Part 2: Our audit of the Government's 2014/15 financial statements

Central government: Results of the 2014/15 audits.

In this Part, we report the results of our audit of the Government's financial statements for 2014/15, and discuss the significant and other matters arising from this audit. The significant matters relate to:

  • continuing uncertainties due to the Canterbury earthquakes;
  • the effect of new accounting standards for the public sector;
  • how tax revenue is recognised; and
  • discount rates used to value long-term liabilities.

The other matters arising from our audit relate to:

  • valuation of the state highway network;
  • valuation of Solid Energy New Zealand Limited's assets and liabilities, given its uncertain financial situation;
  • accounting for the Government's Treaty of Waitangi settlement obligations;
  • accounting for KiwiRail Holdings Limited in the Government's financial statements;
  • Accident Compensation Corporation residual levies;
  • consolidation of the financial results of schools;
  • valuation of the Government's social housing stock;
  • accounting for and disclosure of minority interests; and
  • reduction in disclosures.

Our audit report

We issued a standard audit report, which included an unmodified audit opinion on the Government's financial statements for the year ended 30 June 2015.

We issued our audit report on 30 September 2015.

The audit report appears on pages 28 to 30 of the Government's financial statements. It includes our opinion that those statements:

  • present fairly, in all material respects:
    • the Government's financial position as at 30 June 2015;
    • the Government's financial performance and cash flows for the year ended 30 June 2015; and
    • the Government's borrowings as at 30 June 2015, unappropriated expenditure and expenses or capital expenditure incurred in emergencies for the year ended on that date, and trust money administered by departments and Offices of Parliament as at 30 June 2015; and
  • comply with generally accepted accounting practice in New Zealand.

Significant matters arising from the audit

Continuing uncertainties due to the Canterbury earthquakes

We are satisfied that the effects of the Canterbury earthquakes have been appropriately accounted for in the Government's financial statements.

The Crown's earthquake-related obligations at 30 June 2015 totalled $3.9 billion, which was about 2% of the Crown's total liabilities. These earthquake-related amounts were considerably less material to the whole-of-government position than they were to the individual entities that manage the liabilities.

Significant uncertainties remain

However, significant uncertainties remain in the valuation of liabilities and associated insurance recoveries, as explained in Note 32 to the Government's financial statements. Broadly, the uncertainties are:

  • uncertainty in estimating the earthquake-related outstanding claims liabilities and reinsurance receivables for the two insurance entities – the Earthquake Commission and Southern Response Earthquake Services Limited (Southern Response);
  • uncertainty relating to the Crown's obligation to provide a support package to local authorities for repairing damaged infrastructure (the "three waters" – waste water, stormwater, and drinking water systems); and
  • uncertainty about the red zone and, in particular, the insurance receivables assumed by the Crown as part of the Crown's offer to acquire property in the red zone.

The main sources of the uncertainty in estimating outstanding claims liabilities are:

  • severe land damage and a complex land claims environment from both an engineering and legal perspective (the land aspect affects only the Earthquake Commission);
  • the effect of multiple earthquakes on the Earthquake Commission's insurance cover and associated reinsurance cover (with consequential effects on other insurers, such as Southern Response); and
  • estimating the time to repair or rebuild and inflation in building costs.

For the Earthquake Commission, the volatility of these claims is partly mitigated by the maximum settlement amounts for dwellings ($100,000) and contents ($20,000). However, claims made for residential land are not subject to a monetary limit and are therefore subject to greater volatility.

To take account of the inherent risk in estimating outstanding claims liabilities, a margin is added to the expected cost of fulfilling the claims to increase the probability that the provisions in the Government's financial statements will be enough. For 2015, despite the decrease in the overall liability, there has been a small increase in the total risk margin for the Earthquake Commission and Southern Response.

In December 2014, at the Earthquake Commission's request, the High Court made a ruling (a declaratory judgment) that confirmed that "Increased Liquefaction Vulnerability" and "Increased Flooding Vulnerability" were forms of land damage covered by the Earthquake Commission.

The declaratory judgment also confirmed that the Earthquake Commission could settle certain claims on a diminution of value approach (that is, to compensate owners for the loss of value in their homes arising from the increased risk). This judgment has helped to reduce some of the uncertainty associated with land claims.

Increased Liquefaction Vulnerability and Increased Flooding Vulnerability claims make up most land claims. More than 98% of the properties eligible for cover because of an increased vulnerability to liquefaction have been identified, but the settlement process had yet to be confirmed by the 2014/15 year end. The number of properties more vulnerable to flooding is less certain.

