Auditor-General consideration 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 – performance vs. budget. Bottom Line Fixed and variable costs maintained to 97% of budget Own hours performance, led by vacancies, has driven a deficit variance of R25.5 million. Actual (R'000) Budget (R'000) Variance (R'000)% Revenue1,130,405 1,025, ,424 10% Audit income1,114,195 1,013, ,965 10% Own hours647, ,722 (53,359) -8%Note 1 Contract work423, , ,767 69% Subsistence & travel43,540 61,983 (18,443) -30% Other income16,210 12,751 3,459 27% Expenditure1,141,772 1,011, ,950 13% Contract work423, ,525 (172,767) -69% Subsistence & travel43,540 61,983 18,443 30% Variable costs421, ,167 (1,338) 0% Fixed overhead costs253, ,147 25,712 9% Net surplus / (deficit)(11,367) 14,159 (25,526) -180% Note 1 This variance is made up of the following: Additional vacancies(64,711) Higher recovery rates28,354 Lower utilisation(19,701) Net other recoveries2,700 (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) % ,232156,5089,2766% ,508165,4318,9236% ,431138,594-26,837-16% ,594117,318-21,276-15% Financial year Cash & cash equivalents

4. 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%. Number of staff impacted Own hours budget impacted (R'000) % Own hours income ,2404% ,5744% ,09417% ,73928% ,40844% 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) ,275456,64773%36,9005.9%8.1% ,308510,92572%43,7646.1%8.6% ,466578,34866%12,9001.5%2.2% ,013,230700,72269%14,1591.4%2.0% ,292,643857,09766%8,3590.6%1.0% Budget Financial 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.

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.

5. Compounding factor - Vacancies Vacancies in the year have exceeded budget by 280%. 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 break-even vacancy rate for is 10.5%. In addition, the budgeted average recovery rate (number of recoverable hours per annum) for was missed by 1.9%. BudgetActual YTD %14% %? 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 % Change Local authorities44% % Provincial government25%213462% National government16%43-25% Statutory entities13% % Total % Debtor days % of Debtors value Debtor group ,04111,8992.0% ,25213,5821.8% ,75013,5201.5% ,097,79822,1132.0%69 Bad debts provision (R'000) Financial year Total 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 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 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 Theresultsof the processare summarised in the following table*: Decision criteria No.Detail Charge auditeeParliament Charge & Treasury collection Charge/ Parliament hybrid 1Assures financial viability of the AG 2Simplicity of the solution and its operation 3Assures the independence of the AG 4Transparency of costs for ext. stakeholders 5 Flexibility to dynamically manage changes in demand and supply. 6Promotes efficiencies in the cost of auditing 7 Promotion 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 DetailTotalNPV Discount rate Uncollectable debtors ,207,8052,695, % Uncollectable debtors 2006/078,384,2309,264, % 2007/ /08 actual (unaudited) operating cash flow shortfall 21,276,000 Reserves for future liabilities25,274,273 Uncollectable debtors ,938,190 Capital expenditure postponement to alleviate funding position4,545,320 Total for ,033, forecast operating cash flow shortfall after adjustment for timing of component cash flows. 15,067,537 Reserves for future liabilities27,004,180 Uncollectable debtors ,939,810 Capital expenditure postponement to alleviate funding position4,073,212 Total for ,084,73956,137, % Contingency ( ) Anticipated loss of contribution due to anticipated vacancy rate exceeding budgeted vacancy rate (assumed 14% vacancy - average for )21,765,46220,679, % 157,476,018154,811,434 Note 1 Note 2 The 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.