ATC071113: Report Budget and Strategic Plan 2008-2011

Standing Committee on Auditor General

Report of the Standing Committee on Auditor General on the Budget and Strategic Plan of the Auditor-General 2008- 2011, dated 13 November 2007: 

Introduction 

The Office of the Auditor-General (AG) tabled its Budget and Strategic Plan 2008-2011, as required by Section 38 (3) of the Public Audit Act 25 of 2004, to the Standing Committee on Auditor-General (SCOAG)) for its consideration. The Committee held hearings with the AG on 15 October 2007.

Present at the meeting were: 

Ms B A Hogan (Chairperson); Mr. D M Gumede; Rev N W Ngcobo; Mr. M L Mahlaba; Mr. M Johnson; and Mr M J Nene (ANC); Mr. E W Trent; and Mr. M Stephens (DA); Dr G G Woods (NADECO).

Mr. T Nombembe (Auditor-General); Mr. K Makwetu (Deputy Auditor-General); 

Mr. S Boyd (Acting Chief Financial Officer); Mr. W Tutani (Business Executive: Governance); and Mr. A Kamedien (Senior Manager: Corporate Services)

Review of Budget

1. Funding Basis of the AG

1.1 The AG generates its own revenues to fund its operations and receives no funding from Government. 

1.2 It separately bills each government department, public entity and municipality for the audits; it is constitutionally and legally obliged to perform.

1.3 In the public interest it aims to keep its auditing fees as low as possible and its gross profit at an absolute minimum, generally to cover overheads.

1.4 As a working rule, any surplus it generates is returned to the National Revenue Fund if the funding position[1] reflects a surplus; if the funding position records a deficit, the AG would opt to retain the surplus in order to fund its cash commitments.

1.5 A funding deficit is sustainable as long as it is less than the working capital requirement, as this is regarded as a temporary phenomenon in that the cash (debt) is usually collectable within 60 days. 

1.6 Additional funding would be required should the funding deficit exceed working capital.

1.7 The AG contracts out a fixed percentage of its audit work to private companies during peak auditing periods. No surpluses/ efficiency gains are generated out of work that is contracted out so it is necessary to contain contract work within sustainable limits, to minimize the negative impact on the funding basis of the AG. 

2. Financial Projections for 2008/2011

2.1 Projected Rise in Audit Income

Audit income is projected to rise to R 1, 292.6 billion in 2009 from a forecasted R 1, 072.4 billion in 2008. This is a 20, 5 percent increase. 55 percent of the increase is in Own Hours Income and 45 percent is due to salary increases of 7 percent and general tariff increases of 4 percent.

The following are some of the critical factors underlying the increase in audit income:

2.1.1 Span of control within the audit units and teams. The AG is still not operating at an optimum level because of a number of auditors that do not comply with the minimum qualifications framework, and therefore operate and are remunerated at sub-optimal levels. The AG has decided to change the structures that form a business unit. For 2008/09 a business unit will consist of 6 centres. Two new business units have been created at national level and 4 provinces (E. Cape, KZN, Gauteng and W. Cape) have split into two business units each.  In addition, the span of control ratios have been altered, with significant increases in numbers for administration staff, senior managers, audit managers and trainee accountants and decreases in numbers at audit manager levels. Altogether, audit staff numbers are set to increase by 234 persons. It is hoped that these measures will enhance capacity and efficiency.

2.1.2 Recovery Ratios. Recoverable hours are set to increase by 11, 79 percent due to the increase in staff and two more working days in 2008/09.

2.1.3 Tariffs. Tariffs are set to increase annually by 4 percent. Actual increases are higher though and average at 9, 5 percent due to salary increases of about 7 percent. 

2.1.4 Own Hours Income. The projected increase in the total number of own hours income is set to reverse due to the dramatic rise in the contracting out of audit work. In 2008/09, 39 percent of work contracted out to private audit firms will be returned to the AG. This is due to the anticipated increased capacity at the AG. Furthermore, catch-up work, due to the late submission of financial statements will decrease by 89 percent. New audits, especially those of certain public entities will increase own audit hours as will the increased focus on performance information auditing, asset auditing, the expanding operations of auditees and the use of the capability model in assessing risk. In total, own hours audit income is budgeted to expand 30 percent to R 857.1 million in 2009 above the previous year’s forecast of R 657.9 million. In contrast, contract work expands by a minimal 2, 14 percent from R 360.6 million to R 368 .3 million. However contract work, as a percentage of audit income remains unacceptably above high the norm of 20 percent at 30 percent.

