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1998 April Report of the Auditor General of Canada

Main Points

9.1 The 1980s and early nineties have seen major advances in financial reporting by sovereign governments, with Canada among the leaders. However, over the past two years the Government of Canada has begun departing from both objective accounting standards and its own stated accounting policies for certain transactions. Moreover, the 24 February 1998 Budget indicates that a similar departure will occur in 1998.

9.2 In 1996, transitional assistance for harmonizing PST with GST was included in the deficit even though provinces had not yet agreed to the harmonization by the end of the year. In 1997, funding of the Canada Foundation for Innovation was included in the deficit even though the Foundation did not exist by the end of the year. In 1998, the 24 February 1998 Budget indicates that funding of the Canada Millennium Scholarship Foundation will be included in financial results whether or not the Foundation exists by the end of the year.

9.3 As auditors of the government's financial statements, we are deeply concerned over this recent disregard by the government for objective accounting standards in reporting its financial results to Parliament and to Canadians. This is not merely a technical disagreement between an accountant and an auditor. Objective accounting standards are accepted and identifiable standards that are established by an arm's-length standard-setting body - the Canadian Institute of Chartered Accountants (CICA). Business firms cannot depart from objective accounting standards established by the CICA, to hide losses or to hide profits. Parliamentarians should expect no less from the government.

9.4 Meeting the significant challenges of the next decade will require, among other things, credible annual reports by the government on its overall financial health. In our view, departures from CICA standards and the government's own accounting policies must cease if credibility is to be restored to the reports that parliamentarians and others need.

9.5 Accordingly, we have recommended that the Government of Canada ensure that its accounting policies and practices conform with recommendations issued by the CICA's Public Sector Accounting and Auditing Board. Implementation of this recommendation will require continued diligence by the Public Accounts Committee of the House of Commons in reviewing the government's annual financial statements.

9.6 Although this chapter calls Parliament's attention to inappropriate accounting, there are related concerns that we have and will continue to report separately. They deal with accountability and parliamentary oversight for entities such as the Innovation Foundation and the Millennium Scholarship Foundation, and with whether or not such entities are, in substance, operating at arm's length from the government.

Introduction

9.7 Each year, the Government of Canada reports its financial results in the Public Accounts of Canada . Specifically, Section 1 of Public Accounts Volume I contains government-wide financial statements that this Office is required to audit and report on under section 6 of the Auditor General Act . The overall framework for reporting financial results, as described in this chapter, is depicted in Exhibit 9.1 .

9.8 Our audit of the government's financial statements is carried out to express an opinion on whether the financial statements present information fairly. By performing our audit, we also enhance the credibility of reported financial results. If we find that the financial statements present information fairly, we say so by expressing what is called a "clean" opinion. However, if we have reservations about the financial statements, we give what is called a "qualified" opinion and explain our reservations. Unfortunately, our opinion on the government's 1997 financial statements was qualified for the reason described in paragraphs 9.26 to 9.31.

9.9 The purpose of this chapter is to call Parliament's attention to this recent problem with the financial statements that, if not corrected, could lead to an inappropriate picture of financial results and to qualified audit opinions for some years to come.

Observations and Recommendation

The Need for Objective Accounting Standards

9.10 In the public sector, we believe that there is a fundamental principle of accountability that requires governments to report financial information to legislatures in such a way that citizens can rely on the credibility of the information provided. This principle of credibility applies equally to private sector organizations when preparing financial statements for their readers.

9.11 For financial statements to be credible, readers need to have confidence that the statements follow some accepted and identifiable standards that are established by an arm's-length standard-setting body. Throughout this chapter, these are referred to as objective accounting standards . These standards cannot be subject to the individual preference of the financial statement preparer.

9.12 For example, a reader may wish to compare the financial statements of the federal government with those of a particular province, or to compare the financial statements of the same level of government over time, even though they may have been prepared by different governments drawn from different political parties. If individual governments of the day are free to choose whatever accounting policies and practices they wish, readers will have no confidence that the financial statements are consistent or comparable over time. And without such confidence, the credibility of all financial statements is compromised.

