The Auditor-General has the mandate under the Local Government Act 1993 to audit the NSW local government sector. One-hundred and thirty-nine councils presented their 2016–17 financial statements and eight councils also presented their 2015–16 ¹ financial statements for audit. These audits have been completed. The Office of Local Government (OLG) granted Bayside Council an extension until 31 May 2018 to lodge their 2016–17 financial statements and Bayside Council has not yet presented them for audit.

We also tabled a performance audit report on ‘Council reporting on service delivery’ on 1 February 2018. We will soon release a report on ‘Fraud controls in local councils’ and a report on ‘Council shared services’ later this year. 

This report focuses on the results of our financial audits, highlights issues that were common across the local government sector and provides guidance that councils should consider. This will help Parliament understand the challenges that councils face and the measures that can improve their financial management and reporting.

Each council provides a range of services to meet its communities’ needs 

New South Wales has 128 local councils servicing a geographic area, and 12 county councils formed for specific purposes, such as supplying water, managing flood plains or eradicating noxious weeds. Each council provides a range of services, influenced by population density, demographics, the local economy, geographic and climatic characteristics. These differences also influence the spending profile of metropolitan, regional and rural councils.

Each year, councils lodge their audited financial statements with OLG and publish them on their website. Council financial statements capture their financial activities, performance and position. 

We issued five modified (qualified) audit opinions and identified a range of material financial reporting errors and significant accounting and control issues

We issued unmodified audit opinions on the financial statements of:

• one-hundred and thirty-six out of 139 councils for 2016–17
• two water authorities for 2016–17
• seven out of eight councils for 2015–16
• two out of three water authorities for 2015–16.

An unmodified audit opinion means that the financial statements present fairly the financial position and performance of the council. The Hills Shire Council, Junee Shire Council and Yass Valley Council received modified (qualified) audit opinions for 2016–17. We also issued disclaimers of opinion for the City of Botany Bay Council and Gosford Water Authority for 2015–16.

Our audits identified a further 33 material errors in the previous years’ audited financial statements of 22 councils that have been corrected. Eighty-eight per cent of these errors related to the way councils account for and value assets.

We also reported 39 significant matters to 29 councils. These related to material accounting issues and internal control weaknesses, of which 77 per cent related to assets. Councils should improve the way they account for their assets as a priority. 

Chapter 4 of this report further discusses the asset accounting issues identified during our audits.

Councils can improve their financial reporting processes
Our audits found that 43 councils need to improve the way they prepare their financial statements. A more robust review of the financial statements by councils prior to submitting them for audit would improve both quality and timeliness. 

Recommendation

Councils can improve the quality of financial reporting by reviewing their financial statements close processes to identify areas for improvements

Our experience at the State level shows that the preparation of annual financial statements benefits from review by independent audit committees.  Councils are not currently required to have an audit, risk and improvement committee and consequently 53 councils do not have an audit committee. For those councils with an audit committee, 55 per cent play no role in the review of financial statements.

Amendments made to the Local Government Act 1993 by the Local Government Amendment (Governance and Planning) Act 2016 will require all councils to appoint an audit, risk and improvement committee. Under transitional provisions, councils will not be required to comply until March 2021, six months after the next ordinary election. 

Recommendation

Councils can improve the quality of financial reporting by involving an audit, risk and improvement committee in the review of financial statements.

OLG can improve the quality and timeliness of guidance provided to councils each year
The Office of Local Government (OLG) needs to release key guidance documents, such as the Local Government Code of Accounting Practice and Financial Reporting (Code) and end of year financial reporting circular, to councils earlier. 

Councils are required to prepare financial statements in accordance with Australian Accounting Standards and the Code. The Code applicable for 2016–17 financial reporting provided options and guidance that in some instances did not align with Australian Accounting Standards.

Recommendation

The Office of Local Government should release the Local Government Code of Accounting Practice and Financial Reporting and the End of Year Financial Reporting Circular earlier in the audit cycle, ideally by 30 April each year.

The Local Government Code of Accounting Practice and Financial Reporting should align with Australian Accounting Standards.  

Seventy-one per cent of councils lodged audited financial statements by the statutory deadline
Councils must lodge audited financial statements with OLG by 31 October each year, that is, within four months after the end of their financial year. Forty councils did not meet this deadline for their 2016–17 financial statements and required an extension from OLG. Bayside Council received a lodgement extension for their 2016–17 financial statements to 31 May 2018 and has not yet presented them for audit.

Early close procedures help to improve the quality and timeliness of financial reporting
Early close procedures can identify issues and key risk areas that councils need to consider and resolve before the year-end process. Asset valuation issues affected the quality and timeliness of many councils' financial statements in 2016–17. Completing infrastructure, property plant and equipment valuations is a key early close procedure that can improve the quality and timeliness of financial reporting.

Recommendation

The Office of Local Government should introduce early close procedures with an emphasis on asset valuations.

Our next chapter reviews the financial performance of councils using indicators that the OLG prescribe. Councils must report against these in their audited financial statements: 

• operating performance
• own source operating revenue
• unrestricted current ratio
• debt service cover ratio
• rates and annual charges outstanding percentage
• cash expense cover ratio.

Councils’ annual reports also include the unaudited Special Schedule 7 'Report on Infrastructure Assets', in which councils report performance against four further measures:

• building and infrastructure renewals ratio
• infrastructure backlog ratio
• asset maintenance ratio
• cost to bring assets to agreed service level.

Three rural councils did not meet OLG benchmarks for three audited performance measures 
Most councils met OLG benchmarks for at least five or all of the six audited performance measures. Eight rural, four regional, four metropolitan and two county councils did not meet OLG’s benchmarks for two out of the six audited performance measures. Three rural councils did not meet OLG’s benchmarks for three out of the six audited performance measures. 

Eighteen councils operating expenses exceed their revenue base
The first measure of financial sustainability looks at the operating revenue that councils raise to cover their operating expenses. Eighteen councils operating expenses exceed their revenue base. For 11 councils, this has been the case for the past three years. Another 20 councils would not have met the operating performance benchmark without the advance receipt of their 2017–18 financial assistance grant, which was recorded as revenue during 2016–17.

