Auditor-General consideration of alternate funding options

1. Auditor-Generalconsideration of alternate funding options SCoAG Presentation 12 June 2008 Internal document - confidential

2. 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.

3. Content • Background • Issue • Key financial indicators • Drivers of funding deficit • Compounding factors • Process to date • Global benchmarking • Options considered • Evaluation of options • Recommendation • Way forward

4. 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.

5. Actual Budget Variance (R'000) (R'000) (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 1 Contract 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 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) 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.

6. Financial Cash & cash equivalents year Opening Closing Change % (R'000) (R'000) (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% 3. Key financial indicators – movement in cash & cash equivalents. Bottom line – The Auditor-General’s funding position is deteriorating annually and is expected to worsen in the absence of remedial action.

7. Financial Capping impact Own hours year Number budget % Own of staff impacted hours impacted (R'000) income 2004-05 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% Budget Financial Surplus year Surplus / ratio Surplus Total audit Own hours Own hours (Deficit) R (audit ratio (own income income as % of total '000 income) 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% 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%.

8. Std Revenue Band & No. of recoverable % level Package staff hours Tariff Revenue increase Year Year 1 A 30 + 2 100 100.00 20,000 B 20 -30 3 100 90.00 27,000 C 10 - 20 4 100 80.00 32,000 79,000 Year 2 A 30 + 5 100 104.00 52,000 B 20 -30 2 100 93.60 18,720 C 10 - 20 2 100 83.20 16,640 87,360 10.6% Year 3 A 30 + 6 100 108.16 64,896 B 20 -30 3 100 97.34 29,203 C 10 - 20 0 100 86.53 0 94,099 7.7% Year 4 A 30 + 9 100 112.49 101,238 B 20 -30 0 100 101.24 0 C 10 - 20 0 100 89.99 0 101,238 7.6% Year 5 A 30 + 9 100 116.99 105,287 B 20 -30 0 100 105.29 0 C 10 - 20 0 100 93.59 0 105,287 4.0% • 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 4. Drivers – Demonstration of incremental impact of tariff capping. 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.

9. AG cash flow profile 2008-09 Audit income 1,500 1,294 1,000 500 Interest 8 R million 0 Capex Creditors -50 -500 Contractors -228 -368 Salaries -651 -1,000 -1,500 -15 0 15 30 45 60 69 Days from month-end 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.

10. Financial Vacancy percentage year Budget Actual YTD 2007-08 5% 14% 2008-09 8.3% ? 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%.

11. Debtor days Debtor group % of % Debtors 2006-07 2007-08 Change value Local 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% Provision Bad debts as % of Average Financial Total audit provision total debtor year income R (R'000) income days 2004-05 600,041 11,899 2.0% 55 2005-06 751,252 13,582 1.8% 50 2006-07 893,750 13,520 1.5% 55 2007-08 1,097,798 22,113 2.0% 69 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.

12. 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.

13. 7. Global benchmarking

14. 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.

15. 8. Options considered Four options were considered in detail. These are: • 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.

16. 9. Evaluation of options The results of the process are summarised in the following table * : Decision criteria Option alignment to criteria Charge & Charge/ Charge Treasury Parliament auditee Parliament collection hybrid No. Detail 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 Flexibility to dynamically manage changes in 5 demand and supply. 6 Promotes efficiencies in the cost of auditing Promotion of rational economic behaviour 7 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%.

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

18. Revised request for unconditional grant required to address known and committed or estimated future expenditure not funded within the current funding model May 2008 Discount rate Detail Total NPV 2005-06 Uncollectable debtors 2005-06 2,207,805 2,695,785 10.50% 2006-07 Uncollectable debtors 2006/07 8,384,230 9,264,574 10.50% 2007/08 2007/08 actual (unaudited) operating cash flow shortfall 21,276,000 Reserves for future liabilities 25,274,273 Uncollectable debtors 2007-08 14,938,190 Capital expenditure postponement to alleviate funding position 4,545,320 Total for 2007-08 66,033,782 66,033,782 2008-09 2008-09 forecast operating cash flow shortfall after adjustment for 15,067,537 timing of component cash flows. Reserves for future liabilities 27,004,180 Uncollectable debtors 2008-09 12,939,810 Capital expenditure postponement to alleviate funding position 4,073,212 Total for 2008-09 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 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 (R45 million provided over five years) Note 2 The discount rate is the weighted average PIC investment rate of return

19. 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.