Part 1: Financial reporting in the public sector and why it matters

1.1
In this Part, we discuss financial reporting in the public sector, including the importance of independent standard-setting.

1.2
Financial reporting is how public entities account for their stewardship of – that is, the care they take with – public money and other assets.

1.3
Financial reporting helps in decision-making and in increasing accountability, openness, and transparency. It also helps to improve the performance of, and trust in, the public sector.

1.4
Each year, my Office audits more than 3800 public entities, from large government departments to small rural schools and cemeteries. Our 2014/15 work programme theme, Governance and accountability, reflects the importance of public entities operating and accounting for their performance in the way that Parliament intended.

1.5
The public sector is made up of a diverse range of organisations and agencies, including government departments, local authorities, Crown entities, State-owned enterprises, district health boards, tertiary education institutions, schools, and cemetery trusts. There are also public entities outside these broad categories, such as the Reserve Bank of New Zealand.

1.6
Many public entities are funded by money from taxpayers, ratepayers, donors, local and overseas investors and lenders, and others to achieve their intended outcomes. Public entities are accountable to the providers of money and to the recipients of the goods and services the entity delivers.

1.7
The primary objective of most public entities is to deliver services to the public rather than to generate a commercial return for investors. These entities are referred to as public sector public benefit entities.

1.8
Some public entities have a greater focus on achieving a commercial return. These entities are referred to as public sector for-profit entities. They include State-owned enterprises (such as New Zealand Post Limited), mixed ownership model companies (such as Mighty River Power Limited), and Crown Research Institutes (such as National Institute of Water and Atmospheric Research Limited).

1.9
As well as having entities with different purposes, the public sector also has several different ownership and governance models. For example, a local authority represents the interests of a particular community, while mixed ownership model companies have both private sector and public sector shareholders.

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In all instances, people outside the public entity are interested in, and/or need to know, how the public entity is spending the money it manages. This includes knowing whether the entity is performing effectively to achieve what was intended with the money.

General purpose financial reports

1.11
Financial reports provide basic information to people interested in the performance of an entity (the users).¹ They allow the entity to be held accountable for how it manages and uses the money it receives.

1.12
Many individuals with an interest in the performance of a public entity do not have the power to require the entity to produce customised financial or performance information. Instead, they rely on the general purpose financial reports that public entities provide.

1.13
General purpose financial reports are designed to provide financial and, where required, performance information to a range of users. To be relevant, the information must meet the accountability and/or decision-making needs of the users.

1.14
Figure 1 shows the information that general purpose financial reports provide.

Figure 1
Information provided in general purpose financial reports

1.15
Users of a public entity's general purpose financial reports might want to find out about:

• the goods and services the entity has delivered;
• what the entity has achieved;
• revenue generated and expenses incurred by the entity;
• the level of assets the entity controls and the liabilities it has incurred;
• the amount of equity the entity has; and
• other matters that help users to understand the entity's financial position and performance.

Requirements for public entities to produce general purpose financial reports

1.16
Most public entities are formally required to produce general purpose financial reports. The requirement to do this can be set by legislation, founding documents (such as trust deeds), the parent entity, or the responsible Minister. Entities can also decide to prepare these reports, if they think that doing so would be useful.

1.17
Usually, legislation requires that the information in general purpose financial reports must comply with generally accepted accounting practice (also known as GAAP).

1.18
Generally accepted accounting practice is the overall body of accounting standards and other guidance that sets out how an entity should prepare general purpose financial reports. Importantly, generally accepted accounting practice is a set of objective principles and requirements that are not subject to the preparer's individual preference.

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General purpose financial reports are more likely than other reports to be reliable because of the requirement to comply with generally accepted accounting practice.

1.20
It is important that independent standard-setters carefully consider the requirements for preparing general purpose financial reports to ensure that the reports are based on consistent, unbiased, and transparent accounting standards.

1.21
In the public sector, the Auditor-General provides assurance to users that the information a public entity reports materially complies with these accounting standards and fairly presents the performance of the entity for the period that the financial report covers.

Importance of an independent standard-setting process

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An independent standard-setting process helps to ensure that accounting standards are high quality and, when applied, result in reported information that meets the needs of users. Without an independent standard-setting process, accounting standards could be poorly thought through and unduly influenced by special interest groups.

1.23
The main elements that contribute to an effective, independent process for setting accounting standards include:

• selecting independent members of the standard-setting body who have an appropriate level of technical expertise and experience;
• monitoring the performance of members of the standard-setting body;
• having a policy about managing conflict of interests;
• holding public meetings to allow views to be heard;
• having an oversight process that supports the public interest;
• giving the standard-setting body adequate resources and technical support; and
• having a transparent process to identify and prioritise changes to accounting standards.

Who sets the accounting standards?

1.24
Two international boards set global accounting standards – the International Accounting Standards Board and the International Public Sector Accounting Standards Board. They create accounting standards for for-profit and public benefit entities in both the public and private sectors. The International Accounting Standards Board created the International Financial Reporting Standards (IFRS), and the International Public Sector Accounting Standards Board created the International Public Sector Accounting Standards (IPSAS).

1.25
In New Zealand, the External Reporting Board (XRB) prepares and issues accounting, auditing, and assurance standards and guidance. The XRB is an independent Crown entity. The Governor-General appoints its Board on the recommendation of the Minister of Commerce. However, the XRB's work is not subject to direction from the Government. It prepares accounting, auditing, and assurance standards independently of the professional bodies for accountants in New Zealand and Australia.

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Figure 2 shows the different roles of the independent standard-setting bodies and the accounting standards that they set.

Figure 2
International and New Zealand independent accounting standard-setting boards

Structure of this report

1.27
In Part 2, we describe the changes in accounting standards in the public sector from 1993 to 2009. We also set out the concerns that we, and others, raised in 2009. In short, those concerns were that accounting standards set for much of the public sector were unsuitable because they were designed for the private sector.

1.28
In Part 3, we outline the significant changes since 2009, including setting up the XRB, the new Accounting Standards Framework, accounting standards for public benefit entities (PBE accounting standards), alignment of accounting standards with international standards, and legislative reforms.

1.29
In Part 4, we discuss whether the changes since 2009 have resolved our concerns. In Part 5, we discuss the challenges arising from the new accounting standards. In Part 6, we discuss next steps for financial reporting in the public sector.

1: Users of financial reports include citizens, resource providers, and service recipients or their representatives (including members of Parliament, statisticians, analysts, the media, financial advisors, public interest and lobby groups, regulators, trustees, and rating agencies).