9.13 Financial statement preparers, indeed their auditors, may have their own ideas as to what accounting standards should say - they might prefer that a particular standard be different from what was promulgated and there may be good theoretical arguments for alternative viewpoints. But that is why, as described in Exhibit A.1 of Appendix A to this chapter, the processes for developing accounting standards provide ample opportunity to express individual points of view. Once the standards are promulgated, however, individual preferences must be submerged. And it follows that the standard-setting body must be at arm's length from the financial statement preparer - otherwise, the standards could be changed arbitrarily from year to year to suit the current preferences of management.

9.14 In the private sector, there are additional reasons for following objective accounting standards. Business firms who wish to sell debt or equity securities to the investing public must not be able to exaggerate financial results by devising and using accounting policies and practices to hide losses. Similarly, firms who wish to minimize taxes or dividends must not be able to use policies and practices that hide profits.

9.15 Therefore, in order to guard against distortions of this type and to achieve credibility, the Canada Business Corporations Act requires all federally chartered public companies to prepare their financial statements in accordance with Generally Accepted Accounting Principles established by the Accounting Standards Board of the Canadian Institute of Chartered Accountants, or GAAP, as these principles are often referred to.

9.16 The consequences of not complying with GAAP could be very serious for a business firm. The reason is that the firm's auditors would be obliged to state in their opinion that GAAP had not been followed, which would send a clear signal to readers of the financial statements that the reported results were not credible. Further, Canadian securities regulatory authorities take a very dim view of qualified opinions. As a result, in the private sector one rarely sees financial statements departing from GAAP. Management cannot tolerate the negative consequences of a qualified opinion and will generally comply with GAAP to avoid it.

9.17 Parliamentarians and the Canadian public should expect no less from the federal government. And yet results frequently were inappropriately reported in the government's financial statements from the late 1970s through the end of the 1980s, as described in Appendix A to this chapter. This unfortunate situation occurred because there were no arm's-length standards of recommended accounting to which both the government and our Office could refer. It was therefore difficult for readers of the government's financial statements to have confidence that a consistent and fair presentation was being given to them. During debates in the House of Commons at the time, the government described the situation as an "honest division of opinion" between two experts on technical accounting matters, and said that it could "list a number of accountants who will argue one side of this issue and a number who will argue the other side."

9.18 Fortunately, since that time, objective accounting standards for Canadian governments have substantially been developed and published by the Public Sector Accounting and Auditing Board (PSAAB) of the Canadian Institute of Chartered Accountants. Additional information on the activities and outputs of PSAAB is provided in Appendix A to this chapter. As also noted in Appendix A, the government has substantially brought its accounting policies in line with PSAAB standards, as encouraged by the Public Accounts Committee.

Recent Departures from Objective Accounting Standards

9.19 Over the past two years, however, the federal government has begun departing from both objective accounting standards and its own stated accounting policies for certain transactions. These transactions are part of "transfer payments", which comprise approximately 50 percent of the government's expenditures. Some of the more significant transfer payments made by the government are for old age security benefits to individuals, and the Canada health and social transfer to provinces.

9.20 "Transfer payments", often called grants and contributions, are payments in return for which the government receives no goods or services directly. Because transfer payments comprise such a significant portion of public sector expenditures, PSAAB has published recommendations on accounting for them.

9.21 The government's stated accounting policies adhere to those recommendations. Note 1 to the government's annual financial statements states, " Transfer payments are recorded as expenditures when paid or when the recipient has fulfilled the terms of a contractual transfer agreement ."

9.22 Unfortunately, the government has not followed this policy when accounting for certain significant transfer payments in each of the past two years. Moreover, the 24 February 1998 Budget indicates that a similar departure will occur in 1998.

The 1996 problem: harmonizing GST and PST
9.23 In 1994, the government began a series of discussions with provinces to streamline and simplify the operation of Canada's value-added tax system. The proposal was to harmonize the federal goods and services tax (GST) with provincial sales taxes (PST). In late March of 1996, the government made a formal offer to the provinces of Newfoundland and Labrador, Nova Scotia and New Brunswick to provide transitional assistance totalling $961 million, payable when they entered into a detailed agreement to harmonize their PST with the GST. In early April of 1996, the three provinces agreed to continue negotiations, and memoranda of understanding (MOUs) were signed. The MOUs called for agreements to be negotiated and in place within six months, for enabling legislation to be enacted by Parliament and each provincial legislature and for harmonization to commence on 1 April 1997. The amount of transitional assistance was based on a formula, and officials advised that it was not subject to revision. As disclosed in Note 4(v) to the government's 1996 financial statements, the transitional assistance of $961 million was recorded as a liability at 31 March 1996, and as an expenditure and resultant increase in the deficit for that fiscal year.

