements provide a clear overview of the effects of the Canterbury earthquakes.

2.10
The most significant effects of the earthquakes related to insurance claims managed by EQC and Southern Response and the obligations managed by CERA. These obligations are the Canterbury residential red zone support package and the Government's share of costs for restoring local authority infrastructure damaged by the earthquakes.

2.11
In Note 30 of the Government's financial statements, the Treasury disclosed the uncertainties related to the Canterbury earthquakes. In related notes, it disclosed details about the assumptions and the sensitivities of the assumptions. The Treasury has also completed an analysis to ensure that the major assumptions for EQC, Southern Response, and CERA have been consistently applied and that the base data used is comparable.

2.12
Note 30 describes:

  • the inherent uncertainties involved in estimating EQC's and Southern Response'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 zone, 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.

2.13
We considered it essential to draw readers' attention to these uncertainties in the audit report issued on the Government's financial statements, given the significance of the effects of the Canterbury earthquakes to the Government's financial statements.

2.14
Note 30 also includes the total costs of the earthquakes to the Crown based on the best information available when the Government's financial statements were prepared. Costs of $11 billion have been recognised in 2010/11 and 2011/12.

2.15
Although the net costs are less for the Government this financial year – $1.9 billion compared with $9.1 billion last year – in some respects, the uncertainties have increased. For example:

  • the provision for the Crown's contribution to local authority infrastructure costs is based on a report that includes a margin of error of plus or minus 25%; and
  • the risk margin for EQC's outstanding claims has increased to 14.3% from 10.4% last year.

Accounting for the Government's share of costs to repair Canterbury infrastructure assets

2.16
Under the Civil Defence Emergency Management Plan8 and Guide,9 the Government has an obligation to provide financial support for response and recovery costs after a local or national emergency. This includes up to 60% of the recovery costs arising from natural disasters for water infrastructure assets (freshwater, stormwater, and waste water) and river management systems owned by local authorities.

2.17
Last year, a liability was not recognised in the Government's financial statements because the uncertainties were too great to reliably estimate a provision. However, although significant uncertainties still remain, both CERA and the Treasury considered that a provision could be reasonably estimated this year.

2.18
CERA's approach to calculating the liability was to work with the four local authorities involved – Christchurch City Council, Waimakariri District Council, Selwyn District Council, and Environment Canterbury – to determine the costs that they expect to recover from CERA. For Christchurch City Council, which has the most significant damage, the best available information at the time of our audit was a September 2011 report. The estimates were detailed enough to identify the Government's potential contribution to Christchurch City Council's costs. The costs are still to be confirmed, and it was difficult to assess the extent of damage to underground assets. These uncertainties contributed to Christchurch City Council estimating a margin of error on its estimates of plus or minus 25%.

2.19
Despite the level of uncertainty, we were comfortable that an estimate has been made and an amount recognised for the Crown's obligation for recovery of local authority water infrastructure in Canterbury.

Accounting for the Government's share of future costs to repair local roads in Canterbury

2.20
The current year's earthquake costs do not include costs associated with the future repair of local roads in Canterbury. These costs were excluded because the first call for funding these future expenses will be from dedicated ring-fenced revenue in the form of road user charges, fuel excise duties, and registration fees paid to the New Zealand Land Transport Fund. Should the Government's share of the costs associated with the future repair of local roads in Canterbury exceed the amount available from that ring-fenced revenue, the Government has several options to allocate future revenue to fund this expense. The Crown's share of the costs for local roads in Canterbury remains uncertain, as is the range of funding options available to the Government.

2.21
The Crown has agreed to meet its share of the cost for repairing Canterbury roads above the $50 million for each year that the New Zealand Transport Agency has agreed to fund from the New Zealand Land Transport Fund. Although the Government has yet to fully consider its options for providing additional funding, the two options being assessed would result in the costs being ultimately funded through the New Zealand Land Transport Fund.

2.22
Based on the known information on the Government's funding decisions to date, we were satisfied that it is appropriate to continue to not recognise a liability (because future repair costs are expected to be met by future funding).

