Victorian Auditor-General’s report
9 November 2011

Water Entities: Results of the 2010–11 Audits 
Audit summary
Background
This report covers the results of our financial audits of 20 entities in the water industry, comprising 19 water entities and one controlled entity. It informs Parliament about significant issues arising from the audits of financial and performance reports and augments the assurance provided through audit opinions included in the entities’ annual reports. 
The report comments on the quality and timelines of financial reporting, the financial sustainability of water entities, and the effectiveness of internal controls over asset valuations, declarations of interests and outsourcing. 
Conclusion
Clear audit opinions were issued on all 20 financial reports and 16 performance reports for the financial year ended 30 June 2011.
The 19 water entities reported a net profit before tax of $405.4 million in 2010–11, a decrease of $18.5 million or 4.4 per cent from 2009–10. However, while the four metropolitan water entities continue to generate strong profits year‑on‑year, eight of the 13 regional urban water entities (62 per cent) reported a lower net profit before tax in 2010–11 relative to the prior year, and five reported a net loss before tax. The two rural water entities continued to report losses.
The overall risk to financial sustainability for the water industry is low. However, the risk is uneven across the metropolitan, regional urban and rural categories. The longitudinal trends indicate that the risk profile for the industry is deteriorating and deeper analysis of indicators suggests that the sustainability of other entities within the regional urban category could be at risk over time unless these trends are reversed. 
Debt levels continue to increase and a number of sustainability indicators, such as liquidity, interest cover, and capital replacement ratio show deteriorating trends. 
The ability for water entities to increase the price they charge for water and the provision of sewerage services is regulated by the Essential Services Commission (ESC), based on five-year water plans developed by each entity. The funding model, therefore, restricts the ability of water entities’ boards to take key decisions on the cost of water to offset the increasing costs of service provision.  
The approved water plans cover from 2008–09 to 2012–13 and were developed over a period of ongoing drought, a decade of below-average rainfall and the imposition of water restrictions. There is now a risk that assumptions in those plans are no longer appropriate and that revenue and expenditure will not be as forecast. In the event that revenue reduces due to reduced demand for water, the financial sustainability of entities can be adversely affected. 
Consequently, it is timely to revisit the ESC’s pricing model and the planning activities of water entities to determine their suitability in a time of changing environmental conditions.
Findings
Audit opinions and quality of financial reporting
Audit opinions issued on financial reports
Clear audit opinions were issued on the financial reports of all 20 entities, consistent with the prior year result.
An emphasis of matter paragraph was included in the audit report issued on the financial report of Watermove, a controlled entity of Goulburn-Murray Water (G-MW). It outlined Watermove’s reliance on the continuing financial support of its parent entity to sustain its operations. Without this support, the entity would not have met the ‘going concern’ requirement of the Australian Accounting Standards at 30 June 2011.
Audit opinions issued on performance reports
Melbourne Water, the 13 regional urban water corporations, and the two rural water corporations each prepared and submitted for audit a performance report. Clear audit opinions were issued on all 16 performance reports.
Quality of reporting
Overall, the financial and performance report preparation processes of water entities were adequate and produced accurate, complete and reliable information, but there were opportunities for improvement in: 
·	establishing preparation plans outlining processes, resources, milestones, oversight and quality assurance practices for financial and performance reporting
·	preparing and providing timely shell financial and performance reports to enable issues to be identified and resolved earlier
·	preparing materiality assessments to identify potential errors in the financial and performance reports
·	performing rigorous quality control and assurance to improve the accuracy of the draft financial and performance reports
·	performing rigorous analytical reviews to help improve the accuracy of the financial and performance reports. 
All entities, except for Watermove, finalised their financial report, and performance report where applicable, within the 12-week legislative reporting time frame, consistent with the prior year. Watermove’s financial report was finalised after 16.6 weeks, compared to 8.9 weeks in 2009–10. Material uncertainty regarding its ability to continue as a going concern required an assessment of the financial viability of the business, and resulted in additional disclosures and adjustments to the financial report.
The average time taken by the 16 water corporations to finalise their financial and performance reports was 9.0 weeks in 2010–11, compared to 7.4 weeks in 2009–10, due to delays in the revaluation of infrastructure assets for the regional urban and rural entities.
