8 Financial management
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17592/08
+ ADD 1
COM(08) 866
| Commission Communication: Towards a common understanding of the concept of tolerable risk of error
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| Legal base | — |
| Document originated | 16 December 2008
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| Deposited in Parliament | 13 January 2009
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| Department | HM Treasury |
| Basis of consideration | EM of 9 February 2009
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| Previous Committee Report | None
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| To be discussed in Council | Not known
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| Committee's assessment | Politically important
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| Committee's decision | Not cleared; further information requested
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Background
8.1 The European Court of Auditors currently use a 2% materiality
threshold as the general acceptable level of error for all expenditure
areas. This measure is also used by the Court in drawing its conclusions
on the legality and regularity of underlying transactions in its
annual reports on implementation of the Community Budget. The
concept of tolerable risk for Community funds was first introduced
by the Court,[31] which
made it clear that "transactions can rarely be absolutely
free of error, and a degree of tolerance in their accuracy is
therefore acceptable".[32]
The Court has further indicated that, because of the inherent
risk of some funds, 2% is not necessarily the right benchmark
for balancing the costs and benefits of control in some areas
of the budget. It has called on the Commission to propose rates
of tolerable risk of error and for these to be decided upon at
political level.
The document
8.2 In this Communication the Commission suggests an approach
to tolerable risk and illustrates the efficient control costs
for two Community funds. The annexed Staff Working Document outlines
in more detail the model and the specificities of the work carried
out. Together these documents provide guidance on how the concept
of tolerable risk can be analysed and examples to illustrate how
varying levels of tolerable risk could provide cost efficient
controls for the Community. The Commission hopes the Communication
will further debate and provide a basis for institutional agreement
on the way forward in analysing the tolerable risk of error. The
Communication, after describing the background, covers three matters:
- definitions and the Commission's approach in considering tolerable
risk;
- illustrative examples of cost of control and
risk of error; and
- the way forward.
8.3 The Commission's definitions are:
- tolerable risk is the level
of undetected error accepted or tolerated, once inherent risk
has been mitigated by cost-effective controls — that is
tolerable risk equals inherent risk less the risk mitigated by
cost-effective controls;
- inherent risk is the risk linked to the activity
itself and includes the number and types of beneficiaries, management
framework, stability of the policy environment, complexity of
legislation and the nature of actions;
- error rates can be limited by more and/or better
controls — these are costly and must be balanced by the
benefit they have in reducing errors.
8.4 The Commission's approach seeks to demonstrate,
with a simple model, the trade off between the costs of controls
and their benefits. The theoretical level of tolerable risk is
outlined as the point where the marginal cost of an additional
control equals the marginal benefit of that control. When the
marginal benefit exceeds the marginal cost it is worthwhile increasing
controls and when the cost exceeds the benefit it is worthwhile
reducing controls. Thus, the efficient level of controls is at
the point where marginal cost and marginal benefit are equal.
The Staff Working Document explains in greater detail the relationship
between the cost and the rate of undetected errors and describes
the assumptions underlying the model.
8.5 In the Communication the Commission outlines
the assumptions upon which the model is reliant. It notes that
some assumptions would tend to overestimate the tolerable risk
point. These are that:
- control costs are always the
same;
- the population is homogenous in risk; and
- ex ante measures to
promote controls, such as training and guidance, be excluded.
8.6 The Commission further notes that other assumptions
would tend to underestimate the costs of controls, such as audit
risk not being taken into account nor the possibility of improving
existing controls. It suggests that the combined effect of these
assumptions may balance each other out. The Staff Working Document
outlines more sophisticated mathematical approaches and concludes
that they produce comparable results to the simplified model.
8.7 The Commission suggests that the model could
be further developed to take account of the inherent level of
risk of projects, the size of projects and the duration of projects.
But it adds that advancing the model would be costly and very
time consuming and so this is not further pursued at this point
juncture.
8.8 The illustrative examples of cost of control
and risk of error the Commission presents relate to the European
Regional Development Fund and the European Agricultural Fund for
Rural Development. For the former, which is part of the Structural
Funds that received an estimated overall error rate of 12% in
2006 and 11% in 2007, the Commission says that:
- the calculation of the tolerable
risk point is based on the European Court of Auditors 2006 Statement
of Assurance and findings;[33]
- as a quarter of errors could be prevented through
better controls at insignificant cost, the 12% error rate could
be reduced to 9%;
- it estimates the tolerable risk point to be 4%
and the efficient level of controls to be around €996 million
(£949 million) — equivalent to 3.5% of total public
expenditure on the fund;
- this indicates that spending more on control
of this fund would be cost effective up to the point of an error
rate of 4%;
- an increase in current controls from 0.7% to
3.5% of public expenditure would be efficient as €100 million
(£95 million) extra spending on controls could yield a net
benefit of €285 million (£271million) in detected errors;
- according to its calculations, achieving a 2%
error rate would require an eightfold increase in control expenditure
— to almost 6% of public expenditure on the fund;
- if costs of control were 50% higher than estimated
in its calculations, the tolerable risk point would increase by
1% — to 5%; and
- this, together with the result of sensitivity
analysis conducted for the Staff Working Document, shows the limited
variation in the tolerable risk point in the European Regional
Development Fund.
