Appendix 2: Report from the independent reviewer

30 July 2019

Mr John Ryan
Controller and Auditor-General
PO Box 3928
Wellington 6140

John R Strahl
P O Box 33141
Petone Post Shop
Lower Hutt

Dear Mr Ryan

ANNUAL REPORT OF THE INDEPENDENT REVIEWER OF AUDIT ALLOCATION PROCESSES 2019

Background and instructions

Pursuant to section 14 of the Public Audit Act 2001 (Audit Act), you are appointed as the auditor of all public entities. Under section 42 you are authorised to fix the fees payable for all such audits which must be reasonable.

Audit New Zealand, a business unit of your Office, has a large and competent staff. However, with approximately 3,900 public entities in New Zealand, of which approximately 3500 must be separately audited, it is impractical for Audit New Zealand itself to carry out all these audits. You thus contract auditors from the private sector to carry out many of these on your behalf. However, Audit New Zealand remains by far the largest single provider, carrying out close to half of all public sectors audits (as measured by audit hours).

The Office of the Auditor-General (OAG), sets strategy, policy, and standards, and appoints and oversees auditors, both from Audit New Zealand and auditors contracted from the private sector, who carry out audits on your behalf.

You have retained me as an independent party to review the basis upon which auditors, both from Audit New Zealand and the private sector, are appointed to act on your behalf, and to review the basis upon which the audit fees for these audits are determined. This is the fourth year that I have carried out this review.

This is my report on that review for the year ended 30 June 2019.

I am a former partner and chairman of law firm DLA Piper New Zealand, and currently am a director of various entities, one of which is audited by Audit New Zealand, and one of which is audited by one of your private sector audit providers. I confirm that I am independent of the Office of the Auditor­General, Audit New Zealand and all private sector audit firms.

My instructions are;

' .. to review and confirm the probity and objectivity of the methods and systems used by the Office of the Auditor-General to;

Allocate and tender audits

Monitor the reasonableness of audit fees; and

Anything else that impacts on those activities'

There has been no limitation placed on the manner in which I may carry out my work and I have been free to inspect any documents or files that I considered appropriate to the review and to discuss matters arising with staff of your office. I confirm that in the conduct of my review I have been given free access to all matters I have requested and have received full co-operation from your Office. I have also discussed the allocation of audits and the processes of fixing fees and your Office's involvement in resolving disputes with two private sector audit providers used by your Office.

Types of Auditor Appointments

In accordance with policies and practices adopted by your Office, there are four main types of audit appointments;

1. an appointment made of an auditor to an entity, usually for a term of 3 years under the Audit Allocation Model (Allocation Model)
2. an appointment of an auditor for an entity, following a contestable process, if you consider that is appropriate in the given circumstances
3. a re-appointment of an auditor for a further term, usually 3 years, to audit that same entity
4. where an audit involves 150 or more budgeted hours, the individual auditor and senior personnel may not undertake the audit work for more than 6 years, thus a new auditor must be appointed, though that may be another person in the same firm.

Appointments for new entities

In the last financial year, the Auditor-General appointed auditors for 38 new entities which included 19 new and ex-partnership schools.
All of these appointments were made following the principles set out in the 'Allocation Model' on which I will comment later. I observed no dissatisfaction by any of those entities to either the appointment made, the terms of appointment, or the proposed audit fee.

Re-appointments (other than for schools)

Existing auditors were re-appointed during the last financial year to audit 283 public entities and their subsidiaries for a further term. In respect of all the appointments covered by this paragraph, I observed no dissatisfaction from any of the entities and an appropriate process appeared to be followed and in accordance with the principles set out in the Allocation Model.

New appointments for existing entities

There were no new appointments made for existing entities other than schools and school related entities.

Appointment of school auditors

The appointment of auditors of all schools and school related entities arises on a 3 year cycle and this was completed during this year. This is a very major exercise with 2445 schools and school related entities involved.

I reviewed the process and outcomes of these appointments, including the resulting audit fees, with some care as there has been some historical tension in this sector, especially in some regions over the level of audit fees. As a result of that historical concern over fees, some careful analysis of existing audit fees in the sector was completed by your Office, both across the whole country and on a more selected regional basis, to better inform what appropriate fees would be for the future.

