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Annex 8
The Government's Response to the Auditor General's Observations on the 2003 Financial Statements

The Auditor General of Canada expressed an unqualified opinion on the Government’s financial statements for 2002–03. This marks the fifth year in a row that the Auditor General has given an unqualified opinion on the Government's financial statements.

The Auditor General, in her Observations on the 2003 Public Accounts of Canada, states that the Government has made major improvements in financial reporting that have established Canada as a world leader in financial reporting by a national government. She lists the following areas of improvement:

• Adoption of full accrual accounting.

• Early adoption of the Public Sector Accounting Board’s (PSAB’s) reporting model for senior governments.^[1]

• Comparison of actual results with the budget.

• Discontinuance of the practice of netting revenues and expenses in most areas.

• Early adoption of the PSAB guideline on financial statement discussion and analysis.

However, the Auditor General also notes that more needs to be done to build on the above improvements. In her Observations, she raises some of these matters for Parliament’s attention:

• Lack of accrual-based budgeting and appropriations at the departmental and agency levels.

• Valuation of National Defence inventory.

• Year-end spending on foundations.

• Employment Insurance Account surplus.

• Timeliness and communication of financial results.

Lack of Accrual Based Budgeting and Appropriations

Effective with the 2003 budget, the basis of presentation of financial information in the budget, the audited financial statements in Volume I of the Public Accounts of Canada, and the Annual Financial Report of the Government of Canada is full accrual accounting.

The basis of presentation of departmental budgets and appropriations in the Main and Supplementary Estimates—including Reports on Plans and Priorities and Departmental Performance Reports—and in Volume II, Part I of the Public Accounts of Canada, is still cash accounting. Given these two bases of accounting, departments are held accountable to Parliament on the cash used against parliamentary appropriations, whereas the Government’s overall financial performance is measured on another basis—full accrual accounting.

The Auditor General views the lack of accrual-based budgeting and appropriations by departments and agencies as an impediment to the Government’s use of full accrual accounting information for better decision making.

A specific work plan has been put in place by the Government to address these concerns based on four key elements: interim arrangements (e.g. accrual costing in Memoranda to Cabinet); Treasury Board Secretariat capital management policies (e.g. renewal and updating of current policy instruments); capital accrual budgeting pilots (e.g. finalizing scope and terms of reference); and ministerial/parliamentary engagement (e.g. development of a consultations strategy).

Valuation of National Defence Inventory

The Auditor General’s audit results at the Department of National Defence revealed that the Department’s inventory records are not suitable for management decision making and that it may be many years before they are suitable for this purpose. National Defence has agreed to implement a plan to ensure that appropriate controls are in place to record the costs of future purchases properly in its inventory system; to relieve the costs of old inventory properly over time as the inventory is used; and to monitor usage properly and determine ongoing adjustments to reflect the obsolescence of inventory items.

National Defence has finalized a Go Forward Strategy to address these various issues and is in the process of carrying out that strategy. An interdepartmental committee—including senior officials of the Department, the Treasury Board Secretariat and the Office of the Auditor General of Canada—has met to provide advice regarding the strategy. A senior accrual accounting oversight committee has been created in the Department to provide departmental guidance on accrual accounting and facilitate the management of horizontal issues and requirements. That committee reports to the Defence Management Committee, which is chaired by the Deputy Minister.

Year-End Spending on Foundations

The Auditor General has noted several concerns related to the Government’s transfers to foundations at year-end and its cumulative transfers to the foundations. These are:

• Whether the Government’s accounting for these transfers as transfers to arm’s-length organizations is appropriate.

• That, for each of the foundations, the Government consider the effects of PSAB’s new accounting standard on the government reporting entity.

• That the Government monitor the progress of PSAB’s project on accounting for government transfer payments, and consider the possible implications for its accounting for transfers to foundations.

• That, although the Government announced changes in the accountability and governance structures for foundations in its 2003 budget, those changes do not provide the Government with the means to make adjustments should there be a major change in public policy and do not remedy the current lack of independent, reviews and evaluations that are made available to Parliament.

• That accounting considerations may be preventing the Government from making all necessary improvements in the accountability and governance structures of foundations.