8.9 On the European Agricultural Fund for Rural Development
the Commission;
- notes the European Court of
Auditor's comments in its Special Report 3/2005[34]
that agro-environmental expenditure is not only risky by its nature
but also impossible to obtain assurance on at reasonable cost;
- says that, as it was not possible to obtain an
estimate of tolerable risk from the Court's statement of Assurance,
the Commission requested statistics from Member States on the
results of on-the-spot controls for the financial year 2007;
- states that it was not possible to verify this
information;
- estimates the error rate for agro-environmental
measures to be 4% and control costs to be €360 million (£343
million) — 13% of total public expenditure on the fund;
- says that the model indicates that the current
level of controls is acceptable, as increasing them would not
be cost-effective — a 1% increase in on-the-spot controls
would yield savings of only 10% of the cost of the additional
controls; and
- estimates that reducing the level of error to
the Court's 2% threshold would raise the cost of control from
13% to almost 30% of total public expenditure on the find and
would not, therefore, be cost-effective.
8.10 Turning to the way forward the Commission's
preliminary conclusions are that:
- it recognises that control
systems could prevent, detect and correct errors more effectively
at the same cost and encourages this;
- its analysis confirms its initial view that the
2% materiality level is not a cost-effective control strategy
for some policy areas;
- it estimates that the tolerable risk level for
the European Regional Development Fund may lie around 5%;
- it estimates that further controls to reduce
errors for the European Agricultural Fund for Rural Development
would not be cost-effective and that the tolerable risk level
is likely to lie around 5%;
- it considers its approach to be robust and thinks
it could be applied to other policy areas; and
- it considers it neither necessary nor cost effective
to extend its analysis to take account of the assumptions underlying
the model.
8.11 Of possible steps towards an agreement on implementing
a tolerable risk approach the Commission concludes that:
- implementation of a tolerable
risk approach would be a sound investment;
- the debate with Council, European Parliament
and the European Court of Auditors should be re-launched and a
presentation given to them by the Commission, with the view to
deciding on the level of risk to be tolerated; and
- should the conclusions of the debate allow, the
Commission would present further analyses on tolerable risk for
expenditure on research, energy and transport and external aid,
development and enlargement before mid-2010.
The Government's view
8.12 The Economic Secretary to the Treasury (Ian
Pearson) tells us that the Government welcomes the Commission's
Communication as a basis for further discussion on the issue of
tolerable risk of error. However, he goes on to comment that:
- the Government does not believe
this Communication can form the basis for agreeing differing levels
of tolerable risk for different areas of expenditure or that this
is the right time to do so;
- its position remains that high standards of financial
management and effective control systems are of paramount importance
across the Community;
- the Government believes that the costs of control
should not outweigh their financial benefits, if these are to
represent value for money for Community taxpayers;
- it is concerned by the Commission's estimate
of the percentage cost of controls that was required for 2000-2006
Structural Funds programmes and will push for the cost of 2007-13
controls to be monitored closely in forthcoming discussions on
financial management of Community funds;
- it supports the European Court of Auditors' view
that if a scheme cannot be satisfactorily implemented at an acceptable
level of cost and with tolerable risk it should be reconsidered;[35]
- it believes, furthermore, that setting the same
level of tolerable risk for all expenditure areas may be too rigid
an approach, which would fail to take account of differing levels
of inherent risk — levels of inherent risk are important
as these have a significant impact on the cost of control and
on the level at which spending on control systems is effective;
- although the Communication is a useful basis
for further discussion, the Government does not believe it can
be used as a foundation for setting differing levels of tolerable
risk for three reasons;
- firstly, the Commission's analysis and examples
relate to spending and error rates of programmes governed by Regulations
of the 2000-2006 Financial Perspective and therefore the error
rates are not relevant to 2007-13 programmes;
- secondly, before having an informed discussion
on appropriate levels of tolerable risk, the impact of the simplification
of procedures, guidance and regulations governing the 2007-13
programme Regulations needs to be assessed and further simplification
must take place. Once published, the impact assessment on the
Commission's forthcoming "Action Plan towards an Integrated
Internal Control Framework" should be useful in informing
this process;
- thirdly, the Government believes that greater
responsibility must be taken by Member States to improve the management
of Community funds at national level. The Government takes this
responsibility very seriously and has taken action to improve
its control and management procedures for both structural and
agricultural fund expenditure;
- the Government has committed itself to publishing
an annual consolidated statement on the use of Community funds
in the UK to help continually improve its management and control
procedures;[36]
- the Government believes that control systems
must remain of the highest standards to ensure Community funds
are properly spent and error rates are kept as low as possible;
and
- the Government will continue to work with like-minded
Member States to maintain the pressure for action on all these
fronts, as well as supporting the Commission in its efforts to
bring about an informed discussion on the issue of tolerable risk
and cost of controls.
Conclusion
8.13 For all the caveats the Minister lists, this
Communication is, as he says, a basis for further discussion on
the issue of tolerable risk of error. Before considering the document
further we should like to hear from the Government as to developments
in carrying forward the issues raised. Meanwhile the document
remains under scrutiny.
31 Opinion 2/2004 of the Court of Auditors of the European
Communities on the single audit model (and a proposal for a Community
internal control framework) OJ No. C 107, 30.4.04, p.1 and (26652)
10326/05: see HC 34-v (2005-06), chapter 43 (12 October 2005). Back
32
The DAS [Statement of Assurance] methodology, European Court of
Auditors: see http://eca.europa.eu/portal/page/portal/audit/StatementofAssurance.
Back
33
(29232): see HC 16-viii (2007-08), chapter 3 (16 January 2008)
and Stg Co Deb, European Standing Committee, 28 January
2008, cols. 3-26. Back
34
(26902) 12921/05: see HC 34-viii (2005-06), chapter 10 (2 November
2005). Back
35
European Court of Auditors, Annual Report on the Implementation
of the 2007 Budget, paragraph 1.52 (d) - (30203): see HC 19-iii
(2008-09), chapter 3 (14 January 2009) and HC Deb, 20 January
2009, cols 654-79. Back
36
The first of these was published in July 2008: see http://www.hm-treasury.gov.uk/d/statement_eufunds170708.pdf.
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