The average time for the three metropolitan retail distribution companies to finalise their financial reports was 8.2 weeks in 2010–11 compared to 8.0 weeks in 2009–10.
Financial results
The 19 water entities reported a net profit before tax of $405.4 million in 2010–11, a decrease of $18.5 million or 4.4 per cent from 2009–10. The decrease was predominantly due to higher finance costs, depreciation expenses, and the write-off of impaired assets. Regular rainfall during the financial year resulted in lower water consumption. This reduced the revenue generated by the entities and nullified the impact of approved price increases.
While the four metropolitan water entities continue to generate strong profits year‑on‑year, eight of the 13 regional urban water entities (62 per cent) reported a lower net profit before tax in 2010–11 relative to the prior year, and five reported a net loss before tax (three in 2009–10). The two rural water entities continued to report losses.
Revenue increased by $411.2 million or 12.6 per cent from 2009–10 due to higher service and usage charges. 
Our analysis of the service and usage charges revealed that a large portion of the customer total water bill is fixed, especially for the regional urban and rural sectors. This means that for many customers, reducing water consumption will not result in a substantially lower water bill.
Financial sustainability
To be financially sustainable, entities need to be able to meet current and future expenditure as it falls due. They must also be able to absorb foreseeable changes and the effect of financial risks materialising, without significantly changing their revenue and expenditure policies.
The six financial sustainability indicators, analysed for the five years from 2006–07 to 2010–11 were:
·	the underlying result
·	interest cover
·	liquidity
·	debt-to-assets
·	self-financing
·	capital replacement. 
These indicators were reviewed and revised during 2010–11. This year we considered the liquidity and interest cover ratios collectively rather than individually to assess financial sustainability given the treasury management policies of the water entities. The ‘debt-to-equity’ ratio was replaced by the ‘debt-to-assets’ ratio as this measure is more widely applied across the water industry.
The results of our analysis of the 19 water entities, at the entity sector level are provided in Figure A.
Figure A
Financial sustainability risk assessment by water sector for 
2010–11 and 2009–10
	2010–11	2009–10	
Sector	High	Medium	Low	High	Medium	Low	
Metropolitan	–	–	4	–	–	4	
Regional urban	3	1	9	2	–	11	
Rural	1	–	1	1	–	1	
Total	4	1	14	3	–	16	
Source: Victorian Auditor-General’s Office.
Four entities (three entities in 2009–10) rated as being a high financial sustainability risk at 30 June 2011 had poor liquidity, inadequate interest cover, or large operating losses. Three of the four were identified as high risk in most years over the past five‑year period. 
Our analysis of the trend in financial sustainability risk results over the five years to 2010–11 showed a deteriorating risk profile for the industry as a whole. 
Analysis of the trend in sustainability indicators over the same period showed the trend for the metropolitan water entities to be relatively stable. They have a large customer base and continue to generate strong profits and positive cash flows from operations annually.
The regional urban water entities, as a cohort are also relatively well placed. However, the results for Coliban Water and Grampians Wimmera Mallee Water Corporation over the past five years are less favourable and require monitoring. Deeper scrutiny indicates that the sustainability of other entities within the sector could be at risk over time unless downward trends are redressed.
For the rural water entities, the results for G-MW are unsustainable and overshadow the results for that sector. In 2010–11 the entire G-MW board resigned and a number of senior managers departed. A new board was appointed late May 2011 and a new managing director in August 2011. The impact of these changes and of decisions they take to improve the financial performance and position of the entity should become more evident in subsequent reporting periods.
Regulation of water prices
Over and above the analysis of financial sustainability indicators, trends and risks, the capacity of management and the governing body to take decisions necessary to affect an entity’s operations needs to be taken into account in assessing the entity’s performance. 
Since 1 January 2004 the ESC has been responsible for regulating and approving the price a water entity may charge its customers for the supply of water and the provision of sewerage services.
The price is determined based on an entity’s water plan which specifies the outcomes the entity plans to deliver, how they will be achieved, and the revenue needed to deliver them over the life of the plan. An entity’s water plan also outlines the proposed operating and capital expenditure over the period of the plan. A range of assumptions underpin the proposed revenue and expenditure forecasts. Should actual and forecast figures vary or their underpinning assumptions prove to be incorrect, the actual financial performance and financial sustainability of the entity can fall short of the plan.
