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

Central government: Results of the 2015/16 audits.

In this Part, we report the results of our audit of the financial statements of the Government of New Zealand (the Government's financial statements) for 2015/16.

We discuss matters arising from our audit, including the audit opinion and our first year of including "key audit matters" in our audit report on the Government's financial statements.

We issued a standard audit report, which included an unmodified audit opinion, on the Government's financial statements for 2015/16.

We issued our audit report on 30 September 2016.

Our audit opinion

The audit report appears on pages 25 to 31 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 2016;
    • financial performance and cash flows for the year ended on that date;
    • borrowings as at 30 June 2016; and
    • unappropriated expenditure, emergency expenses and capital expenditure, and trust money administered by departments for the year ended on that date; and
  • comply with generally accepted accounting practice in New Zealand, in accordance with public sector public benefit entity accounting standards.

Our reporting on "key audit matters"

This year we included in our audit report, for the first time, a section on "key audit matters". Key audit matters are those matters that, in the auditor's professional judgement, are of most significance in the audit of the financial statements. We have reproduced the complete audit report, including the "key audit matters", in the Appendix.

Reporting on key audit matters is a new requirement under a new international auditing standard. It is mandatory only for:

  • listed issuers – those with a statutory meaning under the Financial Markets Conduct Act 2013 (FMC) – for periods ending on or after 15 December 2016; and
  • FMC reporting entities considered to have a higher level of public accountability (other than listed issuers) for periods ending on or after 31 December 2018.6

The Auditor-General decided to apply this standard to the audit of the Government's financial statements for the year ended 2015/16 because she considered the introduction of reporting key audit matters to be of use to the readers of these accounts. It is another step in the evolution of good public sector auditing practice. We have produced what we believe is the world's first audit report on government financial statements to include a section on key audit matters.

In determining the key audit matters, we considered matters that were complex, had a high degree of uncertainty, or were otherwise important to the public. The key audit matters were:

  • recognition of tax revenue;
  • valuing physical assets (property, plant, and equipment);
  • valuing long-term liabilities;
  • valuing financial assets and liabilities; and
  • accounting for the effects of the Canterbury earthquakes.7

Accounting for and reporting these matters was not straightforward, not least because of the judgements, estimates, and assumptions underpinning their measurement. These included assumptions and judgements about the future, particularly the service benefits and cash flows that could be expected from existing assets and liabilities. They could also include assumptions about market prices, interest rates, foreign exchange rates, inflation rates, and discount rates.8

Although relatively small in terms of amount, we included the outstanding Canterbury earthquake liabilities as a key audit matter because of the continuing public interest in them.

Other significant matters arising from the audit

Other significant matters arising from the audit were about:

  • valuing New Zealand Defence Force (Defence Force) assets;
  • valuing the Government's housing stock; and
  • accounting for the proposed Crown contribution to the City Rail Link development in Auckland.

Key audit matters for 2015/16

Recognition of tax revenue

Tax revenue from income tax and goods and services tax, at $63.1 billion for the year ended 30 June 2016, was the main source of funding for the Government. Inland Revenue needed to estimate some components of tax revenue, and the associated receivables and payables, as at 30 June 2016. This was due to timing differences between the reporting date for the Government's financial statements and when taxpayers file tax returns.

The most significant estimates were those related to tax revenue flow from companies and income tax from other taxpayers. We carried out detailed audit work on these estimates, because errors in the underlying judgements could result in significant inaccuracies in the Government's financial statements. Overall, we were satisfied that these estimates were reasonable.

Inland Revenue's Business Transformation programme is expected to improve the accounting for tax revenue. As work progresses on this programme, we have recommended that Inland Revenue, with the Treasury's support, refine and improve the processes for estimating tax revenue receivable in each accounting period.

Valuing physical assets (property, plant and equipment)

Certain assets are more difficult than other assets to value. We identified the following significant assets where there were inherent uncertainties involved in the valuations:

  • state highway network;
  • electricity generation assets; and
  • rail network assets.

Overall, we were satisfied that the valuations for these assets were reasonable and consistent with valuation practices. The disclosures appropriately outlined the basis of valuation and the uncertainties associated with valuations of the assets.

State highway network

The valuation of the state highway network (excluding land), of $22.3 billion at 30 June 2016, was carried out by an independent external valuer. The valuation was based on information from several of the New Zealand Transport Agency's (the Agency's) databases that identify the asset components that make up the network, and their expected useful lives.

The Agency's data is primarily used for asset management purposes rather than financial reporting. Therefore, it is possible that some of the data could be incomplete or indexed using assumptions that cannot be easily verified. This includes data about "brownfield" costs, such as traffic management costs. Including such costs in the valuation better recognises the reality of roading work, particularly in urban areas.