2.2 Overheads

Overheads are set to increase by 23 percent from the R 297 million forecasts for 2007/08 to R364, 9 million in 2008/09. Support staff remuneration recorded at R 120 million for the financial year 2008/09, a 25 percent increase over the forecast figures for 2007/08.[2]

2.2.1 Increased overheads are mainly driven by increased audit work and several strategic operational imperatives in the office.

2.2.2 Overheads are projected to stand at 28 percent of audit income which places South Africa just below the median range of between 25 percent and 35 percent that pertain in developed economies. 

2.3 Capital Expenditure

2.3.1 Capital expenditure in the audit business units cannot exceed certain ratios. It is set to rise by 72 percent to R 50 million in 2008/09, most importantly because of the critical under-investment in technology in previous years, often because of cost-cutting exercises.

2.4 Net Deficit

2.4.1 The disturbing trend of recording net deficits on the income statement that started in 2006 [3] continues in 2008, with a forecasted deficit of R 16, 5 million. The trend should start to improve in 2009 with a projected net surplus of R 8.4 million if corrective measures are successful.

2.4.2 The trend towards deficits is caused primarily by a marked shift towards contracting for auditing purposes; this is prompted by skills shortages, high vacancies and larger than expected numbers of late submissions of financial statements, especially at local government level. In 2008, R 251 million was budgeted for contract work; by 2009 the projected amount is R 368 million, a 47 percent increase over the previous year’s budget. Contract work as a percentage of audit income reaches historical highs [4]in 2007 and 2008 (35 percent) and starts to decrease to 30 percent by 2009

2.4.3 Overheads as a percentage of audit income rise to 28 percent in both 2007 and 2008 and rise even further in later years.

2.5 Funding Deficit

2.5.1 Although the AG has been recording a funding deficit for several years, in 2008 this deficit is forecast to be unsustainable insofar as the deficit of R 150.8 million exceeds net working capital (R 96.2 Million) by R 54.6 million. For 2009, the exceeded limit increases to R 88.6 million and the trend continues unabated for the following two outer years of 2010 and 2011.

2.5.2 Two of the most important causes for the deterioration in the funding base is the greater reliance on contract work (discussed above) and slow debt collection which affects cash flows. In practice and on average, the AG collects on 60 days and pays on 45 days resulting in a significant ongoing need for working capital funding. The tight cash flow situation is made worse by slow and non-paying debtors.[1] Total arrears at beginning of 2007/ 08 amounted to R 59.6 million with local authorities accounting for R 35, 2 million of that debt.

2.5.3 With the recorded deficit in 2006 and the forecast deficit in 2007, the AG will require approximately R 63 million cash this year to meet its operating capital, and reserve requirements for this year.

2.5.4 The AG has embarked on an ambitious programme to alleviate skills shortages[5] and is engaging with the National Treasury concerning the recovery of local government debt in order to improve the funding basis of the AG, but these initiatives will only be fully realized in time to come. However the fact remains that even if the vacancy rate is brought down to the required 8.3 percent and debtor patterns remain the same, the AG will still require a cash injection of approximately R 89 million in 2008/09

3. Committee’s Observations on the Budget

3.1 The Committee is extremely concerned about the unsustainable funding deficits that are projected for the end of this financial year (2008) and for the following years onwards without any reversal. These are ascribable in the main to the increased scope of audit activity, high staff vacancies, inappropriate spans of control within the audit units and teams, increased reliance on contract work and cash flow problems arising out of slow paying debtors and bad debt.

3.2 The AG has embarked on a number of measures to rectify the imbalances, including an ambitious recruitment programme to fill vacancies, thereby decreasing reliance on contract work. Discussions are taking place with National Treasury to secure the payment of debt, principally from non-paying municipalities. However, even if vacancy levels are reduced, additional funding will still be required and contract work as a percent of audit income will remain unacceptably high, at 30 percent, which exceeds the norm of 20 percent.

3.3 Overheads stand at 28 percent of audit income and lies just below the median range internationally of between 25 percent and 35 percent so it is unlikely that significant savings can be made to cover the funding shortfalls. Similarly, capital expenditure is set to rise dramatically by 72 percent, a substantial increase necessitated by underinvestment in previous years, primarily in computer technology, due to cost-cutting initiatives.

3.4 It must be concluded then that the funding problem affecting the AG is primarily on the income side and driven ultimately by the critical skills shortages in the accounting and auditing professions in South Africa today. 