It is the Government’s view that its accounting for transfers to foundations as arm’s-length organizations is appropriate. There is no statement in PSAB’s new government reporting entity standard that would indicate otherwise. Nonetheless, the Government is in the process of examining its relationship to each foundation vis-à-vis the new standard. The results of the examination will be discussed with the Auditor General later this year.

The Government will also closely monitor PSAB’s project on accounting for government transfer payments. That project is at an early stage and a final standard is not anticipated for some time.

To clarify the circumstances under which foundations would be used by the Government, the 2003 budget set out principles under which the Government would consider using a foundation to deliver public policy:

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

• Foundations should harness the insight and decision-making ability of independent boards of directors directly experienced and knowledgeable 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 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.

These policy principles are consistent with the Treasury Board’s new Policy on Alternative Service Delivery which came into effect on April 1,2002.

A key ingredient of the success of foundations is their independence from Government. However, this has led to some concern as to their transparency and accountability. Therefore, funding agreements between foundations and the Government specify their mandates and the conditions under which they operate. Directors are fully responsible for the actions of foundations, and all foundations are subject to annual independent audits of their financial statements.

As part of the Government’s ongoing effort to improve transparency and accountability of foundations, the 2003 budget announced a number of changes to improve the accountability of foundations to parliamentarians and other Canadians.

Parliamentary Approval: The Government has taken steps to ensure that the establishment and funding of foundations is adequately reviewed by Parliament.

• The Government is committed to parliamentary approval of purpose and funding through direct legislation for those foundations that 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.

Public Reporting: To improve the transparency and therefore the accountability of foundations to the public, the Government has taken the following steps:

• Foundations are 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 provided to Parliament.

• In addition, the departmental Reports on Plans and Priorities, which are tabled in Parliament, will now incorporate the significant expected results to be achieved by the relevant foundations and situate these within the department’s overall plans and priorities. As well, 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.

• 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. The annual reports of foundations created explicitly through legislation will be tabled in Parliament by the responsible Minister.

• 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.

Compliance With Funding Agreements: The accountability of foundations was further enhanced through the following measures:

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

• Funding agreements reached with foundations arising from the 2001 budget contain provisions for independent audits of compliance with funding agreements and for program evaluations. Also, there are now provisions for intervention in the event the responsible Minister feels that there have been significant deviations from the terms of the funding agreement. The provisions provide for dispute resolution mechanisms.

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

The above is on a going-forward basis. The Government is consulting with existing foundations to explore making changes to their agreements with the Government to incorporate these new requirements.

Employment Insurance Account Surplus

In the 2003 Observations, the Auditor General states that, in her opinion, the Government has not been observing the intent of the Employment Insurance Act when setting the employment insurance (EI) contribution rate. She urged the Government to resolve this long-standing issue.

The Employment Insurance Act required that the Canada Employment Insurance Commission set premium rates at levels that 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 rate-setting process in the EI Act "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 EI premium revenues and program costs are consolidated in the Government’s budgetary balance, the "look back" provision, the report concluded, would cause serious disruptions to the overall management of the Government’s budget. The report recommended, therefore, that EI rates should be set on the basis of levels of revenues 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. In the 2003 budget the Government set the employee premium rate at $1.98 for 2004. Based on the private sector economic forecasts used in that budget, this was the rate estimated that would generate premium revenues equal to the projected program costs for 2004.

In the 2003 budget the Government also launched consultations on a new permanent rate-setting mechanism based on the following principles:

• Premium rates should be set transparently.

• Premium rates should be set on the basis of independent expert advice.

• Expected premium rates should correspond to expected program costs.

• Premium rate-setting should mitigate the impact on the business cycle.

• Premium rates should be relatively stable over time.

The results of the consultations are now being reviewed. A summary of the consultations is available at www.fin.gc.ca.

It is the Government’s intention to introduce legislation by the time of the next budget to implement a new mechanism that would be consistent with these principles, taking into account the views expressed during the consultations. However, to ensure against the risk that such legislation may not be passed in time to set the rate for 2005, the Government proposes to give the Governor in Council the authority to set, in the fall of 2004, the rate for 2005. In doing so, it would set the rate in a manner consistent with the new rate-setting mechanism.

