LGFP CONFERENCE Appreciating Depreciation QAO Perspective Patrick Flemming Brendan Macrae 25 November 2014
Outline What are financial reporting risks impacting on assets? How do we audit: Ø financial sustainability ratios Ø non current asset accounting policies Ø AASB 13 disclosures Ø asset valuations What are common audit assets relating to assets? Challenges valuing assets
Financial reporting risks Capital v recurrent revenue Capital v recurrent expenses Depreciation and amortization expenses Capital renewals Asset valuations PP&E movements note AASB 13 disclosures Asset accounting policy notes Current year financial sustainability statement
Financial reporting risks Classification of grants between recurrent and capital impact on ratio calculations Accounting for expenditure on assets as either capital or repairs and maintenance Capital renewals and depreciation expense impact on ratio calculations Manipulation of depreciation to provide results that do not reflect reality Not reflecting true sustainability issues
Financial reporting risks ASA 240 Auditing Accounting Estimates Assess degree of uncertainty Judgment involved, sensitivity to changes in assumptions, reliability of external data Observable v unobservable inputs Susceptibility to possibility of management bias Are significant assumptions reasonable? Are there indicators of bias? Review reasonableness of prior year estimates
Financial sustainability We audit the major impacts on ratios Operating surplus ratio and net financial liabilities ratio Classification of capital income and capital expenses Classification of capital grants and recurrent grants Repairs and maintenance expense v capital expenditure Asset sustainability ratio Calculating capital renewals Repairs and maintenance expense v capital expenditure Appropriateness of depreciation expense
Asset sustainability ratio More guidance required from department with examples provided (LG RtP 2014) Compliance with sustainability guidelines Asset sustainability ratio - asset renewal should exceed depreciation Target >90% Are assets being replaced at end of useful life? Renewing, restoring or replacing existing assets Low % may indicate poor asset management plans 20 under 50% in 2013 (12 indigenous)
Asset management plans Reported 31% not having uptodate AMP as at 30 June 2013 (LG RtP 2014) Preliminary 2014 results now upto 40% Robustness and maturity not tested Important reference point to establish and test assumptions Estimated useful lifes, potential obsolescence, Asset performance standards condition assessments, planned maintenance programs Must include estimated expenditure for renewals, upgrading, additions (LG Regs)
Accounting policies Routine operating maintenance, repair costs and minor renewals to maintain the operational capacity of the non current asset is expenses as incurred, while expenditure that relates to replacement of a major component of an asset to maintain its service potential is capitalized Depreciation methods, estimated useful lives and residual values of PP&E are reviewed at the end of each reporting period and adjusted where necessary to reflect any changes in the pattern of consumption, physical wear and tear, technical or commercial obsolescence or management intentions. Condition assessments are used to estimate useful lifes.
Audit issues & observations Prior year error in most accounts around assets Assets found, previous incorrect assumptions AASB 13 disclosures highlighted inputs and assumptions which needed to be supported Poor asset management plans Non current asset policies out of date or inaccurate Low asset recording thresholds Capital v R&M policy needs improvement
Audit issues & observations Better documentation of condition assessments where full valuations not performed Better documentation of review of estimated useful lifes and residual values Assets with WDV of nil but still in use Consider written representations from engineers/ asset custodians Reconciliation of asset register to other databases GIS, rates system land records Engineer v accountants definitions of capital v R&M
Audit issues and observations Improvements required in identifying renewals spending (purposes of AMP and ratios) Are estimated useful lifes reflecting reality? Benchmarking occurring across councils (work being done by FNQROC) - residual values, estimated useful lifes Initiate own benchmarking Look at other Council s annual reports
Asset valuations observations Valuation and Depreciation of Assets Significant volatility continues to be experienced signaling underlying reliability and consistency issues Lack of understanding by councils of their financial reporting assumptions and whether these agree to their asset management plans / practices Inconsistencies between data and assumptions used for financial statement purposes and asset management purposes can lead to inappropriate decision making Financial reports not reflecting financial reality Significant balance in council s financial statements (both asset values and depreciation expense)
Asset valuations observations Significant volatility in valuations: incomplete or inaccurate underlying asset component data valuation and depreciation treated purely as a financial reporting process rather than reflecting council s anticipated asset management practices changing methodologies and assumptions inappropriately to derive a particular financial statement outcome apply unrealistic assumptions in valuation and depreciation calculations.
Asset valuations observations Councils should obtain sufficient evidence to support the key inputs and assumptions used in determining asset values condition assessments unit rates useful lives residual values depreciation method appropriateness of indices Ensure consistency with actual maintenance and replacement strategies as per asset management plans Align financial data with engineering data
Applying the cost approach - principles current replacement cost the amount that would be required currently to replace the service capacity of an asset adjusted for obsolescence: physical deterioration functional (technological) external (economic) obsolescence
Adjusted for obsolescence Physical obsolescence physical deterioration of an asset or its components resulting from its age and normal usage. Functional obsolescence inefficiencies in the subject asset compared to its replacement - two forms: changes in design, materials, technology or manufacturing/construction techniques resulting modern equivalent assets with lower capital costs than the subject asset improvements in design or excess capacity resulting in modern equivalent assets with lower operating costs than the subject asset External obsolescence loss of utility value caused by economic or locational factors external to the asset economic obsolescence when the external factors relate to changes in supply or demand for the asset or for products or services produced by the asset external obsolescence adjustment is deducted after physical deterioration and functional obsolescence
Case study: schools in Victoria valued on a DRC basis - by 30 June 2013 write down carrying values of school buildings by $2.5 billion current replacement cost - based on the size of school that would be required using the higher of current student enrolments or forecast long-term enrolments. premise - would not replace the existing area of a school if the current or forecast future student enrolments do not support a school of the current size and so is considered to be economically obsolete
Case study reasons for qualification relies solely on the number of students enrolled ignores other services that the school currently facilitates such as before and after school care programs ignores common areas used by children regardless of how many students there are (eg assumes that children do not need 26 per cent of a library or gym). unable to fully support the assumptions and judgements used in the calculation (reliable measurement)
Road Valuations - attributes Componentisation Segmentation Condition assessments On going capital and recurrent costs Residual values Long lived
Principles: componentisation Source: Guidelines for measuring and repor4ng the condi4on of road assets (May 2006), Local Government Victoria
Principles: segmentation Source: Guide to Asset Management Part 8: Asset Valua4on and Audit, Austroads, 2009
Depreciation of roads example Example of deprecia/on of a sealed road by components Source: Local Government Victoria
Depreciation of roads example Source: Austroads 2014 Good Prac)ce in Reseal Programming
Depreciation of pipes example
Depreciation of pipes example
Depreciation of pipes example