Annex 8
The Government’s Response to the Auditor General’s Observations on the 2002 Financial Statements

This annex reviews the "Observations" made by the Auditor General on the financial statements of the Government of Canada for fiscal year 2001–02.

The Auditor General expressed a "clean" opinion on the Government’s financial statements for 2001–02. This marks the 9^th time in the last 11 years that the Auditor General has given a "clean" opinion on the Government’s financial statements.

However, the Auditor General raised a number of matters for Parliament’s attention in her Observations on the 2002 Public Accounts of Canada:

• compliance with the Employment Insurance Act;

• transfers to foundations;

• accrual accounting;

• management estimates;

• communicating Canada’s financial results to Parliament and Canadians;

• offsetting Canada Child Tax Benefit disbursements against revenues ("netting"); and

• statement of transactions of the Debt Servicing and Reduction Account.

The Government’s response to a number of these observations is addressed in Chapter 7, "Improving Expenditure Management and Accountability." This annex summarizes the responses contained in that chapter as well as the other observations.

Compliance With the Employment Insurance Act

In the 2002 Observations, the Auditor General noted that she was unable to conclude that the setting of premium rates observed the intent of the Employment Insurance Act.

The Employment Insurance Act required that the Canada Employment Insurance Commission set premium rates at levels that would cover program costs while keeping rates relatively stable over the business cycle.

The December 1999 Report of the Standing Committee on Finance noted that the current rate-setting process, "…involves not only a ‘look forward’ process in assessing the level of revenues sufficient to cover program costs over a business cycle, but also a ‘look back’ process by taking into consideration the level of any past excesses or shortfalls of revenues relative to program costs." As employment insurance premium revenues and program costs are consolidated with other programs in the Government’s financial statements, the "look back" provision, the Report concluded, would cause serious disruptions to the overall management of the federal government’s budget. The Report recommended, therefore, that employment insurance rates should be set on the basis of the level of revenue needed to cover program costs over the business cycle looking forward and not take into account the level of the cumulative surplus or deficit.

Recognizing these difficulties, the Government announced that it would undertake a review of the premium rate-setting process. In the interim, Bill C-2 gave power to the Governor in Council to set the rates for 2002 and 2003.

With this budget, the Government will launch consultations on a new permanent rate-setting regime for 2005 and beyond based on the following principles, which draw from the recommendations made by the Standing Committee on Finance as well as advice received in pre-budget consultations:

• premium rates should be set transparently;

• premium rates should be set on the basis of independent expert advice;

• expected premium revenues should correspond to expected program costs;

• premium rate-setting should mitigate the impact on the business cycle; and

• premium rates should be relatively stable over time.

The Government intends to implement the new rate-setting regime through legislation for 2005. In the interim, the Government proposes to set the employee premium rate for 2004 at $1.98 by legislation. Based on the private sector economic forecasts used in the budget and proposed changes to the program, it is estimated that this rate would generate premium revenues equal to projected program costs for 2004.

Transfers to Foundations

The Auditor General expressed concern with the way the Government accounts for transfers to foundations. The Government’s accounting policy is to recognize a transfer to a foundation in the year in which the transfer takes place. The Auditor General urged the Government to change its accounting policy to recognize expenditures when the foundation transfers the funds to the ultimate recipient.

The booking of the liabilities to these foundations is an area where existing accounting standards do not offer explicit guidance, and professional judgment must be brought to bear. Recognizing this, the Government consulted two major accounting firms, both of which endorsed the Government’s approach. Furthermore, the previous Auditor General reported that he undertook research on the accounting treatment of such "special purpose entities" to determine if they should be consolidated in the Government’s financial statements as part of the Government’s overall reporting entity. From his research, he concluded that the application of current PSAB (Canadian Institute of Chartered Accountants’ Public Sector Accounting Board) accounting recommendations requires considerable judgment to determine the appropriate accounting treatment. A PSAB task force is currently reviewing this issue to determine if additional guidance is required.