Fifty-nine councils did not meet the OLG benchmark for generating own source revenue
Councils are also expected to generate 60 per cent of their revenue from their own sources. Fifty nine councils did not meet this OLG benchmark, and 42 of these were rural councils. Rural councils have high-value infrastructure assets that cover large areas, with smaller populations and less capacity to raise revenue from alternative sources compared with metropolitan councils. 

Most councils have sufficient liquidity and working capital
All but three councils met OLG’s benchmark for the unrestricted current ratio, meaning the councils can meet short-term obligations as they fall due.

Most councils also have the capacity to cover more than three months of operating expenditure as measured by the cash expense cover ratio. However, some of the funds held by councils are restricted and should only be used for specific purposes.

A council with a high proportion of restricted funds may have limited flexibility to pay operating expenses. While a council can resolve to lift internal restrictions on funds to use them for a different purpose, the Minister for Local Government’s approval is required to use externally restricted funds for another purpose.

All but two councils met OLG’s debt service cover ratio benchmark
The debt service cover ratio measures the operating cash available to service debt. All but two councils met OLG’s benchmark of greater than two times. This was due to these two councils repaying borrowings early. 

One-hundred and twenty-three councils reported borrowings at 30 June 2017. Councils utilise borrowings to fund capital projects and to address backlog maintenance. Regional councils accounted for 56 per cent of the value of total council borrowings because they also borrow to manage water and sewerage infrastructure.

Eighteen councils did not meet OLG’s benchmark for collecting rates and annual charges
Most councils are collecting rates and annual charges levied. However, eight rural, five regional, three metropolitan and two county councils did not meet the benchmark of having less than five per cent (metropolitan) or ten per cent (regional, rural and county) of rates and charges outstanding. These eighteen councils also did not meet the infrastructure backlog ratio.

Many councils did not meet OLG’s benchmarks for renewing and maintaining infrastructure assets
The infrastructure asset indicators reported by councils suggest that many need to examine their asset management plans and consider whether investment in infrastructure assets is sufficient. Thirty-one councils reported they do not meet the OLG benchmarks for either the buildings and infrastructure renewals ratio, the infrastructure backlog ratio or the asset maintenance ratio. Individually:

• seventy councils reported that they are not renewing infrastructure assets at the same rate they are depreciating them
• eighty-four councils reported that they have not kept the infrastructure maintenance backlog below OLG’s benchmark
• seventy-one councils reported actual asset maintenance lower than planned asset maintenance.

NSW councils own and manage a significant range of assets, including infrastructure, property, plant and equipment with a value of $136 billion. Many of our audit report qualifications, significant matters, prior-period errors and high risk issues related to assets.

Councils need to strengthen their asset registers
Our audits identified $145 million worth of land and infrastructure assets at 24 councils that were not recorded in asset registers or the financial statements. This is in addition to the rural fire-fighting equipment not recorded by councils that is discussed in the following sections. We also found examples of multiple asset registers with conflicting information, inaccurate or incomplete registers and unreconciled registers. 

Effective asset management requires accurate records of the assets that councils control. Council asset registers should accurately capture all assets to improve the quality and timeliness of financial statements. It is important that councils regularly update registers and reconcile them with asset management systems. Where manual spreadsheets are used to record asset details, suitable controls must be in place. 

A large part of rural fire-fighting equipment is not reported in government financial statements
Our 2016–17 audits of the NSW local government sector noted that 46 councils did record vested rural fire-fighting equipment in their financial statements. However, 62 councils do not record similar rural fire-fighting assets in their financial statements. These councils are of the view that they do not control these rural fire-fighting assets used by the NSW Rural Fire Service.

NSW Treasury and the NSW Rural Fire Service are of the view that the NSW Rural Fire Service does not control rural fire-fighting equipment which has been vested in councils under the Rural Fires Act 1997. NSW Treasury and NSW Rural Fire Service consider that these assets are controlled by councils. The financial statements of the NSW Total State Sector and the NSW Rural Fire Service do not include these assets. Consequently, a large portion of rural fire-fighting assets are not reported in either State government or local government financial statements.

Recommendation

The Office of Local Government should address the different practices across the local government sector in accounting for rural fire-fighting equipment before 30 June 2018. 

In doing so, the Office of Local Government should work with NSW Treasury to ensure there is a whole-of-government approach.

Asset valuation methods are not capturing asset values effectively
The Code requires that council assets reflect the fair value principles in Australian Accounting Standards. 
Many significant issues arose in our audits because council asset revaluation processes were not robust. This affected both the quality and timeliness of the financial statements.

Our audits identified that ten councils overstated the fair value of land assets as their valuations did not take into account external restrictions on community land or land under roads as required by the Code and Australian Accounting Standards. This was the reason for one-third of the material errors that needed to be corrected in councils’ previous years’ audited financial statements and for the qualified audit opinion issued on The Hills Shire Council’s 2016–17 financial statements. 

We also found multiple cases where councils did not adequately review valuation results, comply with applicable codes or obtain accurate valuations. This was the reason for the qualified audit opinion issued on Junee Shire Council’s 2016–17 financial statements. 

Councils need to improve their asset valuation processes by strengthening reviews, supporting valuations with robust documentation and commencing the revaluation process earlier in the financial year.

Considerable variability in the way councils report the useful lives of similar assets
We found considerable variability in the way councils reported the useful lives of similar assets in their financial statements. This in turn affects the depreciation expense recognised in councils' financial statements and the key performance indicators that councils report. The useful lives of all assets need to be reviewed annually using current asset condition assessments.

All councils should comply with OLG asset planning requirements
Sound asset management requires effective planning. All councils should meet the asset management planning requirements in OLG's Integrated Planning and Reporting Framework to help ensure they have a plan to manage assets efficiently over their life.

We found that 13 councils did not have an asset management policy, strategy and plan.

Councils should prioritise high risk governance and control deficiencies
Our audits reported 17 high risk issues relating to policies and procedures, risk management, manual journals, reconciliations, purchasing and payables, and payroll processes. It is important to address high risk matters as a priority.

Councils can improve management oversight and governance structures
We found that councils can strengthen governance measures, by having audit committees and internal audit functions, policies and procedures for critical business processes, legislative compliance frameworks and risk management practices.

