Auditor-Generalconsideration of alternate funding options

SCoAG Presentation

12 June 2008

Internal document - confidential

Reputation promise

The Auditor-General has a constitutional mandate and, as the Supreme Audit Institution (SAI) of South Africa, it exists to strengthen our country’s democracy by enabling oversight, accountability and governance in the public sector, thereby building public confidence.

Content

1. Background

2. Issue

3. Key financial indicators

4. Drivers of funding deficit

5. Compounding factors

6. Process to date

7. Global benchmarking

8. Options considered

9. Evaluation of options

10.Recommendation

11.Way forward

2. Issue

The AG’s funding position is deteriorating for the following reasons:

• In an effort to minimise the national cost of auditing, limitations were placed on tariff increases in respect of a range of senior staffing bands. This has resulted in the “capping” of certain tariff increases at 4% while the current CPIX is 10.4%. As salaries are adjusted upwards, an increasing portion of revenue falls within the “capped” tariff ranges.

• Difficulties are experienced in collecting fees from financially strapped local authorities, resulting in an increase in bad debts and a growing arrear debtors book.

• The scarcity of appropriately qualified audit resources generally, has resulted in higher-than-anticipated vacancies and a consequent outflow of work to external audit firms from which no contribution to fixed costs is recovered.

• The surplus margin is insufficient to cover ongoing working capital and capital expenditure requirements.

3. Key financial indicators – 2007-08 performance vs. budget.

Bottom Line Fixed and variable costs maintained to 97% of budgetOwn hours performance, led by vacancies, has driven a deficit variance of R25.5 million.

Actual (R'000)

Budget (R'000)

Variance (R'000) %

Revenue 1,130,405 1,025,981 104,424 10%

Audit income 1,114,195 1,013,230 100,965 10%Own hours 647,363 700,722 (53,359) -8% Note 1Contract work 423,292 250,525 172,767 69%

Subsistence & travel 43,540 61,983 (18,443) -30%Other income 16,210 12,751 3,459 27%

Expenditure 1,141,772 1,011,822 129,950 13%

Contract work 423,292 250,525 (172,767) -69%Subsistence & travel 43,540 61,983 18,443 30%Variable costs 421,504 420,167 (1,338) 0%Fixed overhead costs 253,436 279,147 25,712 9%

Net surplus / (deficit) (11,367) 14,159 (25,526) -180%

Note 1This variance is made up of the following:

Additional vacancies (64,711) Higher recovery rates 28,354 Lower utilisation (19,701) Net other recoveries 2,700

(53,359)

Bottom line – The Auditor-General’s funding position is deteriorating annually and is expected to worsen in the absence of remedial action.

3. Key financial indicators – movement in cash & cash equivalents.

Opening (R'000)

Closing (R'000)

Change (R'000) %

2004-05 147,232 156,508 9,276 6%2005-06 156,508 165,431 8,923 6%2006-07 165,431 138,594 -26,837 -16%2007-08 138,594 117,318 -21,276 -15%

Financial year

Cash & cash equivalents

4. Drivers – “capping” of tariffs

In the financial year 2008-09, 44% of own hours income will be subject to a year-on-year increase of only 4% (CPIX = 10.4%) due to the application of tariff capping.This has contributed to the decline in budgeted surplus margin to 0.6%.

Number of staff

impacted

Own hours budget

impacted (R'000)

% Own hours

income2004-05 22 16,240 4%2005-06 27 21,574 4%2006-07 106 99,094 17%2007-08 220 197,739 28%2008-09 397 381,408 44%

Financial year

Capping impact

Total audit income

Own hours income

Own hours as % of total

Surplus / (Deficit) R

'000

Surplus ratio (audit

income)

Surplus ratio (own

hours)2004-05 624,275 456,647 73% 36,900 5.9% 8.1%2005-06 712,308 510,925 72% 43,764 6.1% 8.6%2006-07 875,466 578,348 66% 12,900 1.5% 2.2%2007-08 1,013,230 700,722 69% 14,159 1.4% 2.0%2008-09 1,292,643 857,097 66% 8,359 0.6% 1.0%

BudgetFinancial year

4. Drivers – Demonstration of incremental impact of tariff capping.

The table below sets out a hypothetical example demonstrating the annual impact of the current application of the tariff determination mechanism. The limitations that were applied are as follows:

• No new upper levels created

• Tariff increases limited to 4% per annum

All staff on level A increase revenue by only 4%. The impact is cushioned by staff progressing up levels until such time as the upper level is reached.

