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Note 2: Key Assumptions and Judgements

These financial statements reflect the Government's financial position (service potential and financial capacity) as at 30 June 2017, and the financial results of operations and cash flows for the year ended on that date. Underpinning these financial statements are a number of judgements, estimations and assumptions. These include assumptions and judgements about the future, in particular, the service benefits and future cash flows in relation to existing assets and liabilities.

Key assumptions

The assumptions in these financial statements are based on the best information available at the time of their preparation. Given the inherent uncertainty of predicting the future, actual events are likely to differ from these assumptions, which may have a material impact on the results reported in these financial statements. Some of the key assumptions are discussed below.

Assumption

Foreign exchange rates

That foreign currency denominated financial assets and liabilities will be able to be translated to New Zealand dollars at the exchange rate prevailing at the reporting date. 

Share prices

That listed share investments, which consist of approximately 95% of the Government's total share investments, can be realised at quoted market prices at balance date.

Interest rates

That current market yield curves provide an appropriate basis for determining the value of the majority of marketable securities and borrowings.

Carbon price

That the carbon price, determined by the Ministry for the Environment based on the quoted NZU spot price at the end of the reporting date as published by OM Financial Limited on their CommTrade Carbon website, reflects the value of units that will be surrendered to the Crown.

Property prices

That current property prices, determined using market evidence, provide the most relevant basis on which to value land and buildings owned by the Crown.

Depreciation rates

That the economic useful life of assets (used to determine depreciation rates) will equate to the estimates determined using a combination of engineering and historical evidence.

Asset Purpose

That assets will continue to be held for their intended purpose. Assets that are held for for-profit purposes are subject to a commercially recoverable amount test (the higher of the income that can be generated from the asset, or the proceeds from its sale).  Assets that are held for public benefit purposes are generally valued at optimised depreciated replacement cost. Optimisation means that surplus assets are identified.  If not surplus, it can be assumed the asset will be replaced, and therefore the asset value is not reduced below its optimised depreciated replacement cost.  If surplus, the asset will be valued at its net selling price.

With respect to the asset purpose assumption, the valuation of the Rail Freight Network is particularly uncertain at present. Treated as a for-profit asset since 2012, this asset has a carrying value of $96 million (2016: $101 million). The Crown is currently conducting a review to consider KiwiRail's operating structure, capital requirements and funding mechanisms within the context of rail's purpose within New Zealand's broader transport mix. This review may change the assumptions underlying the future valuations of KiwiRail's Rail Freight Network.

A number of outcomes are possible from the review, including the possibility of some assets being determined as surplus to requirements, which could result in a portion of the freight assets being revalued using the optimised depreciated replacement cost methodology that was used prior to 2012. The potential impact of this revaluation could increase the asset value up to $4.4 billion and result in the reversal of some or all of the $1.4 billion impairment expense previously recognised. For further information, see note 16.

A number of long-term assets and liabilities are valued by estimating future cash flows which are then discounted to present value. Some of the cash flows, in particular those relating to long-term liabilities (egg, ACC and GSF obligations) use assumptions to predict cash flows up as far as 80 years into the future. Therefore, changes in a number of economic variables can have a significant impact of the Government’s financial position and performance. The most significant of these are:

Changes in economic variables
Economic variable Assumptions and Methodology
Inflation rates Inflation rate assumptions are used to help estimate future cash flows, as prices are expected to increase through time.  The consumer price index (CPI) is most commonly used to indicate the inflation rate.  However, some costs are assumed to increase faster than the rate of inflation (referred to as superimposed inflation) due to factors such as innovation in medical treatment.
Discount rates (time value of money) Discount rates are used to determine the value of future cash flows in today's dollar values.  The Treasury sets a risk free discount rate for accounting valuation purposes. In the near term discount rates are based on market data and then smoothed to a single long-term risk-free interest rate of 4.75%. A full description of the evidence and methodology used to determine this rate can be found at: http://www.treasury.govt.nz/publications/guidance/reporting/accounting/discountrates
Amount and duration of future cash flows

Judgements around the duration of future cash flows are critical for valuations.  Some examples of this are:

  • the length of rehabilitation from injuries for the ACC obligation
  • mortality rates for the GSF obligation
  • repayment rates of student loans.

These assumptions are largely based on extrapolating historical experience.  As time goes on, better information becomes available and estimates are updated to reflect more current information.

Sensitivity of key assumptions

The tables below outline the sensitivity of the key assumptions discussed above on the significant valuations included in these financial statements.

The value of financial assets and financial liabilities are particularly sensitive to changes in market prices and account for a significant portion of the financial position. At 30 June 2017 financial assets totalled $133.3 billion (2016: $125.8 billion) while financial liabilities totalled $128.4 billion (2016: $127.2 billion).

  Impact on operating balance
2017
$m
2016
$m
Share prices strengthen by 10% 3,044 2,394
Share prices weaken by 10% (3,044) (2,394)
Increase in NZ interest rates 1% (100 basis points) (946) (896)
Decrease in NZ interest rate 1% (100 basis points) 1,122 926
NZ dollar exchange rate strengthens by 10% (793) (963)
NZ dollar exchange rate weakens by 10% 922 1,087
NZD carbon price increases by $1 (118) (127)
NZD carbon price decreases by $1 118 127

In relation to assumptions concerning property prices, land and buildings account for 58% (2016: 57%) of total property, plant and equipment and 68% (2016: 65%) of the asset revaluation reserve. A significant decline in property prices would not impact the operating balance but would reduce net worth.

Long term liabilities such as the ACC claims liability ($40.3 billion) and the GSF retirement plan ($11.0 billion) are particularly sensitive to the assumptions associated with estimating discounted cash flows. The table below outlines the sensitivity of those liabilities to key assumptions:

Change Impact on
operating balance
2017
$m
2016
$m
Sensitivity of assumptions  
Risk-free discount rate +1% 6,675 6,967
-1% (8,712) (9,139)
Inflation rates (including superimposed inflation) +1% (8,769) (9,100)
-1% 6,818 7,048
Social rehabilitation benefits - superimposed inflation
after four years for serious injury claims (ACC only)
+1% (3,233) (3,336)
-1% 2,384 2,445
Average weighted term to settlement from reporting date (ACC only) +1 year 1,139 1,106
-1 year (1,175) (1,141)
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