Opening Statement to the Committee on Public Accounts

Public Accounts of Canada 1998

Thank you, Mr. Chairman, for the opportunity to be here with you today to discuss the government's 1997-98 financial statements, including my opinion and observations thereon. These financial statements are a key accountability document of the government that contain significant messages on the financial condition of the government. Even in years where there are no disagreements between the government and the Auditor General, it is important for the Committee to review them and I appreciate your efforts in this important activity.

As it clearly relates to my opinion this year, I am also pleased to discuss Chapter 9 of my April 1998 Report.

With me today is Mr. Ron Thompson, Assistant Auditor General, and Mr. John Hodgins, Principal, who are responsible for our annual audit of the government's financial statements.

We last appeared before this Committee to talk about the Public Accounts almost exactly one year ago. In its Seventh Report on that hearing, the Committee stated that: "transparency and accountability to Parliament and Canadians are best served by recording non-recurring liabilities in the year in which they are incurred, provided the enabling legislation or authorization for payments receives parliamentary approval before the financial statements for that year are closed."

I agree that if a liability is incurred, it should be recorded in the accounts and shown on the face of the financial statements. My disagreement with the government in 1997, and again this year, deals squarely with the recording of liabilities that have not been incurred.

Appended to the Committee's Seventh Report was a dissenting opinion that recommended, in part, that the government and my Office reconcile their differences. Unfortunately, Mr. Chairman, we were unable to do so in 1998. The February 1998 Budget announced the proposal to create the Canada Millennium Scholarship Foundation and include a $2.5 billion liability to the Foundation in the 1997-98 financial statements. We took strong exception to this because the government was intending to book this liability in 1998, whether or not it was incurred in that year by reference to objective accounting standards.

We therefore produced Chapter 9 of our April 1998 Report.

My hope in publishing the chapter was that the government would reconsider its proposed accounting for the Foundation when finalizing its 1998 financial statements. However, the financial statements we are looking at today do include the Foundation transaction, and I am disappointed that the government changed its accounting policies so that compliance would be assured.

My opinion on the government's 1998 financial statements is therefore qualified with regard to their fair presentation. But because my Act requires me to give an opinion on whether the government has complied with its own accounting policies, my opinion with regard to compliance has no qualifications.

My qualification related to the accounting followed for the Foundation is described in further detail in my Observations.

In that part of my Observations, I refer to testimony presented on this same issue before the House of Commons Standing Committee on Finance on 6 May 1998, and two letters from public accounting firms that were tabled with that Committee.

We carefully analyzed those letters before finalizing our opinion on the 1998 financial statements. Our analysis - and the two letters - are appended to this statement as Annex A. In addition, Chapter 9 includes a very technical accounting debate on this issue. Annex B to this statement summarizes these technical accounting interpretations. Mr. Chairman, I would request that these Annexes to my opening statement be appended to the record of proceedings of today's hearing.

Let me make two points on the analysis in Annex A. First, these public accounting firms did not advise the government to follow the method of accounting with which I disagree. The letters only provided references to objective accounting standards, in both the public and private sectors, that could be considered in deciding how to account for transactions such as the Foundation. And second, contrary to reports that the private sector follows this method of accounting, let me assure you that it does not.

My Observations also include a description of my audit and matters that I consider require continuing attention by the government. In particular, I raise a concern related to the creation of arm's length organizations to carry out government activities. And I am also very concerned with the government's ability to fully and fairly account for Aboriginal claims in the financial statements.

Mr. Chairman, in conversations with the press and others after the 1998 Public Accounts were tabled, two questions were frequently asked of me.

First, I was asked what more I can do, as Auditor General, to encourage the government to fully adopt objective accounting standards. My answer is quite simple: I can do nothing further about 1997 and 1998; those years are closed. But I would welcome the opportunity to continue discussions with government officials to try to head off similar problems in future years.

Second, I was asked what I consider to be the ramifications to the issue I raised this year. My answer is a bit more complicated and is included in my conclusions to the Observations.

A qualified opinion from the Auditor General is serious as it affects the credibility of the financial information reported to Canadians by the government. Although it is unlikely that a qualified opinion from me will result in higher debt costs to the government, it can create skepticism in the minds of Canadians and erode their confidence in government institutions.

I would urge this Committee to recommend that the government follow objective accounting standards in preparing the annual financial statements, and to discuss with my Office how best to resolve the contentious accounting and financial reporting issues that are bound to arise from time to time.