Provision for water infrastructure costs

After the Canterbury earthquakes of 2010 and 2011, the Government had an obligation to provide financial support for response and recovery under the Civil Defence Emergency Management Plan and Guide (CDEM Plan and Guide). This included 60% of the repair (recovery) cost for water infrastructure assets (drinking water, stormwater, and waste water) owned by local authorities.

In May 2011, a permanent legislative authority was put in place to replace the obligation under the CDEM Plan and Guide. This committed the Crown to funding 60% of the water infrastructure costs for Christchurch City Council, Waimakariri District Council, Selwyn District Council, and Environment Canterbury.

After this decision, the Crown entered into cost-sharing agreements with Christchurch City Council and Waimakariri District Council in 2013. The purpose of the cost-sharing agreements was to establish a value that the Crown would commit to, so the previous permanent legislative authority was able to be removed.

The most significant costs are for horizontal infrastructure, with a cap of $1.8 billion agreed as the total Crown obligation. This obligation includes not only the obligation of CERA for the recovery of horizontal infrastructure (water infrastructure assets) but also the initial response costs under the CDEM Plan and Guide, which have been settled with the Department of Internal Affairs, and the repair costs for local roading to be funded by the New Zealand Transport Agency.

In May 2015, an independent assessor reviewed the eligible costs for the cost-sharing agreement with Christchurch City Council. After considering the independent assessor's report, CERA has not changed its original estimate of eligible costs.

At 30 June 2015, there was uncertainty over policy decisions for the funding of land drainage and work to renew the horizontal infrastructure.

Crown announcement on the revised red zone offers

A group of uninsured and commercial property owners took legal action against the Crown about the initial red zone offers made. A Supreme Court decision directed CERA to reconsider several offers. In doing this, CERA prepared a draft Residential Red Zone Offer Recovery Plan, which set out five main criteria for new Crown offers to buy vacant insured commercial properties and uninsured improved properties in the red zone and the Crown's preliminary views on new offers. The Plan was approved by Cabinet after 30 June 2015, and new offers were then made.

Because the offers were approved after 30 June 2015, a contingent liability of $48 million was disclosed in the Government's financial statements.

Treatment of local roading costs for the Canterbury earthquakes

For accounting purposes, repairs to local roads are recognised in the year of repair. There is no provision in the Government's financial statements for costs associated with future repairs of local roads, which differs from the water infrastructure assets described above. This exclusion reflects that the first call for funding these future expenses will be from dedicated revenue in the form of road user charges, fuel excise duties, and registration fees paid into the National Land Transport Fund.

Although the Government is committed to repairing local roads in Canterbury, the effect of the earthquakes has been to increase the priority of the work in the Canterbury region, rather than create an additional obligation to be recognised in the Government's financial statements. The Government has a continuing programme of funding the repair and development of local roads throughout New Zealand.

If the Government's share of the costs associated with the future repair of local roads exceeds the amount available in the National Land Transport Fund, then the Government has several options to allocate future revenue to help fund this expense.

Based on information about the Government's funding decisions to date, we are satisfied that it is appropriate to continue to not recognise a liability (because the effect of the earthquakes has been to increase the priority of the local roading work in the Canterbury region and future expenses are expected to be funded primarily through future funding).

Effect of new accounting standards for the public sector

We are satisfied that the Government's financial statements have been appropriately prepared in keeping with new accounting standards for public benefit entities (PBE standards).

The Government's financial statements for 2014/15 were the first to be prepared using the newly introduced PBE standards. Previously, the Government's financial statements were prepared using NZ IFRS (PBE) accounting standards.

Sovereign revenue

One of the significant effects of the new standards related to the recognition of "sovereign revenue", such as taxes, fines, and penalties. The relevant accounting standard now requires the initial recognition of revenue and related receivables at fair value. Under the previous standard, such revenue was initially recorded at its nominal value.

For fines and penalties, revenue was recognised at its fair value in the statement of financial performance (consistent with a revised accounting policy wording), with the nominal amounts, and initial allowance for impairment, disclosed in the notes.

However, no fair value adjustment was made to the nominal value of tax revenue. We accept that initially recognising tax receivables at nominal value is materially in keeping with both the accounting policy for the Government's financial statements and the applicable new standard. Determining the fair value of tax revenue requires estimation to determine whether the amount outstanding that is not collected is because of events in place at the time the taxable event occurred or because of events that occur later.

Sub-consolidation of tertiary education institutions

The Ministry of Education carries out a consolidation of 30 June financial returns of tertiary education institutions (TEIs) so that their consolidated financial performance and position can be included in the Government's financial statements. For 2014/15, this was required to be completed using the newly introduced PBE standards.

