European Scrutiny Committee Contents


8 Financial management

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COM(08) 866

Commission Communication: Towards a common understanding of the concept of tolerable risk of error

Legal base
Document originated16 December 2008
Deposited in Parliament13 January 2009
DepartmentHM Treasury
Basis of considerationEM of 9 February 2009
Previous Committee ReportNone
To be discussed in CouncilNot known
Committee's assessmentPolitically important
Committee's decisionNot cleared; further information requested

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.  Back


 
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