Complex accounting issues do arise quite regularly. But it is rare that I am forced to render a qualified opinion. This year, for example, we successfully resolved several difficult accounting issues with the government; we resolved a long-standing problem with pension accounting, and we came to an agreement with the government, albeit a temporary one, on the recording of Aboriginal claims. Our communications with government officials are excellent and you should know that serious disagreements are the exception rather than the rule. I consider my role in the preparation of the government's financial statements to be one of the most important parts of my mandate and I hope that I will not have to render a qualified opinion again.

As this Committee begins to explore the area of international accounting standards and the practices of other national governments you will see that Canada is one of the few national governments in the world that produces audited financial statements. I am proud of that. Over the years, the Public Accounts Committee has played a strong role in this accomplishment.

Mr. Chairman, that concludes my opening statement and we would be pleased to answer your Committee's questions.

ANNEX A

Comments by the Office of the Auditor General on Private Sector Accounting Advice to the Government

Introduction and Purpose

On 18 March 1998, Messrs. Alain Benedetti and Douglas Cameron of Ernst & Young, wrote to the Minister of Finance to describe how a commercial enterprise might analyse and record a transaction such as the $2.5 billion transfer payment to the Canada Millennium Scholarship Foundation, under accounting principles that are generally accepted for commercial enterprises. This letter is attached to this annex. On 4 May 1998, Coopers & Lybrand wrote to the Deputy Comptroller General regarding factors to consider in assessing the appropriateness of the accounting treatment for this same transaction. This letter is also attached to this annex. These letters were made public at a hearing of the House of Commons Standing Committee on Finance held on 6 May 1998. The purpose of this paper is to provide detailed comments on those letters.

Ernst & Young letter dated 18 March 1998

The Ernst & Young letter makes a number of significant points as summarized below, together with our reaction to them.

1. The second paragraph of the letter states "...it should be noted that accounting standards for commercial enterprises are not directly applicable to the Government's financial statements."

2. The section of the letter entitled Recognition Criteria and The Nature of Liabilities, begins by examining Sections 1000.43 and .44 of the CICA Handbook. It then explains that "another approach" to assessing the issue is to consider whether the Government has incurred a liability as defined in Sections 1000.32 to 34. Section 1000 recommends that there is only one process to be followed in determining whether a liability should be recorded -- first determine whether a liability exists and then, if it does, determine when it should be recognized. In the case of the Canada Millennium Scholarship Foundation (the Foundation), we do not believe that the proposed $2.5 billion transfer as at 31 March 1998 meets the definition of liability in Section 1000.33 (c) because the transaction or event obligating the Government -- enactment by Parliament of the Budget Implementation Act -- had not occurred as at that date. Because the $2.5 billion is a grant, the Foundation did not have an enforceable right against the Government until Parliamentary approval was obtained.

Parliament's role in our system of democratic government is fundamental, and should never be viewed as merely a rubber stamp of a government's announced intentions, even if those announced intentions are included in the Budget as a firm commitment. Accordingly, we believe strongly that actions taken by Parliament after the year end cannot properly be construed as evidence that Parliamentary approval had, in substance, been obtained as at year end.

3. The next section of the letter, Management's Plans as an Accounting Event, sets out three specific references to the CICA Handbook to illustrate that, in some circumstances, commercial enterprises are required to recognize liabilities based on "management's plans or commitments". But as pointed out quite carefully in the letter, these requirements apply to specific fact situations and are not readily applied by analogy to other circumstances. In this respect, each of the three references deals with activities that exist as at the end of a fiscal year and that are being discontinued, unlike the Foundation which is a new activity to be carried out by an entity that has not yet been created. To our knowledge, there is no provision in the Handbook that permits liabilities and expenses to be recognized in the current year in anticipation of activities to be carried out in a subsequent year. In fact, EIC 60 of the CICA Handbook specifically prohibits such accruals. Clearly, the fact situations referred to in this section of the letter are not analogous to the Foundation situation.

Accordingly, we do not believe that the discussion in this section of the letter demonstrates authoritative support for determining that commercial enterprises should record a liability for a situation like the Foundation. In fact, we cannot think of an analogous situation in the private sector, simply because commercial enterprises do not, in all material respects, make non-reciprocal "transfer payments".