Since 1 July 2013, the Agency has estimated brownfield costs for work carried out on the network from that time, and incorporated those costs in the valuation of the network. The cumulative amount of such costs recognised at 30 June 2016 is $1.1 billion. Over time, brownfield costs will be progressively recognised in the valuation of the network.

Electricity generation assets

Electricity generation assets are majority-owned by the Government (at least 51%). The valuation of those assets, of $15.7 billion at 30 June 2016, was carried out by specialist valuers. Specialist valuers are used because of the complexity and significance of assumptions about the future prices of electricity, the generation costs, and the generation volumes that these assets will create.

Small changes to assumptions, such as the forecast prices of electricity and discount rates, could significantly change the reported value of these assets.

As set out in Note 18 to the Government's financial statements, the specialist valuers of each of the electricity generation companies had different assumptions and made different disclosures about the valuation of their generation assets. Although there were differences, we were satisfied that the differences were reasonable.

We accepted the differences because:

  • each company used the best information available, based on its circumstances and expectations, which was supported by the specialist valuers the company engaged; and
  • the information in the Government's financial statements was consistent with other information available in the market.

Rail network assets

The rail network was valued at $959 million at 30 June 2016. The freight and metro passenger transport parts of the network were valued on different bases, reflecting the commercial nature of the freight part of the network and public benefit nature of the metro passenger transport part of the network.

The extent to which the freight part of the network is commercial is open to debate, given the expected government funding required in future. If it was not considered commercial, the freight part of the network would be valued to reflect a public benefit nature. This would increase the reported value of the rail network by $4.2 billion.

The Government's accounting policy choice for the valuation of the freight part of the network was a difficult accounting matter to consider during our audit. That part of the network continues to be valued on a commercial basis, taking into account the net cash flows it generates.

As in past years, we considered the evidence supporting a commercial or public benefit valuation of the freight part of the network. The evidence showed mixed results. Some evidence, such as the requirements of the State-owned Enterprises Act 1986, clearly points to KiwiRail's commercial nature. And KiwiRail continues to behave commercially. However, evidence about long-term forecast results raises questions about the realistic prospect of generating a commercial return in the long term. KiwiRail's current financial projections show a continuing dependency on the Government for funding.

The decision to continue to accept the basis of valuation for the freight part of the rail network was marginal. We have recommended that the Treasury carry out a robust review of the accounting treatment for the year ending 30 June 2017, given KiwiRail's dependence on the Government for ongoing financial support.

Valuing long-term liabilities

The valuation of the Government's long-term liabilities is complex and requires actuaries to estimate the value, based on assumptions about the future. The two significant long-term liabilities at 30 June 2016 were the $36.6 billion outstanding claims liability of the Accident Compensation Corporation (ACC), and the Government employees' superannuation liability of $12.4 billion. These liabilities were significant by value and there were inherent uncertainties in valuing them, due to a high degree of judgement and estimation.

The assumptions used to calculate the value of ACC's outstanding claims liability included estimating the length of rehabilitation from injuries, amounts of cash payments and when they will occur, and inflation and discount rates.

The assumptions used to calculate the value of the Government employees' superannuation liability for past and current members of the Government Superannuation Fund included estimating the return on assets owned by the Fund, expected rates of salary increases for members of the Fund, and inflation and discount rates.

Note 2 to the Government's financial statements sets out the sensitivity of assumptions. There can be a large effect on the amount of these liabilities where there are changes in the assumptions, which also affects the amount of actuarial gains and losses.

We evaluated the appropriateness of the key assumptions used in valuing the long-term liabilities. For discount rates and inflation assumptions, the Treasury determines a table of risk-free discount rates and inflation assumptions each year using an agreed methodology. These are required to be consistently applied to valuations of long-term liabilities. We reviewed the table of risk-free discount rates and inflation assumptions as at 30 June 2016, and concluded they had been calculated in keeping with the agreed methodology.

Overall, we were satisfied that the valuations of the ACC outstanding claims liability and the Government employees' superannuation liability were reasonable and that appropriate disclosures had been made about them.

Valuing financial assets and liabilities at fair value

According to the Government's financial statements, the Government had financial assets of $125.8 billion, of which $71.8 billion was measured at fair value. It also had financial liabilities of $127.2 billion, of which $12.3 billion was measured at fair value. The financial assets and financial liabilities measured at fair value included marketable securities, share investments, advances, and derivatives (which had a principal value of $221.5 billion).