YearBand & level Package

No. of staff

Std recoverable

hours Tariff Revenue

Revenue %

increaseYear 1 A 30 + 2 100 100.00 20,000

B 20 -30 3 100 90.00 27,000C 10 - 20 4 100 80.00 32,000

79,000

Year 2 A 30 + 5 100 104.00 52,000B 20 -30 2 100 93.60 18,720C 10 - 20 2 100 83.20 16,640

87,360 10.6%

Year 3 A 30 + 6 100 108.16 64,896B 20 -30 3 100 97.34 29,203C 10 - 20 0 100 86.53 0

94,099 7.7%

Year 4 A 30 + 9 100 112.49 101,238B 20 -30 0 100 101.24 0C 10 - 20 0 100 89.99 0

101,238 7.6%

Year 5 A 30 + 9 100 116.99 105,287B 20 -30 0 100 105.29 0C 10 - 20 0 100 93.59 0

105,287 4.0%

4. Drivers – Negative cash flow profile

50% of working capital outflows occur 84 days prior to debtor receipts. The extended duration of debtor collections negatively impacts working capital.

AG cash flow profile 2008-09

Salaries-651

Interest8

Creditors-228 Contractors

-368

Capex-50

Audit income1,294

-1,500

-1,000

-500

0

500

1,000

1,500

-15 0 15 30 45 60 69

Days from month-end

R m

illi

on

5. Compounding factor - Vacancies

Vacancies in the 2007-08 year have exceeded budget by 280%.

A vacancy rate of 14% in 2008-09 would equate to a negative bottom line impact of R21.8 million due to the under-recovery of fixed overheads.

The break-even vacancy rate for 2008-09 is 10.5%.

In addition, the budgeted average recovery rate (number of recoverable hours per annum) for 2007-08 was missed by 1.9%.

Budget Actual YTD2007-08 5% 14%2008-09 8.3% ?

Financial year

Vacancy percentage

5. Compounding factor – Bad debts and debtors

In the past year average debtor days increased by 25%. This is driven mainly by a deterioration in collections from local authorities and provincial government.

Provision for bad debts increased by 33% relative to total audit income.

2006-07 2007-08%

ChangeLocal authorities 44% 83 122 47%Provincial government 25% 21 34 62%National government 16% 4 3 -25%Statutory entities 13% 81 50 -38%Total 55 69 25%

Debtor days% of Debtors

value

Debtor group

2004-05 600,041 11,899 2.0% 552005-06 751,252 13,582 1.8% 502006-07 893,750 13,520 1.5% 552007-08 1,097,798 22,113 2.0% 69

Bad debts provision

(R'000)Financial

yearTotal audit income R

Average debtor

days

Provision as % of

total income

6. Options – Process to date

The following process has been followed regarding the analysis of the problem and the evaluation of alternative options:

• Brought funding problem to the attention of SCoAG on I October 2007 and initiative to evaluate the way forward was endorsed.

• Analysed current tariff model and identified limitations and compounding factors.

• Identified probable options to resolve the funding problem.• Reviewed options with AG special interest group.• Minister of Finance and Deputy-General National Treasury were

briefed in principle as to the purpose of the initiative.• Engaged with selective management of National Treasury to

understand applicability of options.• Presented preliminary funding model considerations to SCoAG.• Benchmarked global SAI funding models.• Finalised document and one-off non-refundable grant request.• Received AG Exco approval.

Basis of funding Country Treasury approval Implied assessment of independence

No auditee charging USA No High

Netherlands Yes Moderate (1)

Japan No Moderate (2)

Morocco Yes Low (3)

Parliamentary apportionment with minor charging

Canada Yes Moderate (4)

Norway No High

Australia No High

Ghana ? Moderate ? (5)

Parliamentary approval with more significant charging

United Kingdom No High

New Zealand No High

7. Global benchmarking

(1) Initiated discussions to ensure that the AG has direct access to Parliament in terms of motivating budget submissions and not only directly through the Treasury.