The current water plans cover from 2008–09 to 2012–13 and were developed during a period of ongoing drought with around a decade of below-average rainfall and the imposition of water restrictions. With many customers adopting water conservation measures the volume of water supplied in recent years has also been less than forecast resulting in revenue being less than forecast. Following a period of above average rainfall, and with water storages nearing capacity, especially in regional Victoria, there is now a risk that assumptions in the plans are no longer appropriate and that revenue and expenditure will not be as forecast. In the event that revenue further reduces due to reduced demand for water, financial sustainability may be adversely affected.
Given that the financial sustainability of some water entities and sector categories has deteriorated it would be timely to revisit:
·	the duration of water plans
·	the appropriateness of the funding model and its flexibility in times of unpredictable weather patterns
·	the rigour of the planning and forecasting by water entities.
Performance reporting
VAGO’s report titled Water Entities: Results of the 2008–09 Audits recommended that the Department of Sustainability and Environment (DSE), in conjunction with the Department of Treasury and Finance, develop a consistent and contemporary performance reporting framework. The report also concluded that it was timely that the relevance, appropriateness and usefulness of the indicators be reviewed. 
Key developments during 2010–11 were:
·	including Melbourne Water in the list of entities required to prepare a performance report and submit it for audit 
·	review and revision of key performance indicators 
·	amendment of explanatory material, which includes a performance report template, by DSE to clarify the expectations of government and with the aim of improving the quality and consistency of reporting by the water entities.
Our key observations were:
·	five of the 16 entities (31 per cent) prepared and submitted for audit a performance report that included indicators not specified by the directives issued under section 51 of the Financial Management Act 1994
·	12 of the 16 performance reports (13 of 15 in 2009–10) included indicators without targets.
When performance indicators have no related targets the usefulness of performance reports is reduced because a comparison of actual performance against the target cannot occur.
Given that performance reporting has been in place for more than five years, it is now appropriate that future audit opinions relating to the performance report conclude on the relevance and appropriateness of the performance indicators presented. It is intended that this approach be in place from 2012–13 onwards.
During consultation with my office regarding the proposed audit approach, representatives from both DSE and VicWater, the peak industry body, indicated support for the establishment of a working party with responsibility for developing relevant and appropriate indicators to be included in a performance report. 
Internal controls
General internal controls
The internal control structures for all entities were adequate for producing reliable, accurate and timely financial reports. However, entities could strengthen their internal controls by:
·	improving information system processes, restrictions, and access rights
·	reporting and reviewing masterfile changes, access rights and termination payments relating to payroll
·	reviewing and updating the methodology for calculating unbilled revenue accruals and monitoring long outstanding receivables. 
Information system control weaknesses were identified at 45 per cent (nine of 20) entities which is concerning given the sensitivity of information captured by the entities, and the heavy reliance on information systems.
Controls over asset valuations
At 30 June 2011, the water industry had total assets of $35.2 billion ($27.8 billion in 2009–10). Infrastructure assets, property, plant and equipment accounted for $34 billion ($26.8 billion in 2009–10) or 96 per cent of total assets. In accordance with Financial Reporting Direction 103D Non-Current Physical Assets the 19 water entities revalued land, buildings and infrastructure assets during 2010–11.
Internal controls across the industry with respect to asset valuation were considered effective. However, there are opportunities for improvement of controls over valuations including the:
·	47 per cent of water entities that did not have asset valuation policies and procedures
·	20 per cent that had policies and procedures that were not reviewed by the governing body
·	50 per cent of policies and procedures that did not address the requirement to value assets at a component level
·	40 per cent of policies and procedures that did not specify who was authorised to make changes to them or how often they should be reviewed
·	20 per cent of policies and procedures that did not indicate how fair value should be determined.
The revaluation exercise within regional urban and rural entities identified significant differences of opinion between management and the Valuer-General Victoria (VGV) regarding the methodology adopted. It also identified a need for VGV to improve its quality assurance processes to minimise errors and adjustments in valuations.