4. The last section of the letter entitled Similarities with Other Commercial Transactions, suggests that the formation and funding of the Foundation are similar to "carve-outs" in a commercial enterprise, and that "carve-outs" are recorded in advance of completion under certain limited or unusual circumstances. However, as pointed out in the first paragraph of this section, ownership of the new entity is typically transferred to existing shareholders of the original entity. Since there is continuity of beneficial ownership of the same net assets throughout the carve-out process, the timing of recognition of the carve-out is generally not a critical issue.

It seems to us that this condition would clearly not apply in the case of the Foundation because it is being set up to be at arm's length from the Government in order to avoid the need to consolidate it in the annual financial statements. Because carve-outs are not analogous to the Foundation situation, we do not see how this section of the letter demonstrates authoritative support for determining when commercial enterprises should recognize a liability for a situation like the Foundation.

In summary, the Ernst & Young letter responds to the request of the Minister of Finance by setting out a number of factors that business firms are required to consider in determining whether to recognize liabilities at year end under accounting principles that are generally accepted for commercial enterprises. However, for the reasons set out above, we do not believe that the letter supports a conclusion that, in the circumstances faced by the Government with respect to the Foundation, commercial enterprises would record a liability as at 31 March 1998.

Coopers & Lybrand letter dated 4 May 1998

The Coopers & Lybrand letter makes a number of significant points as summarized below. The location of these points in the letter is indicated in brackets.

1. Although there is no requirement that the Government of Canada comply with accounting recommendations of the Public Sector Accounting and Auditing Board (PSAAB), such recommendations should figure prominently in any evaluation of the Government's financial reporting practices. (Top of page 2)

2. PSAAB has issued specific recommendations in Public Sector Accounting and Auditing Handbook Section PS 3410 on how Canadian governments should account for transfer payments. (Pages 3 and 4).

3. Payment or payments by the Government to the Canada Millennium Scholarship Foundation (the Foundation) would constitute a grant as defined in and for the purpose of applying PS 3410. (About the middle of page 4)

4. In accordance with PSAAB recommendations, in order for a grant to become non-discretionary and thus an obligation of the Government of Canada, two conditions must be met: (a) the Government of Canada must commit to make the transfer; and, (b) there must be legislative approval for the grant or for the program under which the grant is made. (Bottom of page 4)

5. Condition (a) is not met because the Government of Canada does not have the authority "to commit" when the expenditure does not relate to an existing program or other arrangement previously approved by Parliament. (Top of page 6)

6. As to condition (b), "second reading" is the earliest point at which the requisite Parliamentary approval might be considered to have been substantively obtained. (Bottom of page 7) However, actions taken by Parliament after the year end cannot properly be construed as evidence that Parliamentary approval had, in substance, been obtained as at year end, which is a prerequisite to accruing the obligation to create the Foundation. (Bottom of page 8).

7. Since the transfer is in the nature of a grant as discussed at point 3 above, it is completely within the discretion of the grantor (the Government of Canada). Thus, even if the Foundation had existed as at the end of the year, it would not have had an enforceable right (against the Government of Canada) until such time as the Government of Canada commits to the funding which, as discussed at point 5 above, the Government does not have the authority to do in this instance. (Top of page 9)

8. In formulating accounting recommendations for Canadian governments, PSAAB has intentionally chosen not to adopt a commitments-based approach for recognizing transactions. This has been done in order to faithfully mirror the legislative process whereby all spending, revenue-raising, investing and borrowing must be sanctioned by legislation. (Bottom of page 9)

9. Although note disclosure cannot compensate for an inappropriate accrual, if the Government of Canada does record a liability to the Foundation as at 31 March 1998 the note disclosure proposed by the Government of Canada could permit the reader of the financial statements to make the necessary adjustments to overcome the effect of the inappropriate accrual. However, if it were perceived that the Government of Canada was moving towards something like a commitments or intentions-based approach to financial reporting, the ability of the reader to make compensating adjustments to the statements might change. (Top of page 10)

In summary, these above points speak for themselves and generally require no further analysis from our point of view. Point 9 above, however, requires some explanation. The implication is that if note disclosure is used to compensate for an inappropriate accrual, the Auditor General would be required to give a 'qualified' opinion on the financial statements. Further, if the ability of the reader to make compensating adjustments to the statements was compromised by the Government moving to a commitments or intentions-based approach to financial reporting, the Auditor General could be required to issue an 'adverse' opinion on the statements. An adverse opinion is far more serious than a qualified opinion, because the auditor reports that the financial statements are not presented fairly, rather than saying that they are presented fairly except for certain reservations.