As part of the process every school was given the opportunity for some input. 64 schools in total expressed some degree of dissatisfaction with either the current auditor and/or level of audit fee, or both. This in part resulted in 19 changes of auditor in respect of those schools.

All existing auditors were also consulted. At the beginning of the process, several current auditors withdrew and some more did so during the process. This was for various reasons including retirement, quality concerns by your Office, and some for financial/fee concerns.

As a result it was considered appropriate that a greater than usual number of school audits be bundled in groups and auditors then selected via a competitive tender process, where often (but not always), the incumbent auditor took part. In total, auditors were appointed to 300 schools using a tender process. The outcome of the fees resulting from that tender process was then able to be taken into account as one factor in assessing reasonable fees for other school auditor appointments.

I reviewed the tender process undertaken and concluded that it was reasonable.

The balance of appointments and reappointments in the school sector, (still the vast majority), were completed by following the principles of the Allocation Model.

The overall outcome of the review process resulted in the re-appointment of 2119 incumbent audit service providers, the appointment of 307 new providers, (mostly via tender), and the appointment of new audit service providers to the 19 new and ex-partnership schools. Across the sector there was a very modest increase in audit fee levels - although more for some schools than for others.

I was impressed with the care, background preparation, and flexibility of approach taken in the carrying out of this review. Because of the generally small size, the need for a minimum level of work on any sized audit to achieve reasonable quality, and the varying level of financial reporting expertise in individual schools, both at an operating and governance level, the amount of the audit fee under the current school governance structure is going to provide tension. For some schools, the cost of audit represents a big portion of their operating budget and for some the audit cost exceeds the cost of preparing the accounts.

Given this background, overall I was entirely satisfied with the approach taken, the process used and the resulting outcomes of both the appointments and the level of fees determined. Auditors are now in place for all schools, and all appointments and the fee levels agreed. The overall response from schools has been good with remarkably little concerned feedback over the new fee levels.

Audit Allocation Model

As can be seen from the appointments above, the vast majority have been made using the Allocation Model. The Allocation Model has been the principal method used for auditor appointments since it was first adopted in 2003 and later revised in 2010. This is now a well established and publicised set of principles as set out in an OAG publication entitled; "Appointing public sector auditors and setting audit fees." The principles are summarised in that document as comprising:

auditor independence

auditor knowledge about public entities and public sector audits

the particular audit skills required

the audit's quality and cost; and

the need for the Auditor-General to always have access to enough audit capacity and capability.

The full publication is available on the OAG website (ISBN-978-0-478-38310-2) and is provided to any entity and auditor when appropriate. It is consistently followed and referred to when issues arise.

I consider the Allocation Model remains fit for purpose. Prior to its adoption most audit appointments were made following a contestable tender process. The conduct of audits in the public sector requires specialist expertise, and a careful balance to ensure good quality and consistent auditing at reasonable cost. I remain of the view that these objectives and the balancing required to retain a consistent level of quality and reasonable cost, is best achieved by use of the Allocation Model as opposed to a pure contestable process in the vast majority of cases. This is a view strongly shared by all of the private sector audit service providers that I consulted. They also considered that the use of the Allocation Model also strengthens the ability to ensure independence of appointments. I understand that the contestable process will continue to be used in individual cases when appropriate, and this was demonstrated as beneficial this year in its use for the appointment of some school auditors. I consider the current mix about right.

By making appointments in accordance with such a model, given the inherent discretion available, a disciplined and consistent application of the principles of the model is required when decisions are made. From my review of appointments made during the last year, a careful and consistent process has been followed.

The Allocation Model has operated well since last reviewed in 2010. I have been informed that the Office proposes to undertake a review of the Model in the current year. I welcome that review but do not necessarily expect that there will be major change. I would suggest as part of that review, consideration be given to making more transparent, the principles adopted and reasons for them.

Audit fees

Section 42 of the Public Audit Act 2001 authorises the Auditor-General to set the fee for all audits, which must be reasonable. In the event of a dispute, either party may refer it to arbitration.

This year your Office provided advance guidance to all auditors serving both Crown Government entities and local authorities, of your approach to, and factors that would be acceptable and unacceptable, for any movement in audit fees. Similar guidance was provided to public entities including a request that they participate in good faith discussions with the proposed audit service provider when consulting to agree suggested fees.