Councils are not currently required to have an audit, risk and improvement committee and consequently 53 councils do not have an audit committee. Proposed legislative changes will require all councils to appoint an audit, risk and improvement committee by March 2021.

Recommendation

Councils should early adopt the proposed requirement to establish an audit, risk and improvement committee.

An internal audit function is currently not a requirement for councils, and consequently, 52 councils do not have this function. In addition, the Office of Local Government (OLG) has not updated its Internal Audit Guidelines since they were issued in 2010.
 

Recommendation

The Office of Local Government should introduce the requirement for councils to establish internal audit functions and update its 2010 Internal Audit Guidelines.

The Office of Local Government’s register of council entities is not complete
The Local Government Act 1993 requires councils to obtain the consent of the Minister for Local Government before forming a corporation or any other entity^[2], as defined under section 358(4) of the Act (referred to as a ‘council entity’). OLG maintains a register of council entities for which ministerial approval has been sought. Our audit work concluded that the register that OLG maintains is not complete.

Recommendation

The Office of Local Government should maintain an accurate register of entities approved under section 358 of the Local Government Act 1993.

We also found that the Local Government Act 1993 does not stipulate a financial reporting framework for council entities. As a result, there are disparate reporting and auditing practices for entities established across the sector. 

Recommendation

The Office of Local Government should consider establishing a financial reporting framework for council entities.

Councils can strengthen policies and procedures to support business processes
Our audits identified two high risk instances in two councils where business and IT policies and procedures did not exist to support critical business and information technology processes. It is important that critical policies, standards and guidelines are available to staff and contractors to provide direction for the day-to-day operations of a council, promote consistency in processes, clarify roles and responsibilities and support compliance with laws, regulations and codes.

Councils can improve internal controls in business processes
Effective internal controls are important to help councils operate efficiently and effectively, to meet service delivery objectives, and to enable accurate and timely reporting.

We identified two high risk issues where councils had weak controls over manual journals. In one instance, this resulted in significant errors in the financial statements. Councils should independently review manual journals and prepare and review account reconciliations earlier.

We identified five high risk internal control deficiencies in the purchasing function relating to unauthorised expenditure, non-compliance with tendering guidelines and a significant breakdown of purchasing controls.

We noted one high risk internal control deficiency in the payroll function related to payroll staff having unrestricted access to amend sensitive payroll data in the system.

Like many organisations, councils increasingly rely on information technology (IT) to deliver services and manage sensitive information.

Our audits reported nine high risk issues, predominantly related to inappropriate user access. Information technology deficiencies represented the highest number of issues we reported.

Controls over user access to IT systems need to be strengthened

User access controls reduce the risk of users having excessive access to critical financial systems and sensitive information. Our audits found many instances where user access controls were insufficient. These controls should ensure that individuals only have access to financial systems and data necessary to undertake their job responsibilities.

Our audits also found examples of users with inappropriate privileged access In addition, we found instances of inadequate review and insufficient retention of access logs to monitor the activities of privileged system users. Privileged access occurs when a person can change key system configurations and has wide access to system data, files and accounts. We also identified external IT service providers with unrestricted privileged access to council systems and data.

It is important that councils strengthen user access administration to prevent inappropriate access. They should update user access roles in line with the responsibilities of a position and review the level of user access regularly. Councils also need to ensure their existing risk management framework provides assurance for controls over IT outsourcing, and strengthen controls where required.

We identified weaknesses in user developed applications (UDAs), which are developed or managed outside IT administration. This increases the risk of errors that may adversely affect the integrity and quality of information produced. Councils need to adequately control UDAs where they continue to use them and back up business‑critical information.

Councils need to strengthen information technology governance

IT governance should be founded on:

• a fit-for-purpose IT strategy and operational plan
• appropriate policies, standards and guidelines across all critical IT processes.

We found that one in four councils do not have an IT strategy or IT operational plan and some need to develop or improve IT policies and procedures. Sixty-six councils do not have an adequate information security policy.

Seventeen councils also do not have a documented plan to recover from a disaster. Councils need to develop a plan and periodically review it. They also need to periodically test that they can restore backed-up data to ensure business continuity in the face of a system disaster.

Local government is the third tier of government. It is established under State legislation, which defines the powers and geographical areas each council is responsible for.

Each council is a statutory corporation. Elected councillors form the governing body that directs council affairs in line with the Local Government Act 1993 and Local Government (General) Regulations 2005.

Local councils deliver services and infrastructure to a geographic area. County councils are formed for specific purposes such as to supply water, manage flood plains or eradicate noxious weeds.

During 2016, the NSW local government sector was reduced from 166 to 140 councils, resulting in 128 local councils and 12 county councils. This was due to council amalgamations that formed 19 new councils on 12 May 2016 and one new council on 9 September 2016. Appendix four lists the former councils that were amalgamated into 20 new councils.

The table below shows the number of councils before and after amalgamations.

From 1 July 2017, two more county councils were dissolved. The functions of:

• Mid-Coast County Council were transferred into the newly formed Mid-Coast Council
• Southern Slopes County Council were transferred into the Yass Valley Council and the newly formed Hilltops Council.

This report includes the audit results of the 139 councils that have lodged their 2016–17 audited financial statements with the Office of Local Government, plus two water authorities. Bayside Council received a lodgement extension for their 2016–17 financial statements to 31 May 2018 and has not yet presented them for audit.

This report also includes the audit results of the 2015–16 financial statements of eight councils and three water authorities.

In preparing this report, the comments and analysis are drawn from:

• audited financial statements
• data collected from councils
• audit findings reported to councils
• data from external sources, including population, kilometres of roads, and council area data obtained from the Australian Bureau of Statistics and the Office of Local Government.

We have also classified councils into four groups – metropolitan, regional, rural and county. Further details are provided in Appendix three.

Councils invest significant resources each year to deliver a wide range of services to the community. These include waste collection, planning, child and family day care, and recreational services. Councils also build and maintain infrastructure, including roads, footpaths and drains, and enforce various laws.

Council services vary depending on community needs

While core functions, such as waste collection, are similar across councils, the range of services that each council provides varies greatly. The mix is influenced by population density, demographics, the local economy, geographic and climatic characteristics.

Spending on services

The following graphic shows the councils’ expenditure by function in 2016–17.

