Part 7: The financial management framework

7.1
In this Part, we discuss the third and final main individual content area of the LTCCP - the financial management framework. We discuss the two other main content areas in Part 5 (the performance framework) and Part 6 (asset management planning).

The importance of the financial management framework

7.2
For the LTCCP reader to understand a local authority’s proposed direction, the local authority needs to include its funding and financial policies and financial strategy in the LTCCP.¹ Without such policies, it is often not apparent what the local authority is seeking to achieve and why certain financial results are forecast in the financial information. Further, the policies and strategy are integral to a local authority demonstrating that it is “prudent” in managing its financial resources.²

7.3
The funding and financial policies are also important for determining from where and whom the local authority is seeking to fund its operations. There should be clear links between the policies and the LTCCP’s Group of Activities Statement, the rating level projected in the financial statements, the Funding Impact Statement, and the predicted financial position of the local authority.

7.4
The outworking of these policies, in conjunction with the intended directions for service provision, effectively set a local authority’s financial strategy for the duration of the LTCCP. Unfortunately, few LTCCPs contained any useful summary of the financial strategy used and how it might affect the local authority’s service provision. In many instances, we had to urge local authorities to include additional information – either by clarifying their financial strategy or the effect of that strategy or by stating their strategy in the first place.

7.5
The absence of a clear articulation of a local authority’s financial strategies affected the local authority’s ability to communicate "the right debate". In our view, the LTCCP must clearly state the authority’s financial strategies. This is important for adding value to, and facilitating, appropriate and adequate public debate and agreement.

Three main aspects of the financial management framework

7.6
There are three main aspects of the financial management framework:

• The concept of the balanced budget. This is one of the most important considerations within the Act³ and the LTCCP. It is closely associated with achieving intergenerational equity and the sustainability of a local authority’s service delivery.
• The revenue and financing policy. Arguably, this is the pre-eminent funding and financial policy – in particular, when combined with the Funding Impact Statement and Group of Activities Statement financial information.
• The Cost of Service Statements within the individual Group of Activities Statements. Group of Activities Statements and their related Cost of Service Statements are integral to understanding the local authority’s service intentions and financial strategy.

7.7
Clarity in all three areas within the LTCCP is important.

The balanced budget and prudent financial management

7.8
In our view, one of the most important yet misunderstood aspects of the Act is the balanced budget and prudent financial management provisions contained in sections 100 and 101.

7.9
During our review of the 2006-16 LTCCP audits, we identified concerns about how local authorities articulated their financial strategies – especially the explanation of surpluses.

7.10
In paragraphs 7.11-7.83, we provide our interpretation and application of the balanced budget and prudent financial management provisions of the Act, including how those provisions apply to surpluses. Also included are examples where we issued non-standard audit opinions to highlight concerns about the financial prudence of three local authorities’ LTCCP Statements of Proposal.

Background

7.11
The financial management principles and requirements for LTCCPs are set out in Subpart 3 of Part 6 of the Act.

7.12
While the Act appears to be written from the premise that a balanced budget – where forecast operating revenues are at least equal to forecast operating expenses – is, on the face of it, financially prudent, the most important provision is section 101, which sets out the principles of prudent financial management.

7.13
Section 100 contains the balanced budget requirement, and section 102 covers funding and financial policies. Figure 21 shows the hierarchy of these sections when assessing the financial prudence of any LTCCP.

Figure 21
Hierarchy of the Local Government Act 2002 assessment of financial prudence

Financial management provisions

7.14 The core financial management requirements set out in section 101 of the Act are:

1. A local authority must manage its revenues, expenses, assets, liabilities, investments, and general financial dealings prudently and in a manner that promotes the current and future interests of the community.
2. A local authority must make adequate and effective provision in its long-term council community plan and in its annual plan (where applicable) to meet the expenditure needs of the local authority identified in that long-term council community plan and annual plan.
3. The funding needs of the local authority must be met from those sources that the local authority determines to be appropriate, following consideration of,—

1. in relation to each activity to be funded,—
   1. the community outcomes to which the activity primarily contributes; and
   2. the distribution of benefits between the community as a whole, any identifiable part of the community, and individuals; and
   3. the period in or over which those benefits are expected to occur; and
   4. the extent to which the actions or inaction of particular individuals or a group contribute to the need to undertake the activity; and
   5. the costs and benefits, including consequences for transparency and accountability, of funding the activity distinctly from other activities; and
2. the overall impact of any allocation of liability for revenue needs on the current and future social, economic, environmental, and cultural well-being of the community.

7.15
A local authority gives effect to section 101 through the funding and financial policies mentioned in sections 102 to 108 of the Act.

