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

Central government: Results of the 2016/17 audits

In this Part, we report the results of our audit of the financial statements of the Government (the Government's financial statements) for 2016/17.

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

We issued an audit report that included an unmodified audit opinion on the Government's financial statements for 2016/17.

We issued our audit report on 29 September 2017.

Our audit opinion

The audit report appears on pages 136 to 142 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 2017;
    • financial performance and cash flows for the year ended on that date;
    • borrowings as at 30 June 2017;
    • unappropriated expenditure for the year ended 30 June 2017;
    • expenses or capital expenditure incurred in emergencies for the year ended 30 June 2017; and
    • trust money administered by departments for the year ended 30 June 2017; and
  • comply with generally accepted accounting practice in New Zealand, in accordance with Public Benefit Entity accounting standards.

Key audit matters and other significant matters

This is the second year in which we have included key audit matters in our audit report. Key audit matters are those matters that, in the auditor's professional judgement, are of most significance in the audit of the financial statements.

In determining the key audit matters, we considered matters that, in our view, were complex, had a high degree of uncertainty, or were otherwise important to the public because of their size or nature. The key audit matters for 2016/17 were:

  • recognising tax revenue;
  • valuing property, plant, and equipment;
  • valuing insurance and superannuation liabilities; and
  • valuing financial assets and liabilities.9

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.10

We have reproduced the complete audit report, including the key audit matters, in the Appendix.

Other significant matters arising from the audit

Other significant matters arising from the audit were related to:

  • the Crown's obligation to City Rail Link Limited; and
  • income-related rent subsidy.

Key audit matters for 2016/17

Recognising tax revenue

The main sources of revenue for the Government are income tax and goods and services tax. These revenue sources total $68.3 billion for the year ended 30 June 2017. The calculation of revenue from income tax is subject to significant assumptions and judgements caused by the timing differences between the reporting date and when taxpayers file tax returns.

Judgement was applied to estimating tax revenue, and the associated receivables and payables as at 30 June 2017, where taxpayers are yet to file their returns, or where payments have been received but no provisional or final tax return has been filed.

We carried out detailed audit work on these estimates because errors in the underlying assumptions and judgements could result in significant inaccuracies in the Government's financial statements. Our audit work included:

  • obtaining an understanding of the systems, processes, and controls in place over tax revenue;
  • the testing of underlying data; and
  • assessing the reasonableness of estimation models by checking revenue received relating to previous years against estimates made in those years.

We continue to recommend that Inland Revenue improves its methods for estimating income tax revenue in the year to which it relates. To date, Inland Revenue has determined that its options are limited by the cost and feasibility of making such improvements in its current system. However, we understand that Inland Revenue's management team plans to use the opportunities afforded by work on a new system, as part of its Business Transformation project, to develop more accurate and robust revenue estimation approaches. We support ongoing efforts to improve Inland Revenue's processes for estimating tax revenue.

Overall, we are satisfied that the assumptions and judgements applied in estimating tax revenue were reasonable.

Valuing property, plant, and equipment

The Government's physical assets total $144.6 billion at 30 June 2017. Some assets are more difficult than others to value because of the uncertainties inherent in the valuation of these assets, the quality of data available, and the benefits these assets provide. We identified the following significant assets where there were inherent uncertainties involved in the valuations:

  • rail network assets;
  • the State highway network;
  • electricity generation assets; and
  • social housing.

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

Rail network assets

One of the key assumptions used in preparing the Government's financial statements is that assets will continue to be held for their intended purpose. For accounting purposes, this determines the basis on which these assets are valued, either on a for-profit basis or a public benefit basis.

Assets that are held with the primary purpose of making a profit are valued commercially, based on the income that can be generated from the asset or what the asset can be sold for. Assets that are held for public benefit purposes are generally valued at optimised depreciated replacement cost. This is the cost of replacing all the components of the asset, less an amount that reflects the age and condition of those components.