To aid access, transparency, and comparison of councils’ financial statement data, we have created a data visualisation as part of this report, which is available on the Audit Office of New South Wales website. The visualisation presents revenue, expense, operating surplus, asset and liability data, along with key financial performance and sustainability indicators for each council. The 2016–17 financial statement data used in the data visualisation tool is summarised in Appendix nine and ten of this report.

The data visualisation also presents minimum, median and maximum values within selected council groupings. While these values aid in comparison and assist further inquiry, a good or bad performance conclusion cannot be drawn from this data alone.

The visualisation excludes financial statement data for four councils due to either an incomplete audit, or where our audit opinion on the councils’ financial statements was modified (qualified).

Three indicators help to assess the quality of councils’ financial statements:

• modified and unmodified audit opinions
• significant matters reported to management and those responsible for the governance of a council
• prior-period errors.

While we issued unmodified audit opinions for most councils, the number of significant matters and prior period errors indicate that the overall quality of financial reporting requires improvement.

Asset valuation issues affected the quality of many councils' financial statements in 2016–17, and were the reason for:

• two modified (qualified) audit opinions
• most of the prior-period errors, significant matters and high risk matters reported.

Audit opinions

The key outcome of our audits is an independent audit report on the financial statements that councils must produce each year. We issue either a modified or unmodified opinion on these reports, which indicates whether councils’ financial statements fairly present their financial position and performance.

We issued five modified (qualified) audit opinions

We issued modified audit opinions on the:

• 2016–17 financial statements of three councils
• 2015–16 ⁴ financial statements of one council and one water authority.

The following tables explain the reasons for our modified audit opinions.

In addition, one council received an unmodified audit opinion on its 2016–17 financial statements, that also emphasised an important matter.

We issued unmodified audit opinions for the remaining:

• 136 councils and two water authorities on the 2016–17 financial statements
• seven councils and two water authorities on the 2015–16 financial statements.

We are yet to issue an audit opinion on Bayside Council’s 2016–17 financial statements. 

The outcome of this incomplete audit will be reported in next year’s report to Parliament.

Councils received unqualified audit opinions on special purpose financial information

Councils must also prepare two further documents that are audited:

• special purpose financial statements for declared business activities
• special schedule 8 'Permissible Income’.

The special purpose financial statements are required when councils provide services that compete in the marketplace. Special schedule 8 details the amount that councils can levy from rates for the next financial year. This amount is capped by the rate‑peg limit set by the Independent Pricing and Regulatory Tribunal NSW.

The City of Botany Bay Council's 2015–16 special purpose financial statements were modified for the reason noted above. The Council did not prepare Special Schedule 8 ‘Permissible Income’ in 2015–16.

Significant matters

Australian Auditing Standards require that we report significant matters identified during the audit to those responsible for the governance of a council. This includes the mayor or administrator, councillors and general manager. We also report significant matters to existing audit, risk and improvement committees, given their role in overseeing the financial reporting process.

Significant matters can include material accounting issues and internal control weaknesses.

The 2016–17 audits reported 39 significant matters

Our 2016–17 audits reported 39 significant matters in 29 councils. Most related to asset valuation and accounting issues, including:

• ineffective controls and procedures to support asset valuations
• not appropriately considering external restrictions on the use of community land and land under roads when determining the fair value of assets
• incorrect accounting for Crown reserves and investment properties.

We discuss the asset-related issues further in Chapter 4.

The non asset-related significant matters included:

• internal control deficiencies over IT security
• incorrect recognition of revenue from government grants
• inappropriate use of corporate credit cards
• restricted funds used inappropriately.

The following graph below captures the range of significant matters we reported. (INSERT IMAGE)

Statutory deadlines

Councils had a statutory requirement to lodge their audited financial statements with OLG by 31 October 2017.

Seventy-one per cent of councils lodged audited financial statements by the statutory deadline

One hundred councils (71 per cent) met this requirement for the 2016–17 financial reporting period. However, of these, 71 councils submitted their audited financial statements to OLG during the last week of October 2017.

In many cases, councils provided multiple versions of the financial statements during the audit, including one council where 15 versions of the financial statements were presented for audit. This significantly delayed the audit and the lodgement of audited financial statements with OLG.

Under the Local Government Act 1993, a council may apply to OLG for an extension to the statutory reporting deadline. Forty councils received extensions for their 2016–17 financial statements including 16 newly amalgamated councils. These councils experienced challenges in harmonising accounting policies and practices and combining separate and distinct information technology and reporting systems.

Other reasons that councils put forward to support an extension were council resourcing issues and lack of financial records (particularly poor asset records). These issues had implications on audit resourcing and the timely completion of some audits by the Audit Office.

The graph below maps the lodgement dates of councils’ financial statements.

Early close procedures help to improve the quality and timeliness of financial reporting

Early close procedures are those done before the end of a financial year, usually at the end of a month, such as 30 April. These procedures help to improve the timeliness and quality of financial reporting.

Asset valuation issues affected the quality of many councils’ 2016–17 financial statements and were the reason for two modified (qualified) audit opinions and the majority of high risk and significant matters reported.

Preparing proforma financial statements at an early close date is a good test of a council’s processes and controls.

The audit, risk and improvement committee could support the early close process by ensuring that audit findings are addressed before the year‑end financial statements are prepared. They can identify issues and key risk areas that councils need to resolve before the year-end process. The table provides examples of early close procedures.

Early close procedures
	Complete infrastructure, property plant and equipment valuations.
	Prepare proforma financial statements and associated disclosures.
	Prepare variance analysis and meaningful explanations for movements in financial balances.
	Perform key account reconciliations.
	Assess the impact of material, complex and one off significant transactions.
	Explain any unresolved prior year audit issues including the proposed action plan to resolve them.
	Assess the impact of new and revised accounting standards effective in the current and future years.
	Review of financial statements and processes by management and the audit, risk and improvement committee.

Asset valuation issues affected the quality of many councils’ 2016–17 financial statements and were the reason for two modified (qualified) audit opinions and the majority of high risk and significant matters reported.

Preparing proforma financial statements at an early close date is a good test of a council’s processes and controls.

The audit, risk and improvement committee could support the early close process by ensuring that audit findings are addressed before the year‑end financial statements are prepared.

