Page 1 SCoAG Presentation Analysis of Funding Model 18 September 2009

2 Reputation promise/mission The Auditor-General of South Africa 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 through auditing, thereby building public confidence.

3 Content 1.Background 2.Analysis of revenue 3.Analysis of key cost drivers 4.Self-funding model 5.Presentation made to SCoAG on 12 June Issue 7.Key financial indicators 8.Drivers of funding deficit 9.Compounding factors 10.Options considered 11.Global benchmarking 12.Options considered 13.Evaluation of options 14.Recommendations 15.Way forward 16.Impact of new funding model 17.New funding model 18.Working capital management 19.Conclusion

4 1. Background –AGSA is mandated to provide audit services to the public sector. –AGSA has 866 auditees which can be divided into the following categories: National government – 175 auditees Provincial government – 209 auditees Local government auditees Statutory entities – 47 auditees Other – 101 auditees (Trust Funds, Funds, Pension Funds, etc.) –Fees are based on time spent on engagements. –The AGSA staff complement is as follows:

5 Background continued –The increase in heads is a deliberate strategy by the AGSA to reduce our vacancy rate. We have created more centres within the audit business units. –Due to the high vacancies (15% for audit staff in ), the AGSA is unable to perform all the required audits and therefore contracts out part of its audits to independent audit firms (referred to as CWCs). This also enables the AGSA to fulfill its mandate of contributing to the transformation of the audit profession (by allocating work to CWCs). –Historical vacancies.

6 2. Analysis of revenue

7 3. Analysis of key cost drivers In order to fulfill its mandate, the AGSA has a budget of R1,7 billion for The primary cost driver at the AGSA is staff cost. An analysis of this in relation to own hours revenue is as follows:

8 3.1 Analysis of key cost drivers as per Budget

9 3.2 Analysis of other key cost drivers (cont.) The other key cost drivers in relation to revenue are as follows:

Contract work creditors –AGSA allocates work to contract work creditors (CWCs) which enables it to fulfill its audit obligations. –There is no mark-up on contract work allocated, i.e. the auditee is charged the equivalent amount that the AGSA is charged by the contract work creditor. –While this enables the AGSA to fulfill its audit obligations and make a contribution to the transformation of the audit profession in the country, it impacts the AGSA’s bottom line due to a sacrifice of contribution to overheads (no mark-up). –The AGSA is committed to reducing vacancies, which is evident in the decrease in CWCs in relation to total income as per the table below:

11 4. Self-funding model –The AGSA is self-funded through fees charged to auditees. –The self-funding model is the funding model adopted by the AGSA. –Funds are required by the AGSA for: financing fixed assets financing working capital. –In order to achieve the above, the AGSA needs to make a surplus of between 4% and 6%. However, due to the inherent limitations of the old funding model, the AGSA could only budget for a 0,6% surplus for –As a result, the AGSA has reported recurring deficits for the past few years as follows: (R ) (R ) (R ) (However, after adjusting for the National Treasury grant [R33,5 million] and performance bonus written back to income [R9 million], the deficit increases to R58,613 million) –If this trend were to continue, the effect would eventually have been bankruptcy. –Management therefore commenced with investigations regarding a funding model. –This resulted in a presentation to SCoAG on 12 June –This presentation has been updated with current information and is now presented to you.

12 5. Presentation made to SCoAG on 12 June 2008 Background: The AGSA is mandated to provide audit services to the public sector. The AGSA is almost completely self-funded by fees secured from auditees. Fees are based on time spent on engagements calculated at tariffs linked to staff levels and rates of pay. A range of factors have led to a current suboptimal funding situation. The problem: An increasing proportion of income is linked to a capped 4% p.a. increase, whereby CPIX is 10,4%. The working capital model compounds the impact of funding restrictions. Actual fee-earning staff numbers who enable overhead recoveries have been lower than budgeted. Debtor collections are deteriorating. The impact: The AGSA has reported recurring deficits. Cash resources are deteriorating – reserves are being used to fund ongoing operations. Operating and capital expenditure has been curtailed in response. The AGSA’s ability to deliver on its mandate and achieve its strategic objectives may become threatened.

13 The process followed: Defined the problem and its associated causes. Benchmarked the AGSA against other Supreme Audit Institutions (SAIs). Evaluated alternative funding options. Consulted internally and externally. Selected a preferred option. The preferred option: Retain the current method of fee recovery from auditees with market-related annual tariff increases. Remove constraints on tariff model and re-introduce a mark-up factor based on direct costs. Allow a “catch-up” tariff increase in Allow market-related increases based on direct cost increases. Continuously re-evaluate the mark-up factor based on the relationship between direct and overhead costs. Increase the allowable surplus to between 4% and 6%. Motivation: Retains and ensures the AGSA’s independence. Ensures business sustainability by: generating of adequate surpluses for capital expenditure and strategic initiatives. enabling funding of vacancy contingencies supporting the working capital model enabling funding of self-initiated projects Cross-subsidising non-paying debtors.