In respect of the school round of appointments, the OAG provided to all audit service providers involved at the beginning of the process, a detailed brief of its expectations around fee levels and any movements from previous years.

I consider it good practice to provide in advance this guidance to both entities and auditors.

In practice at an individual entity level, at the commencement of every audit appointment, the fee proposed by the auditor, which is expected to be based on the guidelines previously provided, is first referred to the OAG by the auditor for review to ensure its reasonableness. Considerable detail including a clear breakdown of appropriate team mix and rates is expected. Once the OAG has approved the draft, it is then provided to the entity for the auditor and entity to agree. The OAG will assist in that process and has available a comprehensive data basis of fees in the sector. It is the strong preference of the Auditor-General that the entity and the appointed auditor be able to reach agreement and that is almost always the case, although the fees finally agreed are sometimes lower than what your Office considered reasonable when reviewing the auditor's fee proposal.

One important factor in helping your Office consider what is a reasonable fee for the public sector audits is the benchmark provided by the fees used by Audit New Zealand. While Audit New Zealand's objective is to break even and it does not have a profit component, it is required to be financially viable and self sustaining. However, the integrity of using its fee levels as a benchmark is subject to it operating in an efficient and effective manner.

To provide assurance that Audit New Zealand does provide the public value for money and that the benchmark it provides remains appropriate, an independent review is completed from time to time of its operations. The most recent review was completed in the last year. That review found Audit New Zealand to be operating in an efficient and effective manner.

In addition to the audit fee paid to the audit service provider, every entity that is audited also pays a modest surcharge to cover the actual costs of your Office in supporting and overseeing the public sector annual audit process. This is referred to as the OAG Overhead charge. Because that forms part of the overall audit fee I reviewed both its composition and allocation to ensure that it was reasonable. I was satisfied that it was.

In the year under review there are currently no outstanding disputes over audit fees.

In no case over the last year has the Auditor-General had to exercise the power to fix a fee and not since 2009 has there been a reference to arbitration.

Most issues which arise over fees are during or at the end of an audit. Some arise due to the constrained financial position of particularly small entities. Some arise due to misunderstandings about what is required, some in respect of additional work not covered in the original scope of works being necessary, and sometimes the quality of information provided by the entity and rework by the auditor as a result leads to tension. In all cases reviewed, the OAG has shown consistency and care in helping to resolve these issues.

Overall I am entirely satisfied that the approach of the Auditor-General has been consistent and reasonable in the process of setting and resolving issues over audit fees.

Issues arising after appointment

This year I have observed no disputes over the initial appointment of auditors or the first setting of the audit fee. There continues to be some very limited numbers of subsequent dissatisfaction, but in this year less than previously. This is most commonly raised by the entity. They almost always involve the entity thinking they have to pay too much or that the performance or relationship between the entity and the auditor is not good. It is sometimes both. It is not uncommon for these to arise where extra work had been incurred because of poor quality financial information provided by the entity or a lack of full understanding of the information requirements of the auditor.

The number involved remains very small. I have reviewed several of the disputed cases. In all cases the Auditor-General has taken a consistent, constructive and objective position and has sought to assist the parties resolve the issue. As mentioned earlier, I am unaware of any currently outstanding disputes.

Other issues

There are no other material issues which arose in the previous year which in my view warrant comment in this report.

Conclusions

I have been provided full access to all relevant material and free access to the relevant files and personnel of the OAG. I have met with and obtained full explanations to all my queries by OAG personnel and have observed the relevant internal process of the OAG regarding both appointments and fee setting and monitoring. On the basis of that review and the explanations provided I consider that the policies currently adopted for the allocation of audits and the setting of fees are appropriate and that;

1. the process and methods used to allocate audits has been conducted fairly, reasonably and with suitable probity and objectivity
2. the approach and process taken to fix and monitor the reasonableness of audit fees has been reasonable having regard to the interest of all parties and has been conducted with suitable probity and objectivity
3. the subsequent issues that have arisen for both appointments and fees have been dealt with objectively, fairly and reasonably.

Yours sincerely

John R Strahl
P O Box 33141
Petone Post Shop
Lower Hutt