Annual review of audit allocation processes

From SIR DAVID GASCOIGNE

3 September 2013

Mrs Lyn Provost
Controller and Auditor-General
PO Box3928
WELLINGTON

Dear Mrs Provost,

ANNUAL REPORT OF THE INDEPENDENT REVIEWER OF AUDIT ALLOCATION PROCESSES

You have retained me as an independent reviewer of the basis upon which auditors are appointed to act on your behalf, and the basis upon which appropriate levels of audit fees are determined.
This is my report on those processes for the financial year ended 30 June 2013. I confirm that I am independent of the Office of the Auditor-General (OAG), Audit New Zealand and all private sector audit firms.
My instructions require me to evaluate the processes involved and to report upon the probity and objectivity with which they are implemented. No limitation has been placed upon the manner in which I carry out my assignment I have been free to inspect both paper and computer based files, documents and correspondence as I wished.
There are three distinct types of audit appointment:
1. an allocation made by the Auditor-General of an auditor for a given entity, in accordance with the "audit allocation model";
2. an appointment of an auditor for a given entity, following a contestable tender; and
3. a re-appointment for a further term of an appointed auditor's contract to audit a particular entity.
Allocations: In the past financial year, the Auditor-General appointed auditors for 37 new entities. That number includes 3 schools or school-related entities. Apart from schools, these new entities include, for example, newly established Crown entities, new subsidiaries of existing entities, and new entities resulting from mergers. There has been no evident dissatisfaction expressed by those entities either with the method or with the terms of any of the appointments effected during the year. The "audit allocation model" under which those appointments were made has been the principal method of allocation since 2003. There is an established and now well-publicised set of criteria for those appointments (see paragraphs 6 to 9 below).
Giving effect to the model: Two years ago substantial work was carried out to review, and improve upon, the audit allocation model. The underlying principles of the model, as it then was, were studied and adapted, with a view to making the process more efficient and more responsive to changing circumstances, but in a way that allowed for some flexibility in its operation.
There was widespread consultation with the Auditor-General's audit service providers and with other stakeholders during this process. A seventeen page document emerged and was made public in August 2011. Its title is: "Appointing public sector auditors and setting audit fees". Its contents are succinct, cogent and clearly stated. (ISBN 978-0-478-38310-2 (online))
That document has been consistently and widely deployed since then. In cases of doubt or difficulty - or where an entity or its auditors do not properly understand the nature of their respective roles and responsibilities -the representatives of the OAG direct them to this publication. The result is nearly always beneficial -a shared understanding of what is required generally emerges, and promptly so.
I have reviewed the publication again, for the purposes of this present report. It is still a particularly useful expression of principle and practice. For my part, I see no evident need for change, at least at this stage.
Contestable Tenders: No appointments were made by means of this process during the past year. The process still remains available, in particular circumstances, but the increasing reliability and practicality of the audit allocation model - and its cost effectiveness - mean that the use of contestable tenders is likely to occur only occasionally.
During the year under view the Auditor-General conferred with a selection of the firms that carry out the audits of public entities for her, as well as Audit New Zealand. She wished to consider whether the contestable tendering process might be revived, on a trial basis, for a small number of entities who might themselves wish to make use of the process, bearing in mind that this had been the usual method of audit allocation some years ago.
The course of the discussions with the firms and Audit New Zealand showed that there was likely to be little, if any, long-term advantage in the use of the tendering process. They shared - individually and confidentially - with the Auditor General their castings for past tender rounds and an analysis of fees subsequently charged. These tended to show that the overall net benefits of the tendering process to the public entities, the Auditor General (and the auditors)- were limited and short-lived.
Nonetheless, during the past year, two large public entities have expressed an interest in investigating some form of tender process. These are still in the course of evaluation. But the Auditor-General has expressed the view that, for large public entities - especially those with a commercial focus - a contestable tender process may, in some circumstances, appropriately be put in place.
Re-appointments: generally: Leaving aside the position as to auditors for schools (see the following paragraph 15), existing auditors were re-appointed during the financial year to audit 403 public entities and their subsidiaries for a further term. In addition, in 20 instances a change was effected, with a different auditor being appointed in place of an existing one. The circumstances leading to these latter appointments involved auditor independence and auditor/entity relationship issues. Again, in the case of all 423 appointments covered by this paragraph 14, a careful process has been followed. There have been no unresolved issues arising from the method or the terms of appointment
Reappointments: schools: The term of appointment for the auditors of all schools came to an end once the audits of the financial year ended 31 December 2011 were completed. Existing audit service providers were reappointed for 3 year terms in respect of some 2,378 schools. A change of auditor was effected in respect of 89 schools. And an auditor was appointed for 3 new schools or school related entities (these have previously been referred to in paragraph 5 above).