The first pair of performance indicators relate to the revenue that councils raise to deliver services:

• operating performance
• own source operating revenue.

Operating performance measures how well councils keep operating expenses within operating revenue. Own source operating revenue measures the degree to which a council can generate its own source revenue compared with the total revenue from all sources.

Operating performance

Operating revenue in this measure includes rates and annual charges, user charges and fees, interest, investment and other revenue. It excludes capital grants, capital contributions and changes in the fair value of assets.

OLG sets a benchmark of greater than zero per cent for this measure. Achieving this benchmark means councils are raising enough operating revenue to fund their operating expenses.

This measure assesses performance annually, so the result can be affected by short-term or one‑off events and transactions, such as the profit or loss on disposal of assets and the cost of natural disasters.

Eighteen councils reported negative operating performance

Seven regional, four metropolitan, four rural and three county councils reported negative operating performance in 2016–17.

Of these 18 councils:

• five regional, two metropolitan, two rural and two county councils had reported a negative operating performance for the past three years
• fourteen councils also did not meet the infrastructure backlog ratio and twelve councils also did not meet the buildings and infrastructure renewals ratio.

The next group of indicators help to assess the way councils can:

• meet short term obligations
• service their debt
• collect outstanding rates and annual charges
• meet their future expenses

Unrestricted current ratio

The unrestricted current ratio captures a council’s ability to meet its short-term obligations as they fall due. The ratio excludes externally restricted assets and liabilities. OLG sets a benchmark of having available in unrestricted current assets more than 1.5 times the value of unrestricted current liabilities.

Two regional and one rural council did not meet OLG’s benchmark for unrestricted current ratio.

The assets and liabilities of a council can fall into three categories:

• externally restricted
• internally restricted
• unrestricted.

Externally restricted assets are those affected by legislation or other externally imposed requirements. Internally restricted assets are affected by council resolution or policy, usually for an identified future works program. All other assets are unrestricted. Liabilities are restricted (specific purpose) if they relate to externally restricted assets.

The Office of Local Government (OLG) has prescribed four indicators to assess councils’ asset management:

• buildings and infrastructure renewals ratio
• infrastructure backlog ratio
• asset maintenance ratio
• cost to bring assets to agreed service level.

Appendix ten lists the results of each indicator reported by councils to OLG.

Councils report to OLG against these indicators in the Special Schedule 7 'Report on Infrastructure Assets'. Special Schedule 7 is not required to be externally audited and does not form part of a council's independently audited financial statements. It provides information in addition to that available in the audited financial statements related to the maintenance, renewal, condition and costs of infrastructure assets. The Code requires that the information in Special Schedule 7 is consistent with the council’s asset management plans.

Data reported against OLG’s benchmarks is an indicator of whether councils’ spending on renewing and maintaining their infrastructure assets is sufficient

Thirty-one councils reported they do not meet the OLG benchmarks for either the buildings and infrastructure renewals ratio, the infrastructure backlog ratio or the asset maintenance ratio. These councils may need to examine their asset management plans and consider if their investment in maintaining and renewing infrastructure assets is sufficient.

Councils are required to have asset management plans that consider community needs, available funds, the council’s risk appetite, and the whole-of-life costs of owning and/or managing the infrastructure assets under their control.

The asset management indicators reported in Special Schedule 7 provide a snapshot of data at a point in time. While they may assist with further inquiry, a good or bad performance conclusion cannot be drawn from this data alone.

Buildings and infrastructure renewals ratio

Seventy councils do not meet OLG’s buildings and infrastructure renewals ratio benchmark

The buildings and infrastructure renewals ratio is used to assess the rate at which infrastructure assets are being renewed against the rate at which they are depreciating. OLG sets a benchmark of greater than 100 per cent. The underlying information used to calculate this indicator is derived from a council’s audited financial statements.

Achievement of the OLG benchmark indicates that a council is renewing its assets at the same rate it is depreciating them. Twenty-six rural, 24 regional, 16 metropolitan and four county councils reported to OLG they do not meet the prescribed benchmark for the buildings and infrastructure renewals ratio.

OLG’s Code requires that the buildings and infrastructure renewals ratio is calculated based on a council’s renewal expenditure on specific infrastructure assets listed in Special Schedule 7. OLG has informed the Audit Office that work-in-progress assets are not infrastructure assets for the purposes of reporting in Special Schedule 7. Eighty per cent of councils included work-in-progress assets in calculating the ratio. If work-in-progress assets are excluded from the calculation, a further 23 councils would not meet OLG’s benchmark. This means that 93 councils, or 69 per cent of those that reported this indicator, did not meet the OLG benchmark for renewing their assets.

OLG will need to clarify the requirements for calculating the buildings and infrastructure renewals ratio with councils.

Infrastructure backlog ratio

Eighty-four councils do not meet OLG’s infrastructure backlog ratio benchmark

The infrastructure backlog ratio shows the amount of infrastructure backlog expenditure relative to the total net book value of a council's infrastructure assets. OLG sets the benchmark for this ratio at less than two per cent. Achievement of the OLG benchmark indicates that infrastructure backlog is kept at a manageable level. The underlying information used to calculate this indicator is derived from a council’s audited financial statements and other unaudited sources.

Infrastructure backlog is defined in Special Schedule 7 as the estimated cost to bring a council's infrastructure, buildings, other structures and depreciable land improvements back to a condition determined to be satisfactory by the council and the community.

Thirty-seven rural, 28 regional, 15 metropolitan and four county councils reported to OLG they do not meet the prescribed benchmark for the infrastructure backlog ratio. This means that 60 per cent of councils that reported this indicator did not meet OLG’s benchmark for maintaining their infrastructure backlog.

Asset maintenance ratio

Seventy-one councils do not meet OLG’s asset maintenance ratio benchmark

The asset maintenance ratio compares a council’s actual asset maintenance expenditure to the amount planned in their asset management plans. OLG sets a benchmark of greater than 100 per cent. Achievement of the OLG benchmark indicates that a council is investing enough funds to sustain their assets in a functional state so they reach their predicted useful life. The underlying information used to calculate this indicator is derived from a council’s unaudited asset management plans and other unaudited sources.