The fair value of some of the financial assets and financial liabilities (less than 5%) could not be measured using quoted market prices, and instead were estimated by applying an appropriate valuation approach, such as a valuation model. Inputs into the models use market data when available or inputs derived from non-market data, which requires significant judgement. We paid particular attention to evaluating the appropriateness of inputs to models that had been derived from non-market data.

We were satisfied that the fair values for financial assets and financial liabilities were reasonable and that the disclosures were appropriate.

Accounting for the effects of the Canterbury earthquakes

The outstanding Canterbury earthquake insurance liabilities, although now only $2.1 billion at 30 June 2016, continue to be of significant public interest.

The calculations of the remaining liabilities were complex, partly because of significant uncertainties, and they were carried out by independent actuaries. The calculations took into account estimates of the extent of damage, which was often not clearly known, uncertainties arising from changing land policies, engineering requirements arising from issues such as liquefaction and flooding, and associated legal claims.

We evaluated whether the actuaries used the latest information about the effects of the earthquakes, including damage, claims paid, and repairs carried out. We were satisfied that the earthquake insurance liabilities were reasonable and that the disclosures appropriately outlined the uncertainties about their valuation.

Other significant matters arising from the audit

Valuing New Zealand Defence Force assets

The Defence Force manages assets valued in excess of $5 billion. These assets include land, buildings, and specialised military equipment, which were recognised in the financial statements at fair value. To comply with accounting standards, the Defence Force needs to ensure that the carrying values of assets remain materially consistent with fair value. Where there are indicators of material changes in value, a revaluation needs to be done and the carrying values adjusted.

The Defence Force did not do a good job of assessing whether there had been a material change in the fair value of its assets, compared with their carrying value. In particular, the Defence Force did not make enough use of subject-matter specialists. The appointed auditor could not obtain assurance that the carrying value was materially consistent with fair value. When Defence Force senior leadership became aware that the Defence Force's initial assessment required further testing, it acted immediately to rectify the situation. The Defence Force carried out substantial additional work, with support from the Treasury. However, we did not gain assurance about these balances until 27 September 2016, which is unacceptable.

As a result of the additional work, it was concluded that fair values had moved materially since the last valuation in 2013, and a late adjustment was made to the Government's financial statements. This adjustment increased the asset values by about $500 million. The evidence provided by the Defence Force to support the movement was sufficient for the Government's financial statements. However, further work was performed by the Defence Force in support of its own financial statements.

We have recommended that entities responsible for managing significant assets that are recognised in the financial statements at fair value be reminded of the importance that asset carrying values are materially consistent with fair values. Regular valuations need to be complemented by robust assessments of carrying values between valuation years. Asset management in the public sector is an important element of good public management and timely and regular asset valuations are a vital part of that management.

Valuing the Government's housing stock

The valuation of the Government's investment in its social housing portfolio (primarily held by Housing New Zealand) is based on the highest and best use and on comparable market sales data for each individual property. In the year ended 30 June 2016, the value of the social housing stock increased by $3.2 billion, largely as a result of increases in the value of Auckland properties.

As part of the Social Housing Reform Programme, the Government announced that it is taking steps towards transferring ownership of some Housing New Zealand houses and tenancies to registered community housing providers. This has raised some specific accounting issues.

We identified this matter because of the judgement involved in determining the appropriate accounting treatment for social houses proposed to be transferred to community housing providers, either sold or redeveloped as part of the Government's social housing reform programme.

The social houses designated for ownership transfer in Tauranga and Invercargill were written down by $237 million, a 60% write-down from their original carrying value of $397 million. The value of these properties has reduced because they are "encumbered" – they can be used only for social housing. The write-down is charged against the revaluation reserve, and therefore did not change the operating balance.

A gain or loss on sale of the social houses with encumbrances will be recognised when transfers of state houses are completed, based on the difference between their written down value and sale price.

Accounting for the proposed Crown contribution to the City Rail Link development in Auckland

On 15 September 2016, the Government and Auckland Council signed a Heads of Agreement under which the Government intends to fund 50% of the City Rail Link. The cost of the project is still to be determined.

This matter was appropriately disclosed in the Government's financial statements as an event that occurred after 30 June 2016.

6: ISA (NZ) 701: Communicating Key Audit Matters in the Independent Auditor's Report, available at

7: The Treasury (2016), Financial Statements of the Government of New Zealand for the year ended 30 June 2016, Wellington, pages 27-29.

8: The Treasury (2016), Financial Statements of the Government of New Zealand for the year ended 30 June 2016, Wellington, Note 2 to the financial statements, pages 48-49.