Appendix 2: Report of the independent reviewer

19 July 2021.

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

John R Strahl
PO Box 33141
Wellington Mail Centre Lower Hutt

Dear Mr Ryan

ANNUAL REPORT OF THE INDEPENDENT REVIEWER OF AUDIT ALLOCATION PROCESSESS 2021

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 of the Audit Act you are authorised to charge fees to public entities 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 3,800 public entities in New Zealand, of which approximately 3,400 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. Audit New Zealand still remains by far the largest single provider, carrying out close to half of all public sectors audits (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 person 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 sixth year that I have carried out this review.

This is my report on that review for the year ending 30 June 2021.

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 a public entity audited by Audit New Zealand, and one of which is private and is audited by one of your private sector audit providers. I excused myself from the consideration of the appointment and fee setting for the entity audited by Audit New Zealand. I consider that I am independent of the Office of the Auditor-General, Audit New Zealand and all private sector audit providers.

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 major private sector audit providers used by your Office.

Types of Audit 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 18 new public entities including schools.

All of these appointments were made following the principles set out in the 'Allocation Model' on which I will comment later. I reviewed the reasons given for each appointment which appeared reasonable and I did not observe any dissatisfaction by any of those entities to 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 97 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, including schools.

There were 23 new appointments made for existing entities including schools and school related entities. I have reviewed the explanation given for each appointment, all of which looked reasonable. I have not observed any concern to any of these appointments, all of which were determined by allocation rather than tender.

Appointment of school auditors.

The appointment of auditors to the school sector is currently underway for the next three year cycle for audits for the period ending December 2021. One existing private Audit Service Provider with a large number of schools has withdrawn from the sector for future audits. I expect this is to provide some challenges due to the fact that this is not a sought after assignment for auditors generally, particularly so when resource constraints are impacting all audit firms, including Audit New Zealand at present. While it is likely that most new appointments will be made in accordance with the Allocation Model a final decision on this has not been made. I have been advised that differing approaches are being explored to ensure sufficient audit services are available to this sector. I encourage that innovation.

Audit Allocation Model.

In the last year all appointments of auditors to both new and current entities, and including all re" appointments, have been made using the Allocation Model rather than the use of a contestable tender process. The Allocation Model has been the principal method used for auditor appointments since it was first adopted in 2003 and later revised in 2010. It is a well established set of principles and they are summarised in a public document entitled; "Appointing public sector auditors and setting audit fees.' The principles summarised in that document are;

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 guide 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.

During the year under review, both the objectives of and principles to be applied in making audit appointments pursuant to the Allocation Model has been and remains under review. I understand further modelling and consideration is being given to the practical application of those principles before the revised version is finally adopted. The initial changes made to the principles are largely consistent with the existing model, with the proposed changes being more of altered priorities rather than changes of substance. I would encourage that work to be completed soon and that the public document currently available, be updated to ensure that it accurately reflects the changes proposed. I continue to support the use of the Allocation Model as a reasonable basis for allocation decisions for most appointments. 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 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 shared by all of the audit service providers that I have consulted. They all consider that the use of the Allocation Model also strengthens the ability to ensure independence of appointments and independence of approach during the completion of the audit. I understand that the contestable process will continue to be used in individual cases when appropriate. I consider that once the current work on the principles and practical application has been completed, that it is important that an accurate summary of these are published to ensure transparency and consistency of decision making.

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 and re-appointments made during the last year, a careful and consistent process has been followed.

Audit fees.

Section 42 of the Audit Act authorises the Auditor-General to charge fees for all audits of public entities, which must be reasonable. The factors to be taken into account when determining whether the fee is reasonable are set out in that section. If the Auditor-General and the public entity fail to agree as to the reasonableness of a fee, the matter must be submitted to arbitration.

As has been the case in previous years, your Office provided updated advance guidance to all auditors for upcoming appointments of your approach to and factors that would be acceptable and unacceptable reasons for any movement in the then current level of fees. This clearly set out those reasons where a change may be suggested and those reasons which would be considered unacceptable. In every case the guidance stresses that regardless of the reasons for any proposed fee movement, the Audit Proposal to the entity must properly explain them including why any change is suggested.

I consider it good practice to provide in advance this guidance to auditors before the fee proposal is submitted. I would encourage this approach continue at the commencement of each year.

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, including a clear explanation of any material change is first referred to 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 by the auditor, who then has authority to seek to agree the fee with the entity. The OAG will assist in that process and has available a comprehensive data base of fees in the sector. It is the strong preference of the Auditor-General for the entity and the appointed auditor to reach agreement without further involvement of the OAG.

In the year under review there are currently no active outstanding disputes over audit fees but there remain some limited cases where additional fees have been sought, which are still under discussion. As is normal, there are isolated instances of some general discontent by some entities over the level of audit fees, and fresh issues may well arise following the completion of current audits.

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 after 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 and speed in which information is provided by the entity and rework by the auditor as a result, leads to tension. In the year under review, the advent of Covid 19, which I refer to later, has lead to a greater than usual number of requests from auditors for an additional fee due to additional work requirements directly as a result of Covid 19. Several such requests have been made and they may be approved if the increase sought is first considered reasonable by the OAG and the auditor is then authorised to seek the approval of the entity to the increase. 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, including additional recoveries.

Issues arising regarding re-appointments.

When it is time to consider the re-appointments of auditors, it is the practice of your office to inform each entity and to seek their views. A small number of entities in the last year have made a request for a change of auditor. In most cases this has not been just about fees but more often is about performance and sometimes a perception that better service would be provided with a different auditor with more experience in the particular sector.

The number involved remains very small. I have reviewed several of the requests some of which have been deferred pending your completion of the review of the Allocation Model. In all cases to date I consider the Auditor-General has taken a consistent, constructive and objective position to resolve the issues but there does remain a very small number where finalization is outstanding.

Other Issues. Covid 19 and audit resources generally.

The advent of Covid-19 has had a material impact on the time required to complete the current round of audits. Increased hours in the order of 30-40% have been experienced. This has arisen because of a variety of factors, extended reporting dates, challenges with valuations of many assets, going concerns issues etc. While this has lead to a greater than usual number of requests for additional fees, the additional time spend has not universally been claimed by auditors or approved in full when requested.

Of some concern is the gap in the audit sector generally of suitable resources which has been growing for some time but has been made worse because of the limited ability to recruit additional people with the required skills and experience particularly from overseas because of the limited travel opportunities due to Covid 19. Some estimates place the personnel gap in the audit sector as large as 200 people with suitable skills. This in turn is leading to increased wage outcomes as the need to retain and seek additional resources grows. I am satisfied that your Office is well aware of these challenges and that you are actively looking at possible steps that can be taken to moderate the impact of this, but it remains a difficult challenge for the whole audit sector.

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.