14 6. Issue The AGSA is currently experiencing a decline in its funding position for the following reasons: In an effort to minimise the national cost of auditing, limitations were placed on tariff increases applied to a range of senior staffing bands. This has resulted in a “capping” of certain tariff increases to 4% while the current CPIX is 10,4%. As salaries adjust 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 increases in bad debts and a growing arrears 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.

15 7. Key financial indicators – Performance vs. budget

16 Closing cash balances – The AGSA’s funding position has been deteriorating annually until March The improvement in the year was due to a grant of R90 million received from National Treasury. During , the cash balance is expected to improve due to the new funding model introduced in April Key financial indicators – Movement in cash & cash equivalents

17 8. Drivers – “Capping” of tariffs In the financial year , 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%.

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 which have been applied are as follows: No new upper levels created Tariff increases limited to 4% per annum. All staff on Level A only increase revenue at 4%. The impact is cushioned by staffing progressing up levels until such time as the upper level is reached.

Drivers – Negative cash flow profile Fifty percent of working capital outflows occur 84 days prior to debtor receipts. The extended duration of debtor collections negatively impacts working capital.

20 9. Compounding factor - Vacancies Vacancies in the year have exceeded budget by 180%. A vacancy rate of 14% in would equate to a negative bottom line impact of R21,8 million due to the under-recovery of fixed overheads. The breakeven vacancy rate for is 10,5%.

Compounding factor – Debtors and bad debts

Comparison of debtor ageing over past four financial years

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 1 October 2007 and the 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 AGSA special interest group. Minister of Finance and Accountant-General 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 AGSA Exco approval.

24 Basis of FundingCountryTreasury approvalImplied assessment of independence No auditee chargingUSANoHigh NetherlandsYesModerate (1) JapanNoModerate (2) MoroccoYesLow (3) Parliamentary apportionment with minor charging CanadaYesModerate (4) NorwayNoHigh AustraliaNoHigh Ghana?Moderate ? (5) Parliamentary approval with more significant charging United KingdomNoHigh New ZealandNoHigh 11. 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 2 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.

Global benchmarking Conclusion The analysis highlights a common theme throughout the majority of democracies of 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.

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 within Parliament’s budget vote 3.Recover audit fees from relevant Treasury or Department of Provincial and Local Government. 4.Recover direct cost fees from auditees and fund indirect costs via a Parliamentary allocation.

Evaluation of options

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 re-introduce 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 percent to between 4% and 6% Should these principles not be accepted then the recommendation would be for Option 2 - AG budget included within Parliament’s budget vote

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Way forward The preferred funding option will be recommended after completing the following: Interact with National Treasury at DG level Interact with Minister of Finance Finalize document and presentation to SCoAG – 12 June 2008

Impact of new funding model The new funding model was approved by SCoAG for implementation on the 1 April Capping removed and charge out rates are now based on direct salary cost marked up by agreed factor. 2.A once-off non-refundable grant of R154 million to address working capital and Capex requirements (actual amount received was R90 million in January 2009). 3.Once-off tariff increase of between 25.9% and 30.9%. 4.The impact of the above changes is a 4% budgeted surplus for 2009/10. 5.The 4% surplus will contribute about 91% to the Capex requirement for the financial year (surplus R52 million; Capex R57 million). However, expenditure on capital expenditure would be subject to cash flow availability.

New funding model

Working capital management (way forward) Negative working capital is driven by - Historical deficits and poor cash collections Cash collections - Challenges have been experienced in cash collections especially with local government and statutory auditees. - We have introduced the following interventions to overcome these challenges: Billing will be done twice a month to improve frequency of collections in the foreseeable future with effect from October Three debt collectors have been employed to pursue collections on a full-time basis. Interest will be charged on all overdue accounts (accounts older than 31 days) using prime interest rate as from September Executive management are in discussions with National Treasury on a workable arrangement to ensure fees are paid on time. Project Clean Audit 2014 which has been launched by the Department of Cooperative Governance and Traditional Affairs to ensure that all municipalities achieve unqualified audit opinions on their annual financial statements will hopefully ensure that payment of AGSA accounts will be taken seriously. - We expect the above interventions to have the desired impact and this is evident in our cash-flow budget for 2009/10.

Conclusion Based on the budget and the actual results for the period April 2009 to July 2009, there is evidence indicating that the new funding model would have the desired financial impact. We are of the view that with the current cost control measures in place, the AGSA will maintain its cost ratio to revenue and is therefore expected to achieve the budget surplus of R65,984 million for The AGSA will have to monitor the direct cost/indirect cost relationship going forward, as the funding model calculates revenue based on direct cost marked up by an agreed factor. Any significant deviation in the relationship between direct cost and indirect cost will require the AGSA to revisit the mark-up factor.