3.5 The AG is of the view that the current funding model can no longer cater for meeting the working capital, reserve and capital expenditure requirements of the Office and that a new funding model is required. Possible options include the following:

i. Allocate budget to relevant Treasury. The AG recovers fees from the relevant Treasury, being paid in advance, with tariffs increased to fund capex and reserves after interest received.

ii. Allocate Corporate Services, Reserves and Capex budget to AG. AG tariffs reduced to exclude Corporate Services, whilst tariffs are increased to fund working capital requirements, after interest received.

iii. National Treasury gives a quarterly cash advance for operating expenditure. Tariffs increased to fund capex and reserves after interest received.

iv. Increase AG tariffs for working capital, capex and reserve funding.

v. Allocate Audit Budget to AG. Auditees would note value of ‘service without charge’ in financial statements.

3.6 The most important consideration for any new funding model is that the independence of the Office of the Auditor-General must not be compromised in any way. For this reason, any option that would include grant appropriations either from Parliament or the National Treasury such as in Options ii, iii or v is the least desirable. This is also so because the AG’s Budget and Human Resources practices would inevitably be scrutinized according to the norms and practices pertaining to the Civil Service. In earlier years, the Office of the AG, as with SARS, were deliberately placed outside the domain of the civil service because of the specialist nature of their activities that are not easily compatible with practices in the civil service. 

3.7 Options I-IV all envisage a partial or full increase in tariffs. This seems unavoidable but the National Treasury must be consulted on the matter. Consideration would also have to be given to the impact an increase in internal tariffs would have on the escalation of costs on contract work.

3.8 Option IV does not necessarily solve the cash flow problems arising out slow payment of debt, especially by municipalities.

3.9 Option I appear to be the most desirable in that it potentially solves the cash flow problems and eases the pressures on funding. It does, however involve an increase in tariffs.

3.10 The Committee is of the view that there should be extensive consultation and research on the proposals regarding the new funding model, but cautions that process for the compilation of the national budget for 2008/09 is far advanced. The proposals must be brought back to the Committee for approval.

3.11 The Committee endorses the request for a cash advance from National Treasury for 2007/08.

3.12 The Committee requests that a document be prepared outlining all the legal options afforded the AG to recover debt from municipalities in terms of the Public Audit Act 25 of 2004, and local government-related legislation, and to make proposals to the Committee in this regard.

3.13 The Committee undertakes to request all parliamentary committees, at national and provincial level, that exercise oversight over local government to consistently monitor the payment of audit fees at local government level, as well as the timeous presentation of their audit reports to the AG. The AG should prepare a schedule of non-paying municipalities for distribution in the legislatures.

3.14 The Committee requests regular progress reports on the filling of vacancies in the Office of the AG.

4. Committee’s Observations on the Strategic Plan 2008-2011

Whilst there are very little key differences between the strategic objectives as outlined in 2006/07 and those for the years under consideration viz. 2008-2011, the Committee would like to draw attention to matters that it considers especially important if the AG is to succeed in its objectives.  These include:

4.1 Continued improvement in the quality of audits, with no instances of poor reporting of auditors.

4.2 An improvement in the timeliness of municipal reporting which will be primarily dependent on the improved financial capacities at local government level. National Treasury must be approached to proactively assist in this regard. The AG must make an informed opinion on the likelihood and extent of late submissions, so as to manage backlogs without negatively affecting the funding basis of the AG. 

4.3 The Committee endorses the expansion of performance auditing to 10 percent of total auditing but requests a framework that clearly specifies the focus and parameters of performance auditing and performance information auditing.

4.4 The baselines have been set for measuring leadership and reputation and the Committee awaits progress on these matters.

4.5 The reduction of the rate of staff turnover is critical to the well-functioning of the AG as well as to its financial viability. The Committee awaits reports on the success of the recruitment drive as well.

4.6 Operational excellence is absolutely critical and now that the baselines have been established the Committee looks forward to a progressive maturing of operational processes. 

4.7 Cost of Auditing presents a great challenge to the AG, especially with regards to the over-dependence on contract work. (Refer to discussions above).

4.8 Debt Collection continues to be a major challenge. The Committee requests a schedule of outstanding debtors and progress reports on clearing debt.

Report to be considered.

 

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[1] This refers to funding requirements  that originate from commitments reflected in the balance sheet measured against the amount of cash and cash equivalents viz :

1.      Reserves and Staff Liabilities

2.      +  Working Capital (Current Assets {excluding cash} less Current liabilities     [excluding    leave liability

3.      +  Capital Expenditure

4.      +  Hosting of Prestigious Events,

5. Less    Available Cash Reserves

 

 

[2] Total staff complement is scheduled to increase by 274 personnel , with audit staff increasing by 234.

[3] 2006  Net deficit of  R19,9 million; 2007  R1,8 million

[4] Normally budgeted at 20%.

[5] Cf P.60 of Budget and Strategic Plan of the Auditor-General 2008-2011.