Conclusion

ANNEX B

Summary of Technical Accounting Interpretations

Appendix B to chapter 9 is a very technical accounting debate between the government and the Office of the Auditor General, using various recommendations and other information published by the Canadian Institute of Chartered Accountants. The central issue on which we disagree is the point in time at which the government should recognize transfer payments as liabilities and expenditures. The two views are as follows:

GOVERNMENT	AUDITOR GENERAL
A liability should be recognized when a public commitment to provide funding to an arm's length entity is made, provided proper parliamentary authority is in place before the financial statements are closed.	A liability should be recognized when the recipient has fulfilled the terms of a contractual transfer agreement.

The government believes that its accounting policies and practices generally conform to the recommendations of the CICA. The one-page summary on the reverse side of this introduction is intended to help "non-accountants" understand the government's specific technical references, and our reasoning for why these references do not support their position. It lists the main points in a side-by-side format so that interested readers do not have to find the arguments and counter-arguments in three separate pieces of correspondence.

Readers should be aware, however, that the Canadian Institute of Chartered Accountants (CICA) maintains two Handbooks of objective accounting standards:

1. The CICA Handbook: This three-volume Handbook is intended to apply to all types of profit oriented enterprises and to not-for-profit organizations.

2. The CICA Public Sector Accounting and Auditing Handbook: This Handbook is intended to apply to federal, provincial, territorial and local governments, government organizations, organizations jointly owned or controlled by two or more governments, and school boards.

Many of the government's arguments are taken from the CICA Handbook, much of which is not relevant to the federal government.

In addition, readers should be aware that the arguments and counter-arguments primarily use, as examples, the accounting for the transfers to the Canada Foundation for Innovation and the Canada Millennium Scholarship Foundation. While chapter 9 describes our specific concerns with these transactions as well as the transaction regarding harmonizing GST and PST, the broader message contained in the chapter deals with the importance of complying with objective accounting standards to maintain credibility of the government's reported financial results.

GOVERNMENT	AUDITOR GENERAL
A liability does not have to be legally enforceable; it can be based on equitable (ethical or moral) or constructive (inferred from the facts) obligations. The event of making a decision establishes both an equitable and constructive obligation, provided Parliament subsequently provides the necessary authority.	This text comes from Section 1000 of the CICA Handbook. That section covers broad concepts and is not to be used to override any accounting principle that is considered to be generally accepted, such as CICA Public Sector Handbook Section 3410 on government transfers.
It is appropriate to recognize liabilities under the concept of "substantive enactment", i.e. recognizing liabilities if there is persuasive evidence that the government is able and committed to enacting the proposed legislation in the foreseeable future.	The concept of "substantive enactment" is found in CICA Handbook Section 3465 on Income Taxes. That section deals with how business firms estimate future income tax liabilities that are already recognized. "Substantive enactment" is only used for measurement of the liability, not whether the liability actually exists.
Transactions and events are accounted for and presented in a manner that conveys their substance rather than necessarily their legal or other form. To not recognize the obligations to the foundations on the basis that the "legal work" is not yet in place would be misleading. This philosophy is also used to recognize restructuring costs when the authoritative decision is made to incur them.	The concept of "substance over form" is found in both the CICA Handbook and the CICA Public Sector Handbook. It requires the use of judgment to account for transfers to reflect the substance of underlying events rather than the form or funding pattern -- but only where CICA guidance is not precise. In the case of the foundations, guidance is precise in CICA Public Sector Handbook Section 3410 -- a recipient must exist and a funding agreement must be in place before a liability exists. No judgment is necessary in this case. Restructuring costs are dealt with in the Emerging Issues section of the CICA Handbook (EIC-60). However, it was created to limit costs that business firms could recognize, based solely on management decisions in a year, to those that relate to exiting an existing activity.
Events occurring between the date of the financial statements and their completion should be considered.	Such events are normally used to confirm the measurement of a liability that already exists -- they are normally not used to determine whether a liability exists in the first place. If a liability does not exist at the end of a fiscal year, no amount of "subsequent events" would change this.

Note to Reader: This summary is intended to provide an overview of technical accounting interpretations only. Readers are encouraged to read the entire text of Appendix B in chapter 9.