Since 2012, as part of the restructuring of New Zealand Railways Corporation, the Rail Freight Network assets transferred to KiwiRail Holdings Limited have been valued on the basis that their intended use is to generate a commercial return. The Rail Freight Network assets had a value of $96 million at 30 June 2017. The network not used for freight (including metropolitan rail services), with a value of $724 million at 30 June 2017, is valued on a different basis because these assets are considered to provide a broader public benefit.11

The extent to which the Rail Freight Network is commercial is open to debate. If it were not considered commercial, the basis for valuing the Rail Freight Network would change to reflect a public benefit nature. This would result in the overall rail network increasing in value by up to $4.3 billion.

We considered the evidence for the commercial treatment against that supporting a public benefit treatment of the Rail Freight Network. As in past years, this showed mixed results. The evidence included the State-owned Enterprises Act 1986, KiwiRail strategy documents, forecast results, correspondence setting out Ministers' expectations, and KiwiRail Board minutes. We also considered the terms of reference for the current review of rail in New Zealand, the objective of which is to consider KiwiRail's operating structure, capital requirements, and funding mechanisms. The outcome of this review will be important in deciding whether valuing the Rail Freight Network on a commercial basis remains appropriate.

We have accepted the status quo for the valuation of the Rail Freight Network at 30 June 2017, largely because of the current review. We will continue to monitor the progress of the review to inform our position at 30 June 2018 about whether valuing the Rail Freight Network on a commercial basis remains appropriate.

We have recommended that the Treasury review the accounting treatment for 2017/18, taking into account the progress (or outcome) of the review.

State highway network

The valuation of the State highway network (excluding land), $23.8 billion at 30 June 2017, is carried out by an independent external valuer.

The valuation is 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. There remain some uncertainties about the values assigned to different components (such as bridges), because of limited information on quantities and useful lives.

We are pleased to note that, since 1 July 2013, the Agency has estimated the additional costs associated with road construction in urban areas (such as for traffic management), commonly referred to as "brownfield" costs. The Agency incorporated those costs in the valuation of the network. The cumulative amount of such costs recognised at 30 June 2017 is $1.2 billion. Over time, brownfield costs will be progressively recognised in the valuation of the network. We agree with the Agency and its valuers that, given the uncertainty and lack of data to reasonably quantify the costs, it is reasonable that the brownfield costs incurred before 1 July 2013 are not included in the State highway network valuation.

Electricity generation assets

Electricity generation assets are majority owned by the Government (at least 51%). The valuation of those assets, $15.9 billion at 30 June 2017, is 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 for the forecast prices of electricity and discount rates used to determine the present value of these prices, could significantly change the value of these assets.

The specialist valuers of each of the generation companies have different assumptions and make different disclosures about the valuation of generation assets. Although there are differences, we are satisfied about the reasonableness of the differences.

Differences have been accepted because:

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

Social housing

The social housing portfolio has been valued at $26.8 billion as at 30 June 2017. The portfolio is valued on a "highest and best use" basis, as required by accounting standards, which is aligned to market prices for properties of a similar size and condition in the same geographical location. In the year ended 30 June 2017, the value of social housing increased by $2.5 billion, mainly as a result of an increase in land values in Auckland (where 44% of the housing units are located).

A small portion of the social housing portfolio has been, or is being, disposed of to community housing providers, as part of the Social Housing Reform Programme (the Reform Programme). The Reform Programme is aimed at meeting the needs of social housing tenants by providing houses through a greater range of providers than just Housing New Zealand Corporation (HNZC).

As part of the disposal of properties to third-party social housing providers, encumbrances are placed on the properties to ensure that their social housing purpose is maintained. Encumbrances affect the highest and best use of the properties and therefore reduce their fair value. This reduction in value has been calculated using a valuation model that includes a series of assumptions about future income and expenditure for the properties.

Based on three transactions in the last two financial years, the average reduction in fair value is about 60%. The reduction in value is charged against the revaluation reserve. It has no effect on the operating balance in the Government's financial statements.

As part of these transactions, the Crown, through the Ministry of Social Development (MSD), enters into long-term agreements with the social housing provider to make houses available to people seeking social housing through MSD. In addition, as part of the disposal of the properties, the Crown protects its interest in the difference between the purchase price offered by the social housing provider and the unencumbered fair value (highest and best use value) of the property.

