Port companies: matters arising from our 2016/17 audits

Letter sent on 19 June 2018 to chief executives and chairs of port companies by Greg Schollum, Deputy Controller and Auditor-General giving a brief summary of the main matters arising from the 2016/17 audits of port companies.

Tēnā koe

PORT COMPANIES: MATTERS ARISING FROM OUR 2016/17 AUDITS

In 2009, we reported to Parliament on the financial performance of port companies as a part of our report on 2007/08 local authority audits.¹

At that time, we observed increasing pressure from international changes in shipping and logistics, a trend towards consolidation and bigger ships, and an increasing interest in investment property. We are conscious of these continued influences on individual port companies and the wider sector.

In our 2017/18 annual plan, we said we intended to report on the results of the 2016/17 audits for the port sector.² This letter is a summary of the main matters arising from those audits.³ By identifying and sharing our observations, we hope to increase the value of our audits beyond the independent assurance that they provide.

Our audits identified two main matters that we want to draw to your attention and invite you to consider.

Firstly, we identified considerable variation in individual port companies’ reported returns. In part, the different approaches port companies take to valuing property, plant, and equipment account for the variation in reported returns.

Importantly, these different approaches mask the underlying performance of many entities in the sector and make them difficult to compare. We are concerned that this affects the ability of shareholders, Parliament and the public to assess the performance of the individual port companies and the sector as a whole.

Secondly, as you will know, two port companies have been severely affected by earthquake damage in recent times, which has had consequences for their business continuity and insurance cover.

In this letter, we have also included our observations on the need for good oversight in investment property decisions and information on the audit reports we issued on port companies’ annual reports for 2016/17.

Port company returns

Because port companies are commercially oriented, port company shareholders and the other stakeholders are primarily interested in the profits they generate.

For the year ended 30 June 2017, the port sector generated an average return on equity of 8.9%.⁴ However, there is significant variation in what individual companies generated. In 2016/17, the returns generated by individual companies varied between 2.3% and 26.1%. This variability in reported returns is not new and is noted in other publications, such as Deloitte’s annual New Zealand ports and freight yearbook.

Some of the variability in the reported returns is because port companies do not value their property, plant, and equipment consistently. Nine of the 12 port companies measure some asset classes at fair value. However, these nine port companies do not consistently measure the same asset classes at fair value. These differences have a significant effect on the return on equity reported.

We are concerned that these different valuation approaches make the performance of entities in the port sector less transparent for shareholders and other stakeholders to assess. Port companies continue to invest heavily in their businesses and spent about $290 million in capital expenditure in 2016/17. Because of the different valuation approaches, it is difficult to form a view about whether this capital expenditure was a good use of shareholders’ funds.

We urge port companies to review how they value their assets in the future. We consider that it is more appropriate to use fair value and to assess the fair value based on the expected cash flows to be generated. This will provide the most useful financial information to stakeholders, should help inform investment decisions, and will make company and sector performance more transparent.

Hazards, resilience, insurance, and risk

By their nature, ports are exposed to the elements. The elements take a toll on assets and equipment, and create operational risks.

In recent times, Lyttelton Port Company Limited (Lyttelton Port) and CentrePort Limited (CentrePort) have had their assets badly affected by earthquake damage. The damage to these ports’ assets and their ability to operate was considerable. However, both ports were fortunate enough to be able to continue operating, and both had insurance cover to assist with the amount of reinvestment needed for the future.

Since the respective earthquakes, Lyttelton Port and CentrePort have had significant write-offs and impairment of assets, and suffered losses in revenue. The accounting treatment for insurance proceeds has also been complex.

The implications of such natural events are often ongoing and create a variety of uncertainties for years after the events. These uncertainties are reflected in our recent audit reports for these companies.

In our 2016 audit report for Lyttelton Port, we drew attention to the basis for recognition of an impairment expense of $99.5 million. The impairment arose because the return generated by replacing destroyed assets, and some capital expenditure for the company’s future, did not meet the investment return established by the company’s directors.