Timeliness and Communication of Financial Results

In the 2003 Observations, the Auditor General includes several concerns and recommendations regarding the Government’s communications of summary financial results. She states that:

• As the Public Accounts are extremely detailed, consideration should be given to providing some of the detail separately in other formats, or whether all of the information is needed when other vehicles may meet the same need. While the Annual Financial Report of the Government of Canada is much more a summary document, it is not written to explain the Government’s financial results to a general audience and it continues to use net amounts in its analysis of revenues and expenses. She concludes that the Government, in consultation with key users, should review this information and determine the best way to provide it to parliamentarians and other interested Canadians.

• As the Government gains experience in using accrual methodology—particularly for tax revenues—it should assess the predictive reliability of its estimates and determine if it is feasible to improve the timeliness of releasing its summary financial statements.

• The Government’s financial results should be communicated clearly to Canadians, and the Government should present its financial results using "generally recognized and consistent terminology"—such as "accumulated deficit" as opposed to "federal debt"—in all its communications.

As a follow-on to the 2003 budget, the Government initiated a project to improve reporting to Parliament and Canadians. The project has four objectives:

• To make greater use of electronic reporting.

• To improve reporting on horizontal issues.

• To identify issues with the current suite of parliamentary reports.

• To propose an action plan addressing solutions to these problems and implementing changes to the timing and content of reports.

The project encompasses the Estimates family of reports (Main and Supplementary Estimates, Reports on Plans and Priorities and Departmental Performance Reports), the Public Accounts of Canada and Canada’s Performance. The Government will engage its key stakeholders on the vision for improved reporting, including parliamentarians and interested parliamentary committees.

The first Annual Financial Report of the Government of Canada was prepared for the 1993–94 fiscal year, in part based on a recommendation by the Auditor General. It is published by the Minister of Finance as soon as the audited financial results for the fiscal year are available—often several weeks before the Public Accounts are tabled in Parliament. It provides the link between the budget and the Public Accounts as there are often differences between the two. For example, the budget presents revenue and expenses on a net basis as this is consistent with the way Parliament appropriates funds, while the Public Accounts presents revenue and expenses on a gross basis. The Annual Financial Report provides the reconciliation between these two bases of presentation. As noted in the 2003 budget, in 1998–99 a survey was conducted on the ease of use of the report. The survey results were generally very positive. Nonetheless, the Government will explore ways in which the presentation of the budget, the Annual Financial Report and the Public Accounts of Canada can be prepared on a comparable basis.

The Government agrees with the Auditor General that it should consider how to complete and table its summary financial statements more expeditiously. 2002–03 was the first year under full accrual accounting and, as the Auditor General notes, the accrual of tax revenue does take a significant amount of time after year-end to calculate. The accuracy of reported tax revenue is—and must be—a goal of the Government’s financial reporting. But as the Government gains experience in the next few years with full accrual accounting, more accurate estimates of accrued tax revenues should be feasible on a more timely basis. The Government will work closely with the Auditor General in this time frame to accelerate the release of its financial results.

The Government uses generally recognized and consistent terminology in all of its communications. As noted previously, the Government has fully complied with the form, content and narrative descriptions recommended by PSAB in its new government reporting model. The Auditor General has pointed out an exception: use of the term "federal debt" as opposed to "accumulated deficit."

When full accrual accounting was first announced in the 2003 budget, the Government took great pains to explain the two terms. In almost every instance that the term "federal debt" was used in the 2003 budget, it was explained as being equivalent to the accumulated deficit. The Government uses the term "federal debt" for one main reason. In surveys of Canadians’ understanding of the Government’s finances, many still feel the federal government is in deficit, although it has reported six consecutive annual surpluses. Terms like "accumulated deficit" may present the impression that the federal government is still in deficit. As a result, the Government used the term "federal debt" to describe its accumulated financial position, to avoid any incorrect interpretations.

Other Government Initiatives

Chapter 3, "Sound Fiscal Management," describes a number of other measures the Government is taking to improve financial management. These measures, together with the proposed actions described in this annex and other government initiatives announced by the Prime Minister on December 12, 2003, are aimed at maintaining—and enhancing—Canada’s status as a world leader not only in financial reporting by a national government, but in the broader area of overall financial administration.

¹ The Canadian Institute of Chartered Accountants sets accounting and auditing standards in Canada. Its Public Sector Accounting Board recommends accounting standards for Canadian governments.  [Return]

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