Accounting for the rail assets as a result of a Government announcement about restructuring KiwiRail

2.23
KiwiRail is a State-owned enterprise and therefore expected to be a profitable business. However, KiwiRail has not been profitable in the past and has required a lot of investment from the Government. As a result, for financial reporting purposes, KiwiRail has been designated as a public benefit entity. This has meant that its assets have been valued on the basis of their service potential rather than the net cash flows the assets could generate.

2.24
The Government has been looking at what changes could be made to KiwiRail to turn it into a profitable business. We were asked to look at draft proposals for the restructure of KiwiRail. There were two main parts to the restructure:

  • New Zealand Railways Corporation would continue to hold the 18,000 hectares of rail network land, from which no financial return would be expected; and
  • KiwiRail's freight, passenger, and ferry businesses, including rolling stock, rail infrastructure, and plant and equipment, would be transferred to a new State-owned enterprise, KiwiRail Holdings Limited, which would be expected to be profitable during the medium to long term.

2.25
The KiwiRail Board asked for our opinion on whether it would be appropriate for KiwiRail Holdings Limited to account as a profit-oriented entity if the proposed restructure proceeded. We found this a challenging matter to consider, and it took us some time to work it through. It was challenging and time consuming because:

  • on one hand, the Government wanted to restructure KiwiRail to create a profit-oriented business that owns the entire rail network; and
  • on the other hand, the Government is committed to using the part of the rail network that provides metropolitan passenger services in Auckland and Wellington to provide benefits to the community, including reduced congestion and reduced travel times, regardless of the profitability of that part of the network.

2.26
If we agreed that KiwiRail Holdings Limited could account as a profit-oriented entity, the assets of KiwiRail Holdings Limited would be valued on the basis of the net cash flows those assets could generate. This was expected to result in a very significant impairment to the value of the assets.

2.27
We advised the KiwiRail Board in April 2012 that, although KiwiRail Holdings Limited would be an entity with mixed objectives (because it would incorporate both metropolitan and freight rail infrastructure), on balance we accepted that the Board designating KiwiRail Holdings Limited as a profit-oriented entity was not unreasonable but marginal.

2.28
The main considerations in reaching that view were:

  • although the intentions of the shareholder, the Board, and management were clearly aligned, it was difficult to assess how realistic those intentions were over the medium to long term;
  • as an asset-intensive business, KiwiRail Holdings Limited would continue to incur significant renewal and replacement capital expenditure, which would need to be appropriately accounted for;
  • KiwiRail Holdings Limited is more than a commercially focused freight business – it has responsibility for significant metropolitan infrastructure assets; and
  • the rail infrastructure assets (metropolitan and freight) represent a significant asset management challenge for KiwiRail Holdings Limited irrespective of how those assets are valued.

2.29
We noted concerns that:

  • a very significant recent financial investment in a public good asset (metropolitan rail infrastructure) would effectively be written off and dilute accountability for those assets; and
  • it would not sit comfortably that KiwiRail Holdings Limited was a commercially focused business if, in future years, much of what would normally be accounted for as capital expenditure needed to be expensed.

2.30
We noted the importance of continuing to reassess the appropriateness of KiwiRail Holdings Limited continuing to account as a profit-oriented entity.

2.31
On 27 June 2012, the Government announced the restructure referred to in paragraph 2.24. This resulted in KiwiRail providing for impairing the value of the rail assets, based on the expected cash flows that the assets would generate for KiwiRail Holdings Limited. The provision for impairment of the rail assets reflected by KiwiRail in its financial statements was $7.1 billion.

2.32
When it came to the Government's financial statements, it was important that the rail assets were accounted for in keeping with the Government's underlying drivers for the different parts of the rail network.

2.33
As a result, the part of the rail network that provides only metropolitan passenger services (the metropolitan-only rail infrastructure) has been accounted for on a different basis in the Government's financial statements than in KiwiRail's financial statements. KiwiRail treated the assets on a purely commercial basis because that was consistent with the Government's expectations of KiwiRail Holdings Limited generating a commercial return from the use of the rail network.