Twenty-nine rural, 26 regional, 13 metropolitan and three county councils reported to OLG that they do not meet the prescribed benchmark for the asset maintenance ratio. This means that 54 per cent of councils that reported this indicator did not maintain their assets in accordance with their asset management plans.

Cost to bring assets to agreed service level

The cost to bring assets to agreed service level compares the estimated cost to renew or rehabilitate existing infrastructure assets, that have reached the condition-based intervention level adopted by a council, to the gross replacement cost of all infrastructure assets. OLG has not prescribed a benchmark for this indicator. The underlying information used to calculate this indicator is derived from unaudited sources.

One-hundred and two councils reported results against this indicator to OLG, expressed as a percentage. The reported results ranged from 0.1 per cent to 19.8 per cent. This reflects significant variability between councils in the proportion of outstanding renewal works compared to the total replacement cost of infrastructure assets under their care and stewardship.

Significant matters reported to those charged with council governance

We reported ten high risk asset management issues

Our audits identified ten high risk issues related to asset practices.

Accuracy of asset registers

Effective asset management calls for accurate records of the assets that councils control. Our audits found that council asset registers and systems need to improve. Councils should regularly update asset registers and reconcile them with asset management systems. Suitable controls must be in place to ensure the integrity of manual spreadsheets.

Councils should improve how they manage asset registers

Asset registers record key data on the infrastructure, property, plant and equipment that a council holds. Our 2016–17 audits found:

• twenty-two examples where manual spreadsheets stored asset data without any controls to protect their integrity (discussed further in chapter 6)
• sixteen cases of multiple fixed-asset registers with inconsistent content and formats
• nine instances of inaccurate and incomplete asset registers without supporting documents
• six examples of asset registers that do not, or are not, reconciled with the asset management system used for operational activities
• five instances of completed works-in-progress not capitalised as assets on a timely basis.

Three high risk issues related to councils where multiple fixed asset registers were not reconciled and incomplete. This resulted in numerous errors identified during the audits.

Multiple and decentralised asset registers limit council’s ability to manage and maintain the asset base and report on finances accurately. Manual spreadsheets increase the risk of errors in more complex asset data.

Unrecorded land and infrastructure assets

Councils had $145 million in unrecorded land and infrastructure assets

Our 2016–17 audits identified $145 million of unrecorded land and infrastructure assets at 24 councils. This is in addition to rural fire-fighting equipment not recorded by councils as discussed below.

Seven high risk matters related to asset valuations, including two that resulted in qualified audit opinions

While having accurate asset registers is important, councils must also review the carrying value of their assets regularly so they reflect fair value.

Valuing large infrastructure assets is a complex process that needs to be well planned, managed and documented. The process should commence early in the financial year and, where used, instructions to external valuers need to clearly define the scope of work.

We found that councils need to improve their processes and controls over asset revaluations. Where experts are engaged, council management need to critically review the results to ensure they are robust.

The Office of Local Government (OLG) requires that councils comprehensively revalue each asset class on a five‑year cycle. For those asset classes not subject to a comprehensive revaluation in a given year, councils must still satisfy themselves that asset values materially reflect fair value at the reporting date.

Restricted assets

Valuation methods need to consider restrictions that may affect asset values

At 30 June 2017, councils owned and managed $33.5 billion worth of land, including $17.8 billion (53 per cent) of community land and $4.1 billion (12 per cent) of land under roads.

OLG’s Local Government Code of Accounting Practice and Financial Reporting (Code) sets the financial reporting requirements for councils. The Code requires councils to report assets, such as land under roads and community land, at ‘fair value’.

Australian Accounting Standards define ‘fair value’ as the current exit price to sell or transfer an asset. They require that ‘fair value’ measurement considers an asset’s characteristics, including its condition, location and any restrictions on its sale or use. Such restrictions may be imposed by legislation, regulation or planning instrument.

Most council community land is subject to legislative zoning restrictions though a Local Environment Plan. Land under public roadways is subject to physical restrictions and legislative restrictions under the Roads Act 1993. Councils cannot lift these restrictions without the approval of external bodies.

Our 2016–17 audits found ten councils where the 2015–16 audited financial statements had overstated the value of land assets because the valuation of community land and land under roads did not reflect the physical and legislative restrictions on these assets. Of these, nine corrected the land values in their 2016–17 financial statements.

As a result, the reported value of community land and land under roads at these nine councils reduced by $12.1 billion from the previous years' audited financial statements. Over 90 per cent of the reduction occurred in metropolitan councils, where the value of community land decreased by $7.8 billion and land under roads decreased by $3.5 billion.

Asset revaluations

Asset valuation processes can improve

Councils should have effective controls and procedures to support their asset valuations. Our 2016–17 audits found:

• twelve instances where council management did not sufficiently review valuation results, requiring adjustments in the financial statements
• seven cases where councils did not comprehensively revalue assets in line with the five-year cycle set by the Local Government Code of Accounting Practice and Financial Reporting 
• five examples where council management did not agree on the scope and method of the required valuation with the external valuer before work was completed
• four instances where councils gave the valuer incomplete asset records, resulting in some assets being excluded
• four cases where there were no policies and procedures to support asset valuation processes
• four instances where the revaluation process did not start early enough to update the asset register and general ledger in time for year-end financial reporting
• four examples where supporting papers did not give enough detail of management's accounting treatments, judgements and assumptions underlying asset valuation.

The useful lives of road assets vary across councils

The useful life of an asset is the length of time it should be available for use. The remaining useful life is the period remaining that a council intends to use an asset, largely influenced by its physical condition. The useful life estimates determine the amount of depreciation expense reported in councils’ financial statements.

Our audits reviewed the range of useful lives that councils reported for roads. We found considerable variability in the way councils reported the useful lives of similar road assets.

Effective asset management should be tied together by an effective policy and planning processes. This helps to mitigate risk, support decision-making and ensure that councils manage assets efficiently and effectively over their life cycle. It also helps councils to determine future funding needs in maintaining, renewing and extending their asset base.

Asset management strategy

Thirteen councils do not have an asset management strategy, policy and plan

In 2013, OLG released an Integrated Planning and Reporting Framework (IP&R framework). This helps councils to integrate its plans and policies and align them with its strategic goals.