The Government has consistently argued that foundations such as the Canada Foundation for Innovation are at arm’s length from the Government, so established liabilities to such foundations should be recorded in the years in which the decisions to provide funding are made. Decisions on the projects selected are made by the directors of the foundations, under broad agreements signed with the Government. The Government continues to believe that, in applying PSAB recommendations, these entities should not be considered part of government and, therefore, not consolidated within its financial statements.

The current accounting treatment enhances transparency and accountability to Parliament and Canadians. As such, in accordance with its stated accounting policy, non-recurring liabilities will be recognized in the year the decision to incur them is made, provided the enabling legislation or authorization for payment receives parliamentary approval before the financial statements for that year are finalized.

Consistent with Treasury Board’s new Policy on Alternative Service Delivery, which came into effect on April 1, 2002, this budget outlines the principles which the Government would consider in using a foundation to deliver public policy. These are:

• Foundations should focus on a specific area of opportunity, in which general policy direction is identified through legislation and/or a funding agreement.

• Foundations should harness the insight and decision-making ability of independent boards of directors with direct experience and knowledge about the issues at stake.

• Decisions by foundations should be made using expert peer review.

• Foundations should be provided with guaranteed funding that goes beyond the annual parliamentary appropriations to give the foundations the financial stability needed for comprehensive medium- and long-term planning that is essential in their specific area of opportunity.

• Foundations should have the opportunity and hence the ability to lever additional funds from other levels of government and the private sector.

In addition to clarifying the policy principles underlying the use of foundations, the Government will make a number of changes to enhance the accountability and governance arrangements of these foundations to Canadians and parliamentarians, including:

• The Government will seek parliamentary approval of purpose and funding through direct legislation for those foundations which are significant either from a policy or financial perspective. In all cases Parliament will need to approve funding for foundations. As noted above, the Government’s use of foundations will respect the requirements of the Treasury Board’s Policy on Alternative Service Delivery.

• Foundations will be required to provide corporate plans annually to the Minister responsible for administering the funding agreement over the duration of the agreement. Such corporate plans will include planned expenditures, objectives and performance expectations relating to the federal funding. Summaries of these plans will be made public by the responsible Minister and hence available to Parliament. In addition, the departmental Reports on Plans and Priorities, which are tabled in Parliament, will incorporate the significant expected results to be achieved and situate these within departments’ overall plans and priorities.

• The Annual Report for each foundation, including relevant performance reporting, audited financial statements and evaluation results, will be presented to the Minister responsible for the funding agreement and made public. In addition, the Department responsible for administering the funding agreement will report on the significant results achieved by the foundation(s) in its Departmental Performance Report for the duration of the funding agreement and situate these within the Department’s overall results achieved.

• Foundations will be required to conduct independent evaluations, present these to the Minister responsible and make them public. Departments will incorporate any significant findings within their annual Departmental Performance Reports, which are tabled annually in Parliament.

• All foundations’ Annual Reports will contain performance information as well as audited financial statements prepared in accordance with Generally Accepted Accounting Principles. As foundations are independent not-for-profit organizations that have their own governance structures and members, it is the members, as "shareholders" of the foundation, who appoint their external auditor and to whom the external auditor reports. Foundations will be subject to independent evaluations, comprehensive performance reporting and compliance audits relative to the use of federal funding. These would cover most of the expectations relating to value-for-money audits.

• Funding agreements reached with foundations arising from the 2001 budget contain provisions for audits of compliance with funding agreements and for program evaluations. This will be the case for all new foundations going forward. Departmental internal auditors, external auditors or the Auditor General, at the discretion of the Minister, could undertake these audits.

• There will be provisions for intervention in all funding agreements in the event the responsible Minister feels that there have been deviations from the terms of the funding agreement. The provisions will provide for dispute resolution mechanisms.

• In all new funding agreements provisions will be put in place so that the responsible Minister may, at his/her discretion, recover unspent funds in the event of winding up.

The Government will consult with existing foundations to explore the scope for making changes to their agreements with the Government to incorporate these new requirements.