2.34
However, in the Government's financial statements, the metropolitan-only rail infrastructure has continued to be accounted for on the basis of the service potential provided by those assets rather than the net cash flows they could generate. This is because, despite the Government's expectations of KiwiRail, the primary purpose for the metropolitan-only rail infrastructure at an all-of-government level is a public benefit purpose, such as reduced congestion on roads and reduced travel times, rather than the Government generating a commercial return from those assets.

2.35
The different accounting treatment of the metropolitan-only rail infrastructure in the Government's financial statements has resulted in these assets being valued $0.5 billion higher than they were in KiwiRail's own financial statements. Therefore, the provision for impairment of the rail assets reflected in the Government's financial statements was $6.6 billion. That total amount reflects an impairment of the rail network of $6.3 billion and an impairment of other rail assets, such as rolling stock, of $0.3 billion.

2.36
Of the $6.6 billion total impairment provision, $4.9 billion was accounted for by writing it off against the revaluation reserve. The balance of $1.7 billion was treated as an expense in the Government's financial statements.

2.37
We were satisfied that the carrying value of the rail assets in the Government's financial statements was appropriate and that the impairment provision of $6.6 billion was appropriately accounted for. We are also pleased that the accounting treatment of the metropolitan-only rail infrastructure means that the recent financial investment in those assets is not written off in the Government's financial statements, providing some degree of accountability.

2.38
We note that further work needs to be carried out during 2012/13 to ensure that all rail infrastructure assets used for both the freight business and metropolitan passenger services (dual-use assets) are necessary for the freight business. We expect that those assets that are not necessary for the freight business will be valued on the same basis as the metropolitan-only rail infrastructure in the Government's financial statements, rather than on the basis of expected cash flows.

Other matters from the audit

Significant decrease in the Government's provision for repairing leaky homes

2.39
We were satisfied that the provision of $189 million for the Government's weathertightness financial assistance scheme was appropriately recognised and disclosed in the Government's financial statements. The provision has decreased significantly from the 2010/11 valuation of $567 million.

2.40
After a year's experience of operating the financial assistance scheme, the underlying assumptions were modified. The most significant modification was to the take-up rate by affected homeowners entering the scheme. In calculating the provision this year, it has been assumed that 3544 homeowners will enter the scheme compared with the 2010/11 assumption of 11,040.

2.41
There is still considerable uncertainty about the assumptions used in measuring the provision because of the limited claims experience to date. The three most critical assumptions used in measuring the provision are the number of eligible homes, the take-up rate for the scheme, and the average cost of repair. However, we were satisfied that the nature of the uncertainties and the sensitivities of the assumptions have been satisfactorily disclosed in the Government's financial statements.

Discount rates used for valuing long-term liabilities

2.42
We were satisfied with the discount rates and consumer price index (CPI) assumptions used to value the Government's significant long-term liabilities.

2.43
We reviewed the Treasury's table of risk-free discount rates and CPI assumptions as at 30 June 2012 and concluded that they had been determined in keeping with the Methodology for Risk-free Discount Rates and CPI Assumptions for Accounting Valuation Purposes10 (the Methodology) and that they were appropriate for the Government to use.

2.44
We followed up our observations from the review we carried out last year, and we were satisfied with the outcome. We will continue to monitor these observations next year because they may be subject to future technical developments or different market conditions.

The review of accounting policies for tax revenue recognition

2.45
We were satisfied that the recognition of taxation revenue under current policies materially complies with generally accepted accounting practice. However, in previous years, we have 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. This is an important review because of the complexities involved and the potential effect on the way the Government recognises its tax revenue.

2.46
The Inland Revenue Department (Inland Revenue) is currently part-way through reviewing its Crown revenue accounting policies and methodologies for each of the main tax types it administers: PAYE, GST, and income tax (for individuals and companies). The PAYE and GST components were completed during 2011/12, and the income tax component is expected to be completed in 2012/13. It was originally planned that a review of all three tax types would be completed by December 2011.