A key element of the IP&R framework is that all councils have an integrated asset management strategy, policy and plan. Newly amalgamated councils have until 30 June 2018 to finalise these.

Thirteen councils do not have the required asset management strategy, policy and plan. Eleven of these are regional and rural councils.

Significant matters reported to those charged with council governance

During our 2016–17 audits, we identified 36 high risk governance and internal control deficiencies.

Governance refers to the frameworks, processes and behaviours that help a council achieve its objectives, comply with legislative and other requirements, and meet standards of probity, accountability and transparency.

Effective governance builds community confidence and enables the effective and efficient use of public resources. Governance models need to be fit for purpose and tailored to the needs of each council.

In 2015, the Audit Office released its Governance Lighthouse to provide a best practice model of public sector governance for entities to follow. This covers eight principles and 17 key elements of good governance. Councils may find it useful to assess existing governance practices against the key principles in the lighthouse and address any gaps they find.

While this year’s financial audit did not assess every aspect of governance in councils, this report highlights our findings and observations related to:

• audit committees and internal audit
• council entities
• policies and procedures
• legislative compliance frameworks
• risk-management.

Audit committees and internal audit

The combined benefit of an audit committee and internal audit function is that councillors can obtain general assurance that internal controls and risk management are working effectively. The 36 councils that do not have an audit committee and internal audit function are operating without important safeguards and generally accepted checks and balances.

Fifty-three councils have not established an audit, risk and improvement committee

The public expects that government agencies meet high standards of integrity. This includes the way agencies manage real or perceived conflicts of interest.

An effective audit, risk and improvement committee is an important part of good governance.

Councils are not currently required to have an audit, risk and improvement committee. At present, 53 councils do not have a functioning audit committee.

Changes outlined in section 428A of the Local Government Amendment (Governance and Planning) Act 2016 will require councils to establish an audit, risk and improvement committee. This is expected to be a requirement by March 2021.

Section 428B of the Local Government Amendment (Governance and Planning) Act 2016 specifies that councils may jointly appoint an audit, risk and improvement committee to exercise functions for more than one council.

Fifty-two councils do not have an internal audit function

Internal audit is another important element of an effective governance framework as it supports a risk and compliance culture. Internal audit provides assurance that a council's governance practices and internal control environment are effective, and identifies where performance can improve.

Councils are not currently required to have an internal audit function. As the following table shows, 33 rural councils, eight county councils, eight regional councils and three metropolitan councils do not have an internal audit function. Of these councils, nine are newly amalgamated.

There are 13 councils with an internal audit function but without an audit, risk and improvement committee. An effective audit committee would complement the internal audit function and provide it with a separate reporting line independent of management.

The Office of Local Government (OLG) has not updated the Internal Audit Guidelines it released in 2010. The OLG should, at a minimum, introduce the requirement for councils to establish internal audit functions and update its 2010 Internal Audit Guidelines.

An internal audit function is mandatory for all State government agencies. A useful reference point for councils is available in TPP 15-03 Internal Audit and Risk Management Policy for the NSW Public Sector, issued by NSW Treasury.

Council entities

The Office of Local Government does not have complete information on council entities

Section 358 of the Local Government Act 1993 (Act) specifies that councils must not form or participate in forming a corporation or other entity, or acquire a controlling interest in a corporation or other entity, except with the consent of the Minister for Local Government. These entities are referred to as ‘council entities’.

Section 415 of the Act deals with auditing of the financial statements of council entities. The definition of a council entity in section 415 includes a wide and diverse range of bodies and is consistent with the definition of entities under section 358 of the Act. Our initial audit work identified 261 entities that met the definition of a council entity.

OLG maintains a register of entities where a council has sought approval from the Minister under section 358 of the Act. The register maintained by OLG was not complete and accurate. It also did not identify what entities had been approved by the Minister.

The legislation does not clarify the financial reporting obligations of council entities

We found uncertainty in the legislative framework governing the oversight of council entities⁵ and their financial reporting and auditing requirements. This can result in a lack of transparency and accountability over the activities of council entities.

The Local Government Act 1993 does not require council entities to keep records or prepare financial statements. Some council entities prepare financial statements, while others do not. The financial statements of some entities are audited, where others remain unaudited.

Given this uncertainty, we sought advice from the NSW Crown Solicitor about the Auditor‑General's obligations under the Act. This confirmed that arrangements for council entities under the Act need clarification. Appendix 11 attaches this advice.

Policies and procedures

Formal policies and procedures support effective governance and internal control as they:

• provide direction for the day-to-day operations of a council
• promote consistency
• clarify accountability and other issues to staff and management
• support compliance with laws, regulations and codes.

Policies and procedures are not always in place or kept up to date

Councils need to ensure that policies, standards and guidelines are available to staff and contractors across all critical business processes, and that they are reviewed and updated regularly, including when significant changes occur.

Our financial audits did not review all council policies and procedures, but looked at whether policies and procedures for critical business processes exist and are updated. We found 73 cases across 47 councils where policies and procedures did not exist or had not been updated for:

• financial management
• information technology
• procurement
• contract management.

Of the 73 issues, two were high risk, 48 were moderate risk and 23 were rated low risk

Our audits reported nine high risk information technology control issues in our audit management letters to councils.

Effective user access control involves the following good practice:
	Clear policies and procedures
	Formal approval to establish and modify user accounts
	Removal of access when no longer required
	Regular review of user access
	Password parameters in line with good practice
	Clear records of user access

Privileged access

Privileged access occurs when a person can change key system configurations and has wide access to system data, files and accounts. Our audits found examples of inappropriate privileged access, inadequate review and insufficient retention of access logs to monitor the activities of privileged system users.

To minimise the risk of individuals having inappropriate access to IT systems, councils need to strengthen their policies and procedures over privileged user access.

Staff and third-party contractors had unmonitored access to some council systems

Privileged access controls should follow the same good practice principles as general access controls discussed above. However, the impact of poor administration of privileged access controls can be greater than general access controls, because privileged access enables greater control over key IT systems.

Access to IT systems should be granted using the principle of 'least privilege'. This means that system users should only have the system access privileges needed to perform their job, and
no-one should have ongoing access to highly privileged functions unless their job demands it.