(2) If Cabinet reduces estimated expenditure of Diet, mechanism exists for Diet to correct the amount of expenditure pertaining to Board of Audit.

(3) Indicated need for change from funding and reporting via Treasury to funding and reporting directly to Parliament. Preliminary agreement reached overturned due to “political crisis”.

(4) Completing a two-year pilot in 2008 in terms of establishing a parliamentary oversight committee to arbitrate between the AG and its Treasury.

(5) Pending constitutional instrument to provide for a fee-charging regime to be used by AG.

7. Global benchmarking

Conclusion

The analysis highlights a common theme throughout the majority of democracies regarding the need to ensure and improve financial independence. The analysis also supports the funding model options of obtaining funding from Parliament, charging auditees directly and combinations thereof.

8. Options considered

Four options were considered in detail. These are:

1. Retain the current method of fee recovery from auditees with market-related annual tariff increases.

2. AG budget included in Parliament’s budget vote.3. Recover audit fees from relevant Treasury or

provincial department of local government.4. Recover direct-cost fees from auditees and fund

indirect costs via a Parliamentary allocation.

9. Evaluation of options

The results of the process are summarised in the following table*:

Decision criteria

No. DetailCharge auditee Parliament

Charge & Treasury collection

Charge/ Parliament hybrid

1 Assures financial viability of the AG

2 Simplicity of the solution and its operation

3 Assures the independence of the AG

4Transparency of costs for ext. stakeholders

5Flexibility to dynamically manage changes in demand and supply.

6 Promotes efficiencies in the cost of auditing

7Promotion of rational economic behaviour within both the AG and its auditees.

8Minimisation of cross-subsidisation

Average

Option alignment to criteria

Note: * Shaded area reflects degree of alignment with the criteria. Each complete quadrant represents 25%.

10. Recommendations

Based on the criteria, it is our opinion that, commencing 1 April 2009, Option 1 (Retain the current method of fee recovery from auditees) should be adopted subject to the following:

1. Tariffs should be recalculated to:

• remove tariff caps

• reintroduce symmetry

• factor in reasonable vacancies

• adjust budgeted recoverable hours.

2. Market-related tariff increases should be introduced in subsequent years.

3. An unconditional grant should be made available to relieve the funding position of the AG until the introduction of these recommendations.

4. The permissible budget surplus should be increased from 3 per cent to between 5 and 6 per cent.

Should these principles not be accepted, the recommendation would be for Option 2 - AG budget included in Parliament’s budget vote.

May 2008

Detail Total NPVDiscount

rate2005-06

Uncollectable debtors 2005-06 2,207,805 2,695,785 10.50%

2006-07Uncollectable debtors 2006/07 8,384,230 9,264,574 10.50%

2007/08

2007/08 actual (unaudited) operating cash flow shortfall21,276,000

Reserves for future liabilities 25,274,273Uncollectable debtors 2007-08 14,938,190Capital expenditure postponement to alleviate funding position 4,545,320Total for 2007-08 66,033,782 66,033,782

2008-092008-09 forecast operating cash flow shortfall after adjustment for timing of component cash flows. 15,067,537Reserves for future liabilities 27,004,180Uncollectable debtors 2008-09 12,939,810Capital expenditure postponement to alleviate funding position 4,073,212Total for 2008-09 59,084,739 56,137,519 5.25%

Contingency (2008-09)Anticipated loss of contribution due to anticipated vacancy rateexceeding budgeted vacancy rate (assumed 14% vacancy - average for 2007-08) 21,765,462 20,679,774 5.25%

157,476,018 154,811,434

Note 1

Note 2The discount rate is the weighted average PIC investment rate of return

Revised request for unconditional grant required to address known and committed or estimated future expenditure not funded within the current funding model

Includes increased provision for leave pay and post-retirement medical aid and provision for the INCOSAI conference to be hosted by the Auditor-General (R45 million provided over five years)

11. Way forward

The preferred funding option will be recommended after completing the following:

• Interaction with National Treasury at DG level• Interaction with Minister of Finance• Finalisation of document and presentation to SCoAG – 12

& 19 June 2008.