Our 2017 audit report for CentrePort drew attention to the significant earthquake damage to its assets, including assumptions about insurance proceeds, extent of impairment of assets, related tax treatment, and equity in joint venture properties.

Insurance, risks, and questions to ask

In 2013, we prepared a discussion paper called Insuring public assets. The discussion paper provided a high-level view of insurance for public assets and the main changes after 2010, the year of the first Canterbury earthquake.

Six questions arose from looking at the information available to us, including “How well are risk assessments being done to inform decisions about insurance cover, including assessments of the likely cost to replace assets?”

We encourage you to consider the contents of this discussion paper if you have not already and to ask such questions as “Have we done the work needed to understand and manage our risks?” and “Are we fully satisfied that our valuation methodologies and policies are best practice?”

In March 2017, we wrote to the Chairperson of Parliament’s Finance and Expenditure Committee noting our intention to follow up our 2013 work on the insurance of public assets. We plan to complete this follow-up work in 2018/19.

Investment properties

A significant part of port companies’ combined asset base is made up of investment properties, amounting to about 13% of total assets for the port sector ($670 million) at the end of 2016/17. Investment properties are typically assets such as tenanted commercial buildings.

Five port companies have built up investment property portfolios that are greater than $20 million. Some, such as Port Otago Limited and CentrePort, have clearly separated their investment property activities from operational port activities by holding and managing the investment properties through separate specialised subsidiaries and associated entities.

In our audits of port companies, we have not identified any issues with the governance of investment properties. However, for port companies developing or expanding an investment property portfolio, we encourage you to pay particular attention to the oversight of investment decisions and to ongoing risk management. This will include actively ensuring that:

• corporate governance and management arrangements are appropriate and robust, taking into account the increasing diversity of investments and the management of conflicts of interest; and
• specific decisions about investments and activities include consideration by directors and managers with appropriate experience and expertise.

Our audit reports
Legislation requires that public entities in the port sector meet certain statutory deadlines for the adoption of audited financial statements. All port companies met these deadlines for 2016/17, except for earthquake-affected CentrePort. All port companies also received unmodified audit opinions on their audited financial statements. However, as noted above, our audit report on CentrePort included an “emphasis of matter” paragraph on uncertainties arising from the effects of the earthquake.

Our audit reports for Port of Tauranga Limited and South Port New Zealand Limited included a description of the “Key Audit Matters” in those audits.⁵ This was required because these companies are listed entities. More often than not, the key audit matters related to the valuation of assets (referred to earlier in this letter). These audit reports may be of interest to you if you are required to, or choose to, have a key audit matter audit report in the future.

Concluding comments

In closing, I encourage port company directors and management to make the most of the advice and recommendations of your auditor. The areas for improvement or review raised by our appointed auditors are often about the accounting treatment and valuation of assets and investment properties.

I acknowledge that port companies are capital-intensive businesses with significant ongoing capital expenditure. This high capital expenditure, including in investment properties, means that the consequential risks are also high.

I encourage you to consider the contents of this letter and what the matters raised may mean for your port company. I also encourage you to discuss this letter with your auditor.

Nāku noa, nā

Greg Schollum
Deputy Controller and Auditor-General

1: Office of the Auditor-General (2009), Local government: Results of the 2007/08 audits.

2: Office of the Auditor-General, Annual Plan 2017/18, page 11.

3: The financial information in this letter relates to the consolidated results for port companies and their subsidiaries.

4: We have not adjusted port company results for any one-off events, such as the impairment of assets or the recognition of insurance revenue.

5: Key audit matters are audit report disclosures made in keeping with the auditing standard ISA (NZ) 701 Communicating Key Audit Matters in the Independent Auditor’s Report. They are those matters that, in the auditor’s professional judgement, were of most significance in the audit of financial statements.