2.47
The overall conclusion from the completed reviews of PAYE and GST was that the current accounting policies and methodologies were reliable and fit for purpose. However, to improve the accuracy of estimations, some enhancements to year-end processes were agreed. The enhanced processes have been implemented in the Government's financial statements.

2.48
In addition to the above, we also noted that Inland Revenue needs to strengthen the robustness of its year-end processes. This year, a late year-end adjustment of $109 million, which related to a tax case that has been in dispute for several years, decreased the estimated recoverable amount of a tax receivable.

2.49
We have recommended that the Treasury closely monitor the progress of the income tax component of the review. It will be important that the review is completed within the revised time frame 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 2012/13 financial statements.

Review of the approach to valuing the state highway and rail networks

2.50
During 2011/12, the Treasury commissioned a review of the valuation approach to network assets, including the state highway network and the rail network. The purpose of the review was to determine whether consistent methods were being applied and, if not, whether differences between methods reflected differences in substance between the state highway and rail networks.

2.51
As a result of the review, the Treasury decided to classify all land into a new asset class rather than retain it within each of the networks as a component.

2.52
In 2010, 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 update the valuation methodology to incorporate "brownfield"11 costs, such as the cost of traffic management.

2.53
We have agreed to continue discussions about these costs to determine the appropriateness of making any adjustments to future state highway valuations. Unfortunately, work to date has not provided reliable enough information to adjust the state highway valuation for such costs.

Changes to the net position under the Kyoto Protocol

2.54
Under the Kyoto Protocol, New Zealand is committed to reducing its average net emissions of greenhouse gases during 2008-12 (the "first commitment period") to 1990 levels or to take responsibility for the difference.

2.55
The best estimate of New Zealand's position under the Kyoto Protocol at 30 June 2012 was a net asset of $202 million (based on 35.4 million forecast surplus tonnes of emission units at a carbon price of NZ$5.70 for each unit). In 2010/11, the net asset was $291 million (based on 21.8 million forecast surplus tonnes of emission units at a carbon price of NZ$13.31 for each unit).

2.56
Although surplus units have increased by 13.6 million, the value of the Kyoto Protocol asset has decreased. This is primarily because of the significant drop in the carbon price.

2.57
We were satisfied that the estimated asset of $202 million has been recognised in keeping with accounting standards. However, there is a degree of uncertainty with the asset because fluctuations can occur in forecast surplus emission units and the carbon price.

2.58
The Ministry for the Environment is considering the valuation implications of a second commitment period (beyond 2012). However, no liability for periods beyond 2012 has been recognised in the Government's financial statements because New Zealand currently has no specific obligations.

2.59
There remains uncertainty about what international agreements will come into effect after 2012. This creates uncertainty about the future use and value of any surplus emission units held by public entities. We have accepted that the market takes this uncertainty into account in determining a price for emission units and that this is reflected in the year-end net asset.

Reduction of the Emissions Trading Scheme provision

2.60
The Emissions Trading Scheme was set up to encourage a reduction in New Zealand's greenhouse gas emissions. It currently operates in the forestry, stationary energy, industrial processes, and liquid fossil fuels sectors. No new sectors entered the Emissions Trading Scheme during 2011/12. Waste and synthetic gases entered the Emissions Trading Scheme on 1 January 2013.

2.61
We were satisfied with the accounting treatment and disclosures in the Government's financial statements for the Emissions Trading Scheme provision of $375 million. The Emissions Trading Scheme provision has reduced from $612 million as at 30 June 2011 to $375 million as at 30 June 2012. The main reason for the reduction is the significant drop in the carbon price, which was offset to some extent by an increase in the number of New Zealand units.

2.62
We note that there is currently no authoritative guidance on accounting for the Emissions Trading Scheme and that the International Accounting Standards Board project on emissions trading is on hold. Therefore, the current accounting policy may be subject to change.

Accounting issues associated with the Government's investment in ultra-fast broadband

2.63
We were satisfied with the accounting treatment for the investments by Crown Fibre Holdings Limited (Crown Fibre Holdings) in local fibre companies and Chorus Limited (Chorus).