Controls over declarations of interests
Overall, there were adequate internal controls over declarations of interests by board members or nominated officers. However, they could be strengthened by developing more comprehensive policies and procedures, and monitoring compliance with approved policies and legislative requirements.
Controls over declarations of interests could be further improved by addressing the following identified weaknesses:
·	21 per cent of water entities did not have declaration of interests policies and procedures
·	47 per cent of policies and procedures did not specify who was authorised to make changes or how often they should be reviewed
·	40 per cent of policies and procedures did not specify what records must be maintained and who was responsible for maintaining a central register 
·	11 per cent of water entities did not maintain a central register
·	only 53 per cent provided declarations of interest refresher training sessions to their board and nominated officers
·	68 per cent had not commissioned an internal audit of their compliance with legislative requirements in the past three years.
Controls over outsourcing 
The water industry had $3.3 billion of operating expenses and $1.6 billion of capital works for 2010–11. 
Controls over outsourcing were adequate, although improvements can be made by developing more comprehensive policies and by enhancing the monitoring and oversight activities.
Controls over outsourcing should be improved by the:
·	42 per cent of entities that did not have outsourcing policies and procedures 
·	95 per cent that did not obtain assurance over the effectiveness of the internal controls from the outsourced provider
·	21 per cent that did not include the risks linked to outsourcing in their risk register
·	58 per cent that had not used their internal auditors to perform a review of their outsourcing activities in the last three years.
It is of concern that management of only 5 per cent of water entities obtained a letter of comfort from their outsourced provider. Outsourcing an activity does not absolve management of its responsibility for maintaining adequate internal controls. This is a control weakness in the current outsourcing arrangements across the entire water industry.
Recommendations 
Number	Recommendation	Page	
1.	That water entities further refine their financial and performance reporting processes by developing consolidated financial reporting preparation plans, preparing shell statements, performing materiality assessments, improving their quality assurance processes, and conducting rigorous analytical reviews.	21	
2.	That the Essential Services Commission revisit the duration of water plans, the appropriateness of the funding model and its flexibility in times of changed weather patterns and the rigour of the planning and forecasting by water entities.	47	
3.	That the Department of Sustainability and Environment in conjunction with the Department of Treasury and Finance develop a consistent and contemporary performance reporting framework for the 19 water entities.	53	
4.	That a working party, comprising key stakeholders, be established to develop relevant and appropriate key performance indicators for inclusion in future performance reports of water entities.	53	
5.	That water entities assess their policies and processes against the commonly identified internal control environment weaknesses and act to address them to make sure they are operating reliably and cost-effectively.	78	
6.	That water entities take timely action to address identified information technology control weaknesses.	78	
7.	That water entities develop and maintain comprehensive policies and procedures which are appropriately approved and subject to regular review.	78	
8.	That the water industry work with the Department of Treasury and Finance and the Valuer-General Victoria (VGV) to determine the most appropriate valuation methodology for infrastructure assets.	78	
9.	The VGV should ensure all valuations conducted, including those by service providers, be subjected to rigorous quality assurance processes, and that appropriate effort is invested in establishing agreement with client entities before valuations are conducted.	78	
10.	That water entities obtain letters of comfort about the effectiveness of internal controls of outsourced providers.	78	
11.	That water entities use internal audit to periodically review outsourcing practices and related policy compliance.	78	
12.	That water entities report regularly to their boards on outsourced activities to enable effective monitoring of performance, including of actual performance against key performance indicators in contractual arrangements, risk mitigation activity, cost-benefit analysis, and actual costs against budget.	78	
Submissions and comments received
In addition to progressive engagement during the course of the audit, in accordance with section 16(3) of the Audit Act 1994 a copy of this report, or relevant extracts from the report, was provided to the Department of Treasury and Finance, the Department of Sustainability and Environment, the Valuer‑General Victoria, the Essential Services Commission, the State Owned Enterprise for Irrigation Modernisation in Northern Victoria and the 20 entities with a request for submissions or comments.
Agency views have been considered in reaching our audit conclusions and are represented to the extent relevant and warranted in preparing this report. Their full section 16(3) submissions and comments however, are included in Appendix H.