TEIs will publish their first financial statements in compliance with the new PBE standards for the 31 December 2015 financial year. Few of the TEIs had adequately considered the effect of the new PBE standards as at 30 June 2015. Furthermore, the Ministry of Education had not taken any significant steps to provide guidance or collect additional information to enable an accurate assessment of the effect of the new PBE standards for the purpose of the sector consolidation. This raised concerns about whether the consolidation had been prepared based on a full understanding of the TEI funding streams supported by adequate evidence from the sector.

Our own analysis raised questions about whether TEIs should not have recognised several liabilities as at 30 June 2015. The most material component of this was deferred revenue arising from full-year course fees. We accepted the decisions made about those liabilities because the effect of including them was not material for the Government's financial statements.

Accounting for the Crown's interest in TEIs

The Government's financial statements continue to reflect the Crown's ownership interest in TEIs as 100% equity accounted investments under the new PBE standards.

We agreed with the Treasury that the previous judgement that the Crown does not control TEIs should continue to apply. The accounting standard on control has not changed with the adoption of the new PBE standards. However, this judgement will need to be reviewed when the new standard on control, which is currently being developed, is introduced.

We also agreed that it is reasonable to continue to equity account TEIs rather than consolidating their results on a line-by-line basis.

How tax revenue is recognised

In previous years, we have recommended to Inland Revenue 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 project because of the complexities involved and the potential effect on the way the Government recognises its tax revenue. The PAYE and GST components of the review were concluded in 2012.

A pilot project, which was to be completed by the end of 2014, was being run to assess the effect of some proposed changes against the current revenue recognition policy. However, Inland Revenue has now decided it should not continue with changes to its income tax recognition policy because of:

  • the significant costs involved in making changes to its current tax management system;
  • the expected changes to systems and processes as a result of the Business Transformation project, which is expected to take place in the next few years; and
  • the need to maintain a stable core operating environment during the Business Transformation project.

In our view, there are other approaches that could be implemented, independently of the Business Transformation programme, to help Inland Revenue refine its revenue recognition policy and produce better year-end estimates of taxes receivable. Two such refinements were made to tax accruals as at 30 June 2015, and we look forward to further refinements in 2015/16.

Discount rates for long-term liabilities

We are satisfied that appropriate assumptions about risk-free discount rates and the consumer price index (CPI) have been used to value the Crown's two significant long-term liabilities that can be materially affected by changes in discount rates. Those two liabilities are ACC's outstanding claims obligations and the retirement plan obligations of the Government Superannuation Fund.

The Treasury used its Methodology for Risk-free Discount Rates and CPI Assumptions for Accounting Valuation Purposes (the Methodology) to prepare a 30 June 2015 table of risk-free discount rates and CPI assumptions used to value the significant long-term liabilities of the Government. The risk-free rates are used as a "building block" for deriving a market interest rate for discounting student loan advances.

The long-term interest rate remained at 5.5% and the long-term CPI inflation rate was kept at 2.5%. However, because of generally lower interest rates at the shorter end of the yield curve since last year, there were significant discount rate losses this year ($4.7 billion for ACC and the Government Superannuation Fund combined).

Other matters arising from the audit

Valuation of the state highway network

We are satisfied that the $30 billion valuation of the state highway network, including underlying land, is based on the best information available to the New Zealand Transport Agency at the time of the valuation.

The state highway valuation is complex and involves numerous data sources from several different parties (both external and internal to the New Zealand Transport Agency). There is a high degree of reliance on the expertise and experience of the external valuer. The valuation of the state highway network is based on valuing each of the various components (such as land, formation, and bridges) and adding these together.

We note that "brownfield" costs, such as the cost of traffic management, are not fully incorporated as part of the valuation. Also, we note that there are uncertainties with the quality of some of the underlying data used in the valuation.

In 2010, we recommended that the New Zealand Transport Agency review the reasonableness and validity of the assumptions used to value state highways and that brownfield costs be incorporated into the valuation.

In 2013/14, the New Zealand Transport Agency began to estimate, and progressively include, brownfield costs. Historical costs cannot be reliably measured, so brownfield costs will be recognised over time in the Government's financial statements. The current year's brownfield costs included in the state highway valuation are $702 million. Last year's estimate of $251 million was reduced to $176 million this year after an estimation error was identified.

Because judgements in estimating brownfields costs are particularly challenging, the New Zealand Transport Agency is planning how to better capture such costs in future valuations of the state highway network.

As in previous years, there are uncertainties about whether the underlying data include the right quantity of some components, account for all the costs of some components, and record the right life of some components based on their condition. The valuer's final report also noted some significant errors identified by our auditors that required adjustment.