Where individuals have privileged access, independent oversight should detect and rectify any inappropriate activity. Activity logs of users with privileged access should be reported to someone in a position of authority who is independent of the IT team.

Our audits found:

• IT staff, finance staff and senior management at 22 councils with inappropriate access to privileged finance applications and council data. They could bypass system-based controls or make direct changes to financial data
• fifty-six councils where there is no review of access and usage for users with highly privileged system access
• eleven councils where highly privileged generic user accounts were shared between staff and third-party contractors, limiting the effectiveness of any audit logs
• nine councils with no audit logs detailing the activity of privileged users
• two councils where audit logs were not reviewed or secured
• one council where IT staff could develop and implement changes to financial systems without any authorisation and oversight.

At five councils, these observations were high risk due to a combination of weaknesses. As a result, we were required to perform extra audit procedures to address the risk. These councils also have remediation plans in place, which we will review during our next audit.

Access controls over third-party service providers needs to be strengthened

Most councils rely on third-party service providers for IT administration support. This can be from the vendor of key council systems or an independent IT contractor. Councils need to ensure their existing risk management framework provides assurance for controls over IT outsourcing.

Our audits identified:

• nine councils where there were third parties with unrestricted and unmonitored access to council systems and data
• three councils that had cloud-based financial reporting systems where the council has no assurance that key controls at the service provider are operating effectively
• one council where there was significant reliance on the systems, knowledge and expertise of third parties with no plan should these services be withdrawn.

These examples presented a moderate risk given mitigating controls in place.

User developed applications

User developed applications (UDAs) are computing applications, tools and processes that are developed or managed outside IT administration. These pose extra risks because controls used by internal IT systems may be absent.

User developed applications allow users to bypass user access controls

Councils commonly use UDAs such as spreadsheets, databases and reporting tools in day-to-day operations. There may be internally developed workarounds when a vendor-supplied solution is absent or too expensive to implement.

Reasons why councils might use UDA tools include that they can:

• allow users to interact with council data directly and independently
• be developed cheaply and quickly compared to system enhancements that use a more traditional system development lifecycle.

At the same time, UDAs can pose significant risks. They can lack the traditional controls of a formally deployed business application, and often sit outside the defined control environment. Over time, their original purpose can be lost and their use and complexity can expand. This increases the risk of errors or intentional misuse.

Because of these risks, councils should consider migrating from UDAs to internal IT systems wherever possible. Where this is not feasible, they should implement mitigating controls such as:

• ensuring that UDAs are subject to the council’s software development lifecycle requirements for specification, design, building, testing and maintenance
• reviewing and updating policies for user access controls and ensuring assigned access rights to UDAs are appropriate and periodically reviewed
• ensuring all business-critical UDAs are backed up regularly and their recoverability tested.

Our audits found:

• twenty-two councils where spreadsheets were used for business operations, decision making and financial reporting that were not adequately secured, with changes that were not tracked, tested or reviewed. Examples included the calculation of development application fees and depreciation
• five councils where finance staff and senior management had inappropriate access, using database query tools to directly modify financial data in database tables, circumventing system-based business process controls.

These observations were mostly classed as moderate risk as there were mitigating controls in place. However, it was a high risk issue at one council because of the importance of the data maintained in spreadsheets and the lack of access and version controls.

IT governance refers to the strategies and frameworks, polices and processes that councils use to oversee and manage IT risks.

Strategy, policies and procedures

One in four councils do not have an IT strategy or operational plan

An IT strategy and an operational plan are important for achieving the best use of IT resources.

An IT strategy links technology use to the wider objectives of a council. It needs to be fit for purpose and take into account the size and complexity of a particular council.

An IT operational plan sets out the day‑to‑day tasks, time frames, responsibilities and resources needed to realise the goals of an IT strategy.

Thirty-one councils did not have an IT strategy or operational plan.

We also found that 16 councils had an IT operational plan but not an IT strategy. Without an IT strategy, there is a risk that IT investment is not aligned with council priorities. Some councils need to develop or improve IT policies and procedures.

Effective IT governance is strengthened when:
	There is an IT strategy and operational plan in place that is fit for purpose and suits the size and complexity of the council
	Appropriate policies (such as an information security policy), standards and guidelines are available to staff and contractors across all critical IT processes. These are reviewed and updated periodically, including when significant system or process changes occur
	There are processes to consider, capture and monitor IT risks that would affect operations.

Clear and well-defined IT policies and procedures help organisations to implement their strategies and plans. Our audits found the following issues across 33 councils:

• twenty-four councils without formal IT policies and procedures over IT security, change management, disaster recovery and/or business continuity
• seventeen councils without a formal and defined process to appropriately support access management for financial reporting systems
• seventeen councils that need to strengthen existing policies and procedures for IT security, change management or disaster recovery
• two councils that had not reviewed or updated IT policies and procedures in several years.

Over half of councils do not have an information security policy

We identified that 66 councils do not have a formal information security policy. Without this, councils are likely to rely on the knowledge, risk appetite and diligence of individual staff to maintain the security of key IT systems. All councils should have a formally defined process to support the security of and access to all systems.

On 2 March 2018, the Audit Office tabled a performance audit report on ‘Detecting and responding to cyber security incidents’. Cyber security incidents can harm government service delivery and may include theft of personal information, denial of access to critical technology, or even the hijacking of systems for profit or malicious intent. Recent global and national security incidents highlight the importance for councils to have systems and processes for detecting and responding effectively to security incidents.

Disaster recovery and business continuity

Councils can improve backup, disaster recovery and business continuity controls

The ability to restore data from valid backups is critical to ensure business continuity. Without it, councils may be unable to continue providing essential public services in the face of a system disaster.

Councils need to thoroughly assess their business systems and documented plan outlining how critical business functions will be recovered in the event of a disaster. Once plans are in place, they then need to be reviewed and tested regularly. The ability to restore backed-up data should also be periodically tested.

We found that 17 councils do not have a documented plan to recover from a disaster. We also found that 15 councils do not periodically test their ability to restore backups of data relevant to financial reporting.

Without these measures, there may not be a clear process to minimise the impact of a significant incident interrupting critical business functions to ensure the continued delivery of services.

We expect to focus on these areas in our future audits