AuditorGeneral consideration of alternate funding options SCo AG

Auditor-General consideration of alternate funding options SCo. AG 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. Revenue Audit income Own hours Contract work Subsistence & travel Other income Expenditure Contract work Subsistence & travel Variable costs Fixed overhead costs Net surplus / (deficit) Actual (R'000) 1, 130, 405 Budget (R'000) 1, 025, 981 1, 114, 195 647, 363 423, 292 43, 540 16, 210 1, 013, 230 700, 722 250, 525 61, 983 12, 751 100, 965 (53, 359) 172, 767 (18, 443) 3, 459 1, 141, 772 1, 011, 822 129, 950 423, 292 43, 540 421, 504 253, 436 (11, 367) Note 1 This 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) 250, 525 61, 983 420, 167 279, 147 14, 159 Variance (R'000) 104, 424 % 10% -8% Note 1 69% -30% 27% 13% (172, 767) -69% 18, 443 30% (1, 338) 0% 25, 712 9% (25, 526) -180% Bottom Line Fixed and variable costs maintained to 97% of budget Own hours performance, led by vacancies, has driven a deficit variance of R 25. 5 million.

3. Key financial indicators – movement in cash & cash equivalents. Financial year 2004 -05 2005 -06 2006 -07 2007 -08 Cash & cash equivalents Opening Closing Change (R'000) 147, 232 156, 508 9, 276 156, 508 165, 431 8, 923 165, 431 138, 594 -26, 837 138, 594 117, 318 -21, 276 % 6% 6% -15% Bottom line – The Auditor-General’s funding position is deteriorating annually and is expected to worsen in the absence of remedial action.

4. Drivers – “capping” of tariffs Financial year 2004 -05 2005 -06 2006 -07 2007 -08 2008 -09 Capping impact Own hours Number budget % Own of staff impacted hours income impacted (R'000) 22 16, 240 4% 27 21, 574 4% 106 99, 094 17% 220 197, 739 28% 397 381, 408 44% Budget Financial year 2004 -05 2005 -06 2006 -07 2007 -08 2008 -09 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%. Total audit Own hours income 624, 275 456, 647 712, 308 510, 925 875, 466 578, 348 1, 013, 230 700, 722 1, 292, 643 857, 097 Surplus / Own hours (Deficit) R as % of total '000 73% 36, 900 72% 43, 764 66% 12, 900 69% 14, 159 66% 8, 359 Surplus ratio Surplus (audit ratio (own income) hours) 5. 9% 8. 1% 6. 1% 8. 6% 1. 5% 2. 2% 1. 4% 2. 0% 0. 6% 1. 0%

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 Year 1 Year 2 Year 3 Year 4 Year 5 Band & level A B C Package 30 + 20 -30 10 - 20 No. of staff 2 3 4 Std recoverable hours 100 100 A B C 30 + 20 -30 10 - 20 5 2 2 100 100 A B C 30 + 20 -30 10 - 20 6 3 0 9 0 0 100 100 100 Tariff 100. 00 90. 00 80. 00 104. 00 93. 60 83. 20 108. 16 97. 34 86. 53 112. 49 101. 24 89. 99 116. 99 105. 29 93. 59 Revenue % Revenue increase 20, 000 27, 000 32, 000 79, 000 52, 000 18, 720 16, 640 87, 360 10. 6% 64, 896 29, 203 0 94, 099 7. 7% 101, 238 0 0 101, 238 7. 6% 105, 287 0 0 105, 287 4. 0% 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.

4. Drivers – Negative cash flow profile AG cash flow profile 2008 -09 Audit income 1, 294 1, 500 1, 000 R million 500 Interest 8 0 Creditors -228 -500 Salaries -651 -1, 000 Capex -50 Contractors -368 -1, 500 -15 0 15 30 45 60 69 Days from month-end 50% of working capital outflows occur 84 days prior to debtor receipts. The extended duration of debtor collections negatively impacts working capital.

5. Compounding factor - Vacancies Financial year 2007 -08 2008 -09 Vacancy percentage Budget 5% 8. 3% Actual YTD 14% ? 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 R 21. 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%.

5. Compounding factor – Bad debts and debtors Debtor group Local authorities Provincial government National government Statutory entities Total Financial year 2004 -05 2005 -06 2006 -07 2007 -08 % of Debtors value 44% 25% 16% 13% Total audit income R 600, 041 751, 252 893, 750 1, 097, 798 Debtor days 2006 -07 83 21 4 81 55 Bad debts provision (R'000) 11, 899 13, 582 13, 520 22, 113 2007 -08 122 34 3 50 69 Provision as % of total income 2. 0% 1. 8% 1. 5% 2. 0% % Change 47% 62% -25% -38% 25% Average debtor days 55 50 55 69 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.

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 SCo. AG 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 SCo. AG. • Benchmarked global SAI funding models. • Finalised document and one-off non-refundable grant request. • Received AG Exco approval.

7. Global benchmarking 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) Canada Yes Moderate (4) Norway No High Australia No High Ghana ? Moderate ? (5) United Kingdom No High New Zealand No High Parliamentary apportionment with minor charging Parliamentary approval with more significant charging (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. 2. 3. 4. Retain the current method of fee recovery from auditees with market-related annual tariff increases. AG budget included in Parliament’s budget vote. Recover audit fees from relevant Treasury or provincial department of local government. 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. Detail Charge auditee Option alignment to criteria Charge & Charge/ Treasury Parliament collection hybrid 1 Assures financial viability of the AG 2 Simplicity of the solution and its operation 3 Assures the independence of the AG 4 Transparency of costs for ext. stakeholders 5 Flexibility to dynamically manage changes in demand supply. 6 Promotes efficiencies in the cost of auditing 7 Promotion of rational economic behaviour within both the AG and its auditees. 8 Minimisation of cross-subsidisation Average 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.

Revised request for unconditional grant required to address known and committed or estimated future expenditure not funded within the current funding model May 2008 Detail 2005 -06 Uncollectable debtors 2005 -06 Total NPV Discount rate 2, 207, 805 2, 695, 785 10. 50% 8, 384, 230 9, 264, 574 10. 50% 21, 276, 000 25, 274, 273 14, 938, 190 4, 545, 320 66, 033, 782 2008 -09 forecast operating cash flow shortfall after adjustment for timing of component cash flows. Reserves for future liabilities Uncollectable debtors 2008 -09 Capital expenditure postponement to alleviate funding position Total for 2008 -09 15, 067, 537 27, 004, 180 12, 939, 810 4, 073, 212 59, 084, 739 56, 137, 519 5. 25% Contingency (2008 -09) Anticipated loss of contribution due to anticipated vacancy rate exceeding budgeted vacancy rate (assumed 14% vacancy - average for 2007 -08) 21, 765, 462 20, 679, 774 5. 25% 157, 476, 018 154, 811, 434 2006 -07 Uncollectable debtors 2006/07 2007/08 actual (unaudited) operating cash flow shortfall Reserves for future liabilities Uncollectable debtors 2007 -08 Capital expenditure postponement to alleviate funding position Total for 2007 -08 Note 1 Includes increased provision for leave pay and post-retirement medical aid and provision for the INCOSAI conference to be hosted by the Auditor-General (R 45 million provided over five years) Note 2 The discount rate is the weighted average PIC investment rate of return

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 SCo. AG – 12 & 19 June 2008.