Our previous understanding was that the New Zealand Transport Agency had a plan to improve the accuracy of the asset data, including carrying out a stocktake of all state highway assets during the three years to 30 June 2016. However, we understand that the New Zealand Transport Agency's focus is to have good data on the condition of the roads (such as smoothness) that is regularly updated and used to prioritise maintenance. There are also clauses about uploading network data in contracts with maintenance firms, which specify that asset data be updated whenever work is done.

We will continue to monitor the New Zealand Transport Agency's work on these matters as part of our audit. As better information becomes available, it needs to be used in future valuations of the state highway network.

Valuation of Solid Energy New Zealand Limited's assets and liabilities, given its uncertain financial situation

We are satisfied that the Government's financial statements reflect the assumption that there is no residual value in Solid Energy and that appropriate disclosure has been included in the subsequent events note (Note 34).

On 13 August 2015, the Board of Solid Energy placed that company and all associated companies into voluntary administration. On 17 September 2015, creditors approved a deed of company arrangement. It will allow the company to continue to trade while it carries out an orderly and managed sale of its assets during the next 2.5 years.

The Crown will continue to take responsibility for site rehabilitation costs associated with Solid Energy's historical mining activity. On execution of the deed of company arrangement, existing Crown indemnities were restructured to make them available to any purchasers of the company's mining assets.

Accounting for the Government's Treaty of Waitangi settlement obligations

The deeds of settlement negotiated with Waikato-Tainui and Ngāi Tahu included relativity clauses. Those clauses mean that the Crown is liable to make payments to maintain the proportion of Waikato-Tainui's and Ngāi Tahu's settlements at 17% and 16.1% respectively of all Treaty settlements.

We are satisfied that the Crown's obligation as a result of those relativity clauses have been appropriately accounted for and disclosed in the Government's financial statements. That includes disclosure of an unquantifiable contingent liability for payments that might be required in future under the relativity clauses. In October 2012, the Crown advised that the relativity mechanism had been triggered, after which Waikato-Tainui and Ngāi Tahu made claims under their relativity clauses and received an initial payment. We expect that the reliability of the estimate of the claims under the relativity mechanism will continue to increase as disputed items between the parties are progressively settled.

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

Accounting for KiwiRail Holdings Limited in the Government's financial statements

We are satisfied that, despite facing financial difficulties, it is still appropriate for KiwiRail Holdings Limited (KiwiRail) to designate itself as a for-profit entity2 for financial reporting purposes. As such, we are satisfied with the accounting treatment and disclosures, noting the different treatment of non-freight rail infrastructure at the whole-of-government level (see below).

In our view, the Board's decision to consider KiwiRail a for-profit entity continues to be not unreasonable, but it is marginal because the group is likely to continue to depend on the Government for funding in the medium term.

Information that helps to determine whether an entity is a public benefit entity includes the entity's founding documents, the nature of the benefits provided by the entity, the amount of expected financial surplus, the nature of the equity interest, and the nature of the entity's funding.

In our view, there are conflicting indicators when assessing the designation of the group. For some indicators, such as the founding documents, the group would clearly be "for-profit". To be "for-profit", an entity needs to have both a clear intention and the realistic prospect of generating a commercial return over the long term. Both the KiwiRail Board and the Government appear committed to delivering a sustainable business and the entity continues to behave commercially, consistent with being a for-profit entity. However, KiwiRail's current financial projections show a continuing dependency on the Government for funding in the medium term.

Given the group's financial performance during the past few years and its projected financial performance, we will continue to monitor the appropriateness of the for-profit designation.

Valuation of railway network assets not required for freight services

We are satisfied with the valuation and disclosure in the Government's financial statements of railway network assets not required for freight services (including rail infrastructure assets used solely for metro passenger services).

The "non-freight" portion of the network continues to be accounted for in the Government's financial statements on a different basis from KiwiRail's financial statements. KiwiRail accounts for this part of the network on a purely commercial basis because that is consistent with the Government's expectations of the company (to generate a commercial return from the use of the rail network).

However, in the Government's financial statements, the portion of the network not necessary to run the freight operation is accounted for on the basis of the service potential provided by those assets, rather than the net cash flows they are forecast to generate. This is because, despite the Government's expectations of KiwiRail generally, the primary purpose for the non-freight portion of the network at a whole-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.

The different accounting treatment of the non-freight portion of the network in the Government's financial statements has resulted in this portion being valued $0.8 billion higher at 30 June 2015 than in KiwiRail's own financial statements.

Accident Compensation Corporation residual levies

We are satisfied that the Government's decision to stop collecting residual ACC levies has been correctly reflected in the Government's financial statements.