9.24 At the time of finalizing the 1996 financial statements and our opinion on them, negotiations were still continuing between the three provinces and the government. Matters outlined in the MOUs were still under discussion, such as the definition of the common tax base, mechanisms to tax interprovincial transactions, and the number of provincial employees who would be employed by the government to administer the harmonized taxes. In addition, although federal legislation to authorize the transitional assistance of $961 million was tabled in Parliament on 23 April 1996 and received royal assent on 20 June 1996, enabling legislation for the three provinces had not yet been introduced in their respective legislatures.

9.25 Therefore, at 31 March 1996 the recipient provinces had not fulfilled the terms of a contractual transfer agreement. The agreements to harmonize were not signed and in place until more than six months after the close of the 1996 year. And yet the government recorded the transaction as if the agreements had been signed and in place at 31 March 1996. This represents a significant departure from the government's own accounting policies.

The 1997 problem: the Canada Foundation for Innovation
9.26 In the 18 February 1997 Budget, the government announced its intention to establish the Canada Foundation for Innovation. The Foundation would be operated independently of government through a board of directors, a majority of whom would be drawn from the private sector and research and academic communities. The Foundation's purpose is to combine government and private sector funding to enhance education and research infrastructure at post-secondary institutions and research hospitals. The government stated that the Foundation would be funded by an up-front investment of $800 million. This transaction was recorded in the government's 1997 financial statements as if it were a liability, and was charged to the deficit of that year.

9.27 Legislation to implement certain provisions of the 1997 Budget was not given first reading in the House of Commons until 9 April 1997, and the Budget Implementation Act, 1997 did not receive royal assent until 25 April 1997. Part I of the Act established the Foundation and Part XI provided parliamentary authority for the payment of $800 million plus interest to the Foundation.

9.28 A funding agreement between the Foundation and the government was not signed until 2 July 1997, and the $800 million (plus interest of $964,000) was not paid to the Foundation until that date. Among other things, the funding agreement sets forth the terms and conditions under which the Foundation shall both administer and invest those funds and determine to whom it shall disburse those funds. At the time of writing this chapter, no disbursements had yet been made to eligible recipients.

9.29 One key element of the government's own accounting policies is that for a transfer payment to be included in financial results, a "recipient" must exist. In this case, at 31 March 1997, there was no recipient to which the Government of Canada owed $800 million. The recipient, that is the Foundation, was not created until 25 April 1997 when the Budget Implementation Act, 1997 received royal assent.

9.30 A second key element of the government's own accounting policies is that for a transfer payment to be included in financial results, the recipient must have fulfilled the terms of a contractual transfer agreement. In this case, the funding agreement setting out these terms was not signed until July 1997.

9.31 Nonetheless, the government recorded the transaction as if the recipient had existed at 31 March 1997 and the funding agreement had been in place at that time. This was the second year in a row that the government departed from its own accounting policies.

The 1998 problem: the Canada Millennium Scholarship Foundation
9.32 In the 24 February 1998 Budget, the government announced its intention to create the Canada Millennium Scholarship Foundation. The Foundation will be managed by a board of directors, at arm's length from the government. The Foundation's purpose is to provide scholarships annually to Canadians from low- and middle-income families for post-secondary education.

9.33 The government stated that it will provide an initial endowment of $2.5 billion to the Foundation. An endowment, similar to the funding of the Canada Foundation for Innovation in 1997, is a transfer payment (defined in paragraph 9.20). This transaction will be recorded in the government's 1998 financial statements as if it were a liability, and will be included in the financial results of that year.

9.34 The Budget documents said that legislation to establish the Foundation would be introduced in the House of Commons shortly after the Budget date. At the time of writing this chapter, officials had advised us that it was highly unlikely that this legislation would be passed by 31 March 1998. After the legislation has passed, the Foundation's board members will be appointed and a funding agreement signed that sets forth the terms of investing the endowment and disbursing it to eligible recipients. Officials advise us that this will not occur until well after 31 March 1998. Scholarships will not be awarded to eligible recipients until the year 2000.