Valuing insurance and superannuation liabilities

The valuation of the Government's long-term liabilities is complex and requires actuaries to estimate their fair value, based on assumptions about the future. The two significant long-term liabilities at 30 June 2017 are the Accident Compensation Corporation's (ACC's) outstanding claims liability of $37.7 billion and the Government employees' superannuation liability of $11.0 billion. These liabilities are significant by value, and there are inherent uncertainties in valuing them that require a high degree of judgement and estimation.

The assumptions used to calculate the value of ACC's outstanding claims liability include estimating the length of rehabilitation from injuries, estimating amounts of cash payments and when they will be made, and estimating 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 include estimating the return on assets owned by the Fund, expected rates of salary increases for currently employed members of the Fund, inflation and discount rates, and mortality rates.

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

We evaluated the appropriateness of the main assumptions (such as inflation and discount rates) 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 2017 and concluded that they had been calculated in keeping with the agreed methodology.

We have recommended that the Treasury consider the recommendations from our review of the methodology as part of its annual review process.

Overall, we are satisfied that the ACC outstanding claims liability and the Government employees' superannuation liability are reasonable and that the disclosures outlined the sensitivity of the valuations to changes in assumptions.

Valuing financial assets and liabilities

The Government has financial assets of $133.4 billion, of which $75.3 billion are measured at fair value. It also has financial liabilities of $128.3 billion, of which $7.6 billion are measured at fair value. The financial assets and liabilities measured at fair value include marketable securities, share investments, advances, and derivatives.

The fair value of some of the financial assets and liabilities cannot be measured using quoted market prices and, instead, must be estimated by applying an appropriate valuation model. Market data are used when available, otherwise non-market data are used, which require the exercise of significant judgement. We paid particular attention to evaluating the appropriateness of inputs to models that had been derived from non-market data.

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

Other significant audit matters

The Crown's obligation to City Rail Link Limited

The Government's financial statements for 2015/16 included a note disclosing the Crown's commitment to fund 50% of the costs relating to the City Rail Link in Auckland. We considered whether the Crown had an obligation at 30 June 2017 for the costs incurred to date that should be recognised in the Government's financial statements.

We noted that several agreements had been concluded between the Crown and Auckland Council before 30 June 2017, as well as the establishment of City Rail Link Limited (CRLL), which is the entity that is responsible for carrying out the project and owning the rail link assets.

We concluded that the Crown had no obligation that should be recognised in the Government's financial statements because the Crown's involvement in CRLL will be as a shareholder. At 30 June 2017, CRLL had not issued shares to the Crown nor had the Crown paid in advance for them.

We are satisfied that this matter has been appropriately disclosed in the Government's financial statements.

Income-related rent subsidy

The amounts paid by MSD to HNZC and Tāmaki Regeneration Limited (TRL) for income-related rent subsidies are treated as income by HNZC and TRL and as non-departmental output expenses by MSD. The Government's financial statements reflect these transactions as both income and expenditure, on the basis that the subsidy is equivalent to a benefit payment to the tenant. This results in the Government's financial statements recognising rental income at market levels, even though the rents received from tenants may not be at a market rate.

The underlying documentation used to support the accounting treatment – the agreement between MSD and HNZC/TRL, the tenancy agreement, and scope of the appropriation – is not clear that the subsidy should be viewed as a benefit payment to the tenant. Rather, the subsidy appears to be simply the moving of money from one government agency to another, which, at the Government reporting level, should be off-set.

We have recommended that the Treasury review support for the current accounting treatment for the income-related rent subsidy paid to HNZC and TRL. In doing this, the Treasury, along with MSD, HNZC, and TRL, should review the documentation, clarify who the intended recipient of the subsidy is, and consider whether the subsidy is best characterised (and accounted for) as a benefit payment to the tenant or a purchase of tenancies from a social housing provider.

9: The Treasury (2017), Financial Statements of the Government of New Zealand for the year ended 30 June 2017, Wellington, pages 137-140.

10: The Treasury (2017), Financial Statements of the Government of New Zealand for the year ended 30 June 2017, Wellington, pages 43-45.

11: The rail network assets include the rail freight network, the network not used for freight, buildings, and capital work in progress.