Until 1999, ACC operated under a "pay as you go" basis, collecting only enough levies each year to cover the cost of claims for that particular year. In 1999, the Government decided to change ACC to a fully funded way of operating. As a result, a "residual levy" has been collected to meet the continuing cost of claims incurred before 1999 and to move this part of the scheme to a fully funded position.

Under legislation in force as at 30 June 2015, the residual levy was required to be collected until 1 April 2019. An amendment Act, the Accident Compensation (Financial Responsibility and Transparency) Amendment Act 2015, received Royal Assent on 23 September 2015. The amendments in this Act give the Government the option to stop collecting residual levies before 1 April 2019.

On 21 September 2015, Cabinet agreed that ACC should stop invoicing and collecting residual levies from 1 April 2016. This meant that ACC would no longer charge residual levies on liable earnings from 1 April 2015 onwards.

To recognise this as an event that happened after 30 June 2015 but that affected the 2014/15 financial statements, we had previously agreed with the Treasury and ACC that there were three criteria to be satisfied:

  • the Cabinet decision noted above;
  • a public announcement of the decision in enough detail so levy payers have a valid expectation that they will not have to pay the levy (this took place on 22 September and was widely reported in the media); and
  • a likelihood that a Bill would be passed into law in enough time to put into effect the Cabinet decision to discontinue the residual levy from 1 April 2016. (As noted in paragraph 2.70, the Bill has now been passed into law.)

The effect of this is that accrued revenue and unearned levy liability recorded for residual levies at 30 June 2015 are no longer considered to be collectable and are therefore no longer recorded in the Government's financial statements as at 30 June 2015. Also, as a result of removing residual levies, a deficiency in the work account arises, which led to the recognition of an unexpired risk liability as at 30 June 2015.

Consolidation of the financial results of schools

For 2014/15, there was a significant improvement in the timeliness of information included in the schools sub-consolidation. We therefore have greater confidence in the robustness of information that has been included in the Government's financial statements this year.

The information included in the schools' consolidation incorporated the actual 2014 results for 92% of schools. The other 8% of schools results were estimated, based on the previous year's results (2014: 62% and 38% respectively). This is getting close to the levels achieved before the Novopay issues affected schools' financial reporting.

Valuation of the Government's social housing stock

We are satisfied that the Government's social housing reform programme does not have a significant effect on the Government's financial statements for 2014/15.

The Government has continued to progress its social housing reform programme. During August 2015, the Social Housing Reform (Transaction Mandate) Bill had its first reading in Parliament. This Bill will enable the Government to transfer state houses to third-party providers. No significant transfers of assets took place in 2014/15.

In our view, the valuation of the social housing stock within the Housing New Zealand Corporation appropriately remains at fair value, assessed using current market values of individual properties.

Accounting for, and disclosure of, minority interests

We are satisfied that the presentation and disclosure of minority interests are materially correct.

The Treasury's presentation of minority interests in the statement of financial performance is consistent with the previous year. However, in our view, the presentation does not fully comply with generally accepted accounting practice. We have previously reported this concern to the Treasury. The applicable standard requires:

  • all figures in the statement of financial performance to include minority interests; and
  • the operating balance to be allocated between that which is attributable to minority interests and that which is attributable to owners of the parent (that is, the bottom line should be allocated).

We accepted how the information was presented in the Government's financial statements because minority interest figures are not a material amount in the context of the Government's financial statements as a whole.

Reduction in disclosures

Overall, we consider that the changes to disclosures in the Government's financial statements achieve the Treasury's aim of making the financial statements more accessible to readers, while complying with generally accepted accounting practice.

With the transition to the new PBE standards, the Treasury has considered how it can reduce the disclosures in the Government's financial statements, to make the information more accessible to readers. Another aim is to tell more of a whole-of-government story and remove some of the individual entity disclosures that readers can get from other annual reports.

Clearly immaterial notes, such as inventory, have been removed, along with additional details of limited usefulness. One example is the removal of the breakdowns of each note by source (Core Crown, Crown entities, State-owned enterprises).

The Treasury has made the most significant reduction in its disclosures about financial instruments in Note 30. This note was previously complex, and the Treasury felt that it did not tell a succinct story of the Government's financial instruments. The summarised information for each disclosure also helps readers to more easily navigate this note.

The new note removes several disclosures that are required by a particular PBE standard because, in the Treasury's view, the disclosures were either not relevant to the Government's financial statements or not material. We identified and considered each of the required disclosures that were not presented and were satisfied with the Treasury's judgements.

2: For-profit entities are entities that are not public benefit entities.