9.35 Neither of the key elements in the government's own accounting policies - the legal existence of a recipient or the fulfillment of the terms of a contractual transfer agreement - will have been met by 31 March 1998. Nonetheless, indications are that the government intends to record this $2.5 billion transaction as if they had. This will therefore represent the third year in a row that the government has departed from its own accounting policies for transfer payments.

The government's rationale for these departures
9.36 The government believes that it should take financial accountability - reflected in its financial results - for its decisions to incur expenditures for transfer payments in the year those decisions are taken. The government also believes that transparency is achieved by providing full disclosure of such transactions in the Budget and the financial statements.

9.37 While these views may have some intuitive appeal, they do not conform with objective accounting standards. Under such standards, the announcement of an intention to make payment is more in the nature of a ``commitment". Commitments are reported in notes to financial statements, but are not reflected in financial results. This prevents management from influencing reported results by simply announcing a decision toward the end of a particular year to spend money in some future year. Annually, the government reports tens of billions of dollars in commitments in notes to its financial statements but does not reflect them in its financial results.

9.38 In the 24 February 1998 Budget, the government states, "Non-recurring liabilities will be recognized in the year in which the decision to incur the expenditure is made, provided the enabling legislation or authorization for payment receives parliamentary approval before the financial statements for that year are closed." If the government changes its accounting policies for transfer payments in this manner, those policies will no longer conform with the recommendations of PSAAB. In our view, non-conformance with PSAAB is as serious an issue as departures from the government's own accounting policies.

9.39 The Government of Canada should ensure that its accounting policies and practices conform with recommendations issued by the Canadian Institute of Chartered Accountants' Public Sector Accounting and Auditing Board.

Treasury Board Secretariat's response: It is the government's view that its accounting policies and practices generally conform in substance to recommendations of the Canadian Institute of Chartered Accountants (CICA). The government believes its decisions and public announcements to provide funding to arm's-length organizations such as the Canada Foundation for Innovation establish liabilities that should be recorded in the years in which the decisions are made. These liabilities meet the definitions of both equitable and constructive obligations as defined in the CICA Handbook and reflect substance over form. In addition, the government believes that transparency and accountability are best served by recording these liabilities in the year in which the government made its decision to incur them.

Related Concerns

9.40 We have related concerns regarding entities such as the Canada Foundation for Innovation and the Canada Millennium Scholarship Foundation. One of these concerns, which revolves around issues of accountability and parliamentary oversight, is elaborated upon in Chapter 36 (paragraphs 36.48 to 36.54) of our December 1997 Report. It relates to the fact that the Canada Foundation for Innovation is not obliged to report on the results it achieves with $801 million of public money and that Parliament may consequently have difficulty obtaining the information it needs on this kind of expenditure.

9.41 A second concern relates to what we would call the essential nature or substance of these types of entities. We will be examining this matter further and will report separately if significant findings emerge. Questions that we will address in this study will include whether, in substance or in fact, such entities operate at arm's length from the government.

Conclusion

9.42 The purpose of this chapter has been to call Parliament's attention to a recent departure from objective accounting standards and the government's own accounting policies for recording transfer payments. By not following objective accounting standards - accepted and identifiable standards that are established by an arm's-length standard-setting body - the government puts the credibility of its financial statements into question. We believe that implementing our recommendation would resolve this recent problem and would restore the credibility of government-reported financial results.

9.43 Implementing this recommendation will require continued diligence by the Public Accounts Committee in reviewing the government's annual financial statements to help ensure that objective accounting standards are followed.

About the Study

Objective

Our objective was to call Parliament's attention to a recent problem with the financial statements of the Government of Canada that, if not corrected, could lead to an inappropriate picture of financial results and to qualified audit opinions for some years to come.

Scope and Approach

This study is based on the research of existing literature as follows :

  • Section 1, Volume I of the 1996 and 1997 Public Accounts of Canada and certain sections of the Public Accounts of Canada from 1979 to 1994
  • 24 February 1998 Budget
  • Recommendations of the Canadian Institute of Chartered Accountants Public Sector Accounting and Auditing Board
  • Recommendations of the Public Accounts Committee of the House of Commons
  • Recent activity in government-wide financial reporting across the world

Study Team

Assistant Auditor General: Ronald C. Thompson
Principal: John E. Hodgins

Jeff Greenberg
Andrew Lennox
Margo Longwell

For information, please contact John Hodgins.

Appendix A - Additional Background Information

Appendix B - Recent Correspondence with Government Officials