Overall, about 60 auditors are appointed, nation-wide, from a variety of audit firms - ranging from small local firms through to the major international firms. All auditors must observe the Auditor-General's auditing standards and instructions. The OAG subjects the auditors to regular quality assurance reviews.
A change of auditors may be effected for a variety of reasons. For example, where the previous auditor no longer met the Auditor-General's independence requirements; where an audit firm has withdrawn from auditing schools; where the auditor or the school request a change for good reasons; where the portfolio of audits of an auditor needs to increase to improve the auditor's critical mass of audits.
The circumstances under which audit fee increases were allowed, were very limited. Those circumstances were discussed with the Ministry of Education before being discussed with the auditors concerned. More recently, Novopay issues have affected audits, and additional audit fees have been negotiated with the Ministry of Education. (See also paragraph 38(a).)
The task of effecting these reappointments and appointments is a large and detailed exercise. But it has proceeded both smoothly and effectively on this occasion, and there has been no evident dissatisfaction expressed as to the process that was followed.
Issues about fees and performance: During the course of the past year, a number of entities raised questions or made complaints about the level of their audit fees or, occasionally, about auditor performance. Some of these have been informal in nature (and have been readily and promptly resolved). A few have been more formal in nature (with well articulated letters expressing the grounds for an entity's concern).
The basis for these claims about fees is, often, that in difficult financial times, when an entity's revenue is constrained, it is neither appropriate nor fair that an audit fee should remain at what is perceived to be a high level - or should increase. There is sometimes a perception held by an entity that an alternative auditor could do the task for less than the current fee without affecting audit quality.
The OAG has a detailed data-base which has become increasingly sophisticated and precise. It enables an analysis of audit fees for all public entities. The contributing components (audit hours, average hourly charge-out rates, and levels of experience within the audit team) of the fees for all types and sizes of entities, year by year, individually and sector by sector, may be compared and contrasted. In particular, the movement in hourly rates and the time expended on an audit, or a range of audits, can be accurately identified.
The OAG uses this material, constructively, to help respond to enquiries or complaints received. The response is usually given by the OAG direct to the entity, though sometimes the auditor responds, using information supplied by the OAG. In either case, the comparative data which is relevant to a particular entity is recorded in an explanatory letter, along with a description of the various factors lying behind the audit costs. While the analysis performed by the OAG often indicates that the audit fee is well substantiated and within an appropriate range, it also indicates where audit fees are outside that range either higher than expected, or lower. In either case, the auditor and the entity are informed of those findings and expected to negotiate further in order to reach agreement.
In a small number of cases, it is apparent that the actions of the entity itself have contributed to the increase in fees. For example, in some cases the materials that will require audit are poorly prepared or checked, are incomplete, or have several iterations. Those factors tend to result in an increase in the auditor's time, with a consequent claim for an increase in fees.
But in most cases where the issue of fees has been raised, the detailed explanation given to entities by the OAG (or, in some cases, by an auditor using data supplied by the OAG) has led to a resolution, or to a withdrawal of the complaint, or to no further action being taken by the entity. In the year under review I inspected the records in respect of 21 entities which had expressed concern about the level of fees or, more rarely, auditor performance. In all those cases a resolution has either been achieved or can be seen to be likely. To put it another way, as at 30 June 2013, there were no instances of significant and continuing contention.
My review of the materials for the financial year to 30 June 2013 has again shown that where, occasionally, there is some dissatisfaction expressed by entities or auditors, it tends to centre upon two particular issues.
The first is related to auditor performance or to the auditor/entity relationship. This arises very infrequently, but when it does, it has consistently been resolved. The resolution occasionally entails a well-considered change in the appointed auditor. I have seen nothing untoward in this regard.
The second relates to the level of fees - either initially or upon a subsequent claim for increase. Viewed broadly, the role of the Auditor-General, acting through the OAG, is to ensure that audit fees are fair and reasonable. The OAG provides detailed information, when needed, with a view to assisting the entity and the auditor to come to an accord about this.
Generally, agreement is reached between entity and auditor. The Auditor-General's clear preference is that it is desirable that the audit fee should be the result of an accord between those two parties - within a range suggested by the OAG (using its data base) and acceptable to her.
In practice, that approach can be seen to work very well. The Auditor-General has the statutory power to set audit fees, if needed. But since 2003 that power has been exercised on only three occasions, most recently in 2009.
Auckland Council: residual issues: In my two most recent reports, I commented favourably upon the planning for and the implementation of audit arrangements arising from the amalgamation of councils and council controlled organisations that took place in Auckland in October 2010.