2.64
Crown Fibre Holdings has been established to manage the Government's $1.5 billion investment in ultra-fast broadband infrastructure. Crown Fibre Holdings has established three local fibre companies and entered into agreements with Chorus to progress the Government's ultra-fast broadband initiative.

2.65
The nature of the local fibre companies' arrangements presents some challenging accounting issues. Crown Fibre Holdings has reviewed the control status of the three local fibre companies and determined that, on balance, they are currently controlled by Crown Fibre Holdings for accounting purposes. Therefore, the three local fibre companies have been consolidated in Crown Fibre Holdings' and the Government's financial statements. Private sector partners also have shares in each of the local fibre companies, which means that a non-controlling interest is also accounted for in Crown Fibre Holdings' and the Government's financial statements. The control status of each of the local fibre companies will need to be carefully considered in future years as the share ownership mix of the local fibre companies' changes and the network build nears completion.

Accounting for the Government's Treaty of Waitangi settlement obligations

2.66
We were 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 in the Government's financial statements. That includes disclosure of an unquantifiable contingent liability for payments that may be required under the relativity clauses.

2.67
The deeds of settlement negotiated with Ngai Tahu and Waikato-Tainui included relativity clauses. The clauses provide that, when 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 Ngai Tahu's and Waikato-Tainui's settlements as a proportion of all Treaty of Waitangi settlements.

2.68
We will continue to liaise with the Ministry of Justice and the Treasury on this issue.

Accounting for goodwill

2.69
We were satisfied that the balance of goodwill from the Crown's acquisition of Air New Zealand (Air NZ) has been appropriately accounted for.

2.70
The Crown continues to recognise goodwill of $258 million from the Air NZ acquisition, which is tested for impairment annually. An impairment loss must be recognised if the recoverable amount of the Air NZ investment (the higher of value-in-use and fair value less costs to sell) is less than its carrying amount, including goodwill.

2.71
The Treasury prepared a model to calculate value-in-use using inputs (such as revenue growth rates) provided by Air NZ. The value-in-use model produced a valuation that showed goodwill was not impaired.

2.72
During the year, New Zealand Post Group acquired Gareth Morgan Investments Limited, Express Couriers Limited, and Couriers Please Holding Limited. The total goodwill arising from these transactions was $275 million. The Government's financial statements disclose that the amount of goodwill on these transactions is provisional because a full fair-value analysis has not been performed. We were satisfied that the balances were not impaired as at 30 June 2012.

2.73
We will check that a full fair-value assessment and impairment test for the New Zealand Post acquisitions is performed for the Government's 2012/13 financial statements.

2.74
We have recommended that the Treasury continue to monitor Air NZ's value-in-use and market capitalisation, and the rationale for differences, for future impairment tests.

Inaccurate reporting of commitments

2.75
The reporting of commitments has been an area of concern in previous years because of the number and size of adjustments required as a result of our audit.

2.76
In 2010/11, the biggest problem was the disclosure of other operating commitments. The Treasury decided to remove these disclosures for 2011/12 because they are not required by accounting standards and did not provide useful additional information to a reader of the financial statements. We agreed that removing these disclosures did not materially affect the Government's financial statements.

2.77
Last year, we recommended that the Treasury provide guidance to public entities about disclosure of commitments. We emphasised the need for accuracy in the disclosure of commitments. The Treasury provided this guidance in July 2012.

2.78
Even with this guidance, we identified several errors, primarily with capital commitments. These errors were corrected before the Government's financial statements were finalised.

2.79
We will continue to discuss with the Treasury ways to further improve reporting of commitments.

8: The National Civil Defence Emergency Management Plan Order 2005 (SR 2005/295).

9: Ministry of Civil Defence and Emergency Management, The Guide to the National Civil Defence Emergency Management Plan 2006 (revised June 2009).

10: The Treasury (2010). Available at www.treasury.govt.nz.

11: "Brownfields" in the NZTA context are where highways have been built through built-up areas, resulting in movement of buildings and services.

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