Accrual Accounting

In the December 2001 budget the Government announced a delay in the implementation of full accrual accounting, as certain important components of information required to implement accrual accounting had not yet been finalized. In her 2002 Observations the Auditor General encouraged the Government to implement accrual accounting in the 2002–03 financial statements.

The Government is moving to full accrual accounting in this budget. The 2003 budget fiscal projections are presented on a full accrual basis. Moreover, the 2002–03 financial statements will be audited on that basis. For more details see Annex 6.

Management Estimates

The Government’s financial statements include a number of management estimates for valuation allowances for loans and investments, pension liabilities and estimates of losses arising from contingent liabilities. In her 2002 Observations the Auditor General encouraged the Government to strengthen the way it develops its management estimates and to implement a more rigorous and timely challenge and review function.

The Government has taken steps to strengthen monitoring and development of its management estimates. It has established a senior level committee, consisting of representatives of the Treasury Board Secretariat and the Department of Finance, who meet with representatives of the Office of the Auditor General on a quarterly basis to review the management estimates.

Communicating Canada’s Financial Results to Parliament and Canadians

In her 2002 Observations the Auditor General stated that both the Annual Financial Report of the Government of Canada (AFR) and the Public Accounts of Canada could be improved to better communicate the financial results.

Following previous suggestions from the Auditor General and working closely with the Auditor General’s staff, substantial improvements have been made to the AFR. In addition, a user survey was conducted following the release of the 1998–99 AFR. The results of the survey, which were published in the 2000 budget, were generally very positive.

As with all of its publications, the Government will continue to explore ways in which the presentation of both the AFR and the Public Accounts of Canada can be improved.

Offsetting Canada Child Tax Benefit Disbursements Against Revenues ("Netting")

The Government currently reports revenues and expenditures on a net basis. For budgetary purposes, there are a number of tax expenditures that are netted against revenues and a number of revenue items that are netted against spending. Netted against revenues are the Canada Child Tax Benefit (CCTB), the quarterly goods and services tax (GST) credit and repayments of Old Age Security benefits. Netted against spending are revenues of consolidated Crown corporations and revenues from levies charged by departments for specific services, such as the costs of policing services in provinces. This netting has no impact on the overall budgetary balance.

The Auditor General argues that this represents incomplete financial disclosure. The Auditor General has recommended that the financial statements and the budget be prepared only on a gross basis.

For budget purposes, the Government believes that the "net" presentation is the appropriate approach because it is consistent with the way Parliament appropriates funds. Furthermore, programs like the CCTB and the quarterly GST credit are integral parts of the tax system. They are thus netted from tax revenues for budgetary purposes.

It is important to note that netting has no impact on the overall budgetary balance. From a financial disclosure perspective, it is also important to note that the Government already publishes this information in both the Annual Financial Report of the Government of Canada and the Public Accounts of Canada.

Statement of Transactions of the Debt Servicing and Reduction Account

The Debt Servicing and Reduction Account (DSRA) was established by statute in June 1992. Under that legislation, all GST revenues, net of applicable input tax credits, rebates and the low-income credit, along with the net proceeds from the sale of Crown corporations and gifts to the Crown explicitly identified for debt reduction, must be deposited into this account. The funds in this account are earmarked to pay interest on the public debt and, ultimately, to reduce the debt.

At the same time, all revenues received by the Government must be deposited in the Consolidated Revenue Fund (CRF), and any disbursements from it must be authorized by Parliament. Therefore, the specific revenues of the DSRA must be deposited in the CRF, and the public debt expenditures chargeable to the account must be appropriated from it by Parliament.

Auditors General have repeatedly questioned the need for this account. They noted that "given the fundamental concept of the Consolidated Revenue Fund (CRF) underlying the Government’s accounting system, the Account is an internal mechanism that may not be necessary." This issue was raised again in the Auditor General’s 2002 Observations.

The Government has reviewed the DSRA and agrees that there is limited usefulness in having a separate financial statement for the information contained in the DSRA. Therefore, in this budget, it will introduce legislation to terminate the DSRA. The Government will ensure that all of the information contained in the DSRA continues to be reported in other parts of the Government’s financial statements.

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