Overall, from an auditing perspective, the transitions have gone satisfactorily. Some of the systems have not come together as readily as had been hoped. There is still some rationalisation to be achieved. But the public auditing processes are, largely, working effectively.
There has been some concern expressed that the anticipated savings in audit fees- as a result of the amalgamation - have not yet been realised. This issue was one of many put to the Auditor-General during her appearance before Parliament's Finance and Expenditure Committee this year. Her responses are incorporated in the report of the Committee which was issued in January 2013, and spells out some of the reasons. For example, the speed of change, widespread staff movements, the extent and complexity of the changes required, the increased risk of breakdown in internal controls and fraud, the continued use of some legacy systems, among other factors.
Although the fees for the 2012 year were still higher than those for the base year of 2009, there is an expectation that, as Auckland Council's systems and processes are further rationalised and refined, audit efficiencies and cost savings should begin to be realised.
Christchurch earthquakes: In my report last year, I referred to my review of the files of the more significant public entities whose positions had been affected by the aftermath of the catastrophic earthquakes that had struck that city.
noted the common effort to be both co-operative and practical in matters relating to audit and control. In many cases, greatly increased volumes of work and prevailing uncertainty have justified some increase in fees. Both the entities and their auditors have generally behaved in a principled and responsible manner. There has been give and take on both sides.
The position remains largely the same. The Auditor-General and the OAG have kept matters under review. They are aware of the pressures and complexities that have arisen. So far, there have been no substantial issues that have called for their intervention. But they remain open to the possibility that that may yet occur.
Other issues: I have observed a number of other issues that have evolved during the past year:
1. Novopay: On 24 January this year, the Auditor-General released a statement about her approach to the problem of multiple errors - affecting the remuneration of teachers and administrative school staff - arising from the Ministry of Education's new payroll system known as "Novopay". As at least one other inquiry was under way, she thought it premature to initiate her own inquiry. But she has kept the issues closely under review and has been prepared to take action if there is good cause to do so. That remains the position. From an audit point of view, the difficulty has been the additional time and effort required by schools, the Ministry of Education, auditors, and the OAG to get sufficient certainty about schools payroll reports to enable completion and audit of accurate annual financial statements.
2. Auditors of issuers in the Public Sector: On 31 January this year, the Auditor-General implemented her policy about the appointment of auditors of issuers in the public sector, in a way that meets the requirements of amendments made to the Public Audit Act 2001 as a result of the Auditor Regulation Act 2011. There have been no apparent difficulties with the implementation of that policy.
3. Crown Entities Amendment Act 2013: This has effect to relieve some Crown entity subsidiaries from the obligation to produce separate financial statements and performance reports and submit them to audit by the Auditor General. The parent entity must, for itself and its subsidiaries, comply with the reporting requirements of the Act and submit its financial statements and performance reports for audit. The Minister of Finance has power, however, to require an entity which would otherwise be exempt to comply with the full reporting and audit requirements. This amendment allows for simplification, saving time and money. It is not expected to give rise to any practical difficulties for the Auditor-General.
4. Tiered accounting standards: New public sector accounting standards are in the process of being implemented by the External Reporting Board, and details may be found on its website. While large public entities will not be greatly affected, smaller entities are likely to have reduced reporting and disclosure requirements. In future, efficiencies may be possible in both the preparation, and the audit, of financial statements, where entities are able to benefit frorn reporting under a different tier. The Auditor-General and the OAG are keeping these proposals under review.
Conclusions: I now state my overall conclusions. These follow from what I have said in the preceding paragraphs of this letter. My conclusions are:
1. On the basis of the written material I have seen and the explanations I have been given by OAG personnel, I consider that the processes adopted by the Auditor General and by the OAG in relation to the allocation and appointment of auditors for audits falling within the Auditor-General's mandate, during the financial year to 30 June 2013:
  1. have been appropriate for their purpose; and
  2. have been applied in a way which is fair and responsible, having regard to the respective interests of the parties concerned;
2. That observation applies both to the way in which auditors have been appointed or re-appointed, and to the way in which questions as to the appropriateness of an audit fee have been dealt with;
3. In cases where issues have been raised by entities as to fee levels or as to auditor performance, those issues have been, or are being, dealt with fairly and professionally;
4. Other issues which I have examined (such as those referred to in paragraphs 31 to 38) which touch upon the Auditor-General's mandate and the operations of the OAG have, in my view, been evolved reasonably and responsibly.
Taking everything into account, my conclusion is that the processes by which audits in the public sector have been allocated and fees have been set, in the financial year to 30 June 2013, have been carried out with due probity and objectivity.

Yours sincerely

Sir David Gascoigne, KNZM, CBE