7.16
The key sections (102 to 106) require local authorities to adopt four policies with prescribed content requirements:

• a revenue and financing policy - which specifies how operating and capital expenditure will be funded from sources such as rates, fees and charges, interest and dividends, development contributions, and borrowing;
• a liability management policy - which specifies how debt will be managed, including borrowing limits;
• an investment policy - which specifies how investments will be managed; and
• a policy on development contributions or financial contributions - which specifies the approach to obtaining funding for the asset costs arising from growth.

7.17
Operating and capital costs are a function of the levels of service that a local authority intends to provide. These policies provide the guidelines outlining who costs are recovered from and over what period.

Balanced budget requirement

7.18
The purpose of the balanced budget requirement is to ensure that there is access to enough funding to enable the services and assets of the local authority to be sustainably funded over the long term in a manner consistent with prudent financial management.

7.19
Section 100(1) of the Act sets out the balanced budget requirement:

A local authority must ensure that each year's projected operating revenues are set at a level sufficient to meet that year's projected operating expenses.

7.20
In this context, "sufficient to meet" means that operating revenues must at least equal operating expenses.

7.21
Under section 100(2), a local authority can set the projected operating revenues at a level different from that required to meet projected operating expenses if the local authority resolves that it is financially prudent to do so. In considering financial prudence, the local authority must have regard to:

• maintaining levels of service;
• maintaining service capacity and integrity of assets;
• intergenerational equity; and
• compliance with local authority funding and financing policies (established under section 102).

7.22
The Act improves the provisions in the Local Government Act 1974 in that it:

• provides that local authorities may choose not to balance the budget where they determine it prudent not to do so; and
• makes it clear that asset replacement and ongoing sustainability are relevant considerations in deciding not to balance the budget.

7.23
These provisions create an opportunity for local authorities to consider their funding requirements from an economic sustainability perspective, rather than the accounting perspective that is presented in the forecast financial statements.

7.24
The 2006-16 LTCCPs were for the minimum period of 10 years. However, the consideration around the balanced budget principles is not limited to the period covered by the LTCCP. This is shown by some of the statutory references:

• Section 100(2)(c) requires local authorities to consider funding for the provision and maintenance of assets over their useful life. The useful lives of most assets held by local authorities extend well beyond the period covered by the LTCCP.
• Section 101(3) sets out funding principles that incorporate the principle of intergenerational equity. Again, such a funding principle generally extends beyond the period covered by the LTCCP.

7.25
The Act has provided much needed flexibility to the balanced budget requirements. However, the provisions noted in paragraph 7.21 also increase the complexity of the assessment and the judgements required of the local authority and its community.

Examining the balanced budget requirement and its links to financial prudence

7.26
The forecast financial statements - based on generally accepted accounting practice (GAAP) - are the starting point of any local authority's consideration of the balanced budget requirement of section 100 and of the general financial prudence requirements of section 100(2).

7.27
The definition of operating revenue and operating expenses used for the purposes of considering the section 100 balanced budget requirements should be the same as that used for preparing the annual financial statements in accordance with GAAP. Therefore, projected operating revenue includes such items as assets vested or donated in the period, valuation adjustments for investment properties or forestry investments, interest and dividends, Land Transport New Zealand subsidies, development contributions, and rates. Projected operating expenses will similarly include depreciation, interest on borrowings, employment costs, asset maintenance costs, and other operating costs.

7.28
Section 100 creates a rebuttable presumption that an operating surplus is a pre-requisite to being financially prudent. There may be valid reasons to make adjustments to the GAAP statements of a local authority to determine its funding requirements. In situations where the timing of recognition of an item of revenue or expense for financial reporting purposes differs from any associated cash flows, a local authority may set the level of rates funding at a level different from that which would achieve a balanced budget. For example:

• Use of reserves - a local authority may decide to use reserves built up in previous years to fund an operating deficit in any year or years within an LTCCP.
• Vested assets - the fair value of vested assets is accounted for as revenue in the period they are vested in the local authority. However, the expense recognised in connection with these assets - that is, depreciation - is recognised progressively over the useful life of the asset. From a funding perspective, if the local authority elects not to rate to recover all the expenditure associated with vested assets, then current ratepayers will not be meeting the full cost associated with the vested asset.
• Land Transport New Zealand revenue for capital projects - where roading activity is capital in nature, the cost will be capitalised and depreciated over the useful life of the road. From a funding perspective, a local authority could consider it appropriate to only collect rates revenue on the portion of roading costs funded from local authority reserves, and not seek to rate to recover the depreciation on the Land Transport New Zealand-funded portion of the road asset. This approach assumes that the Land Transport New Zealand regime (or an equivalent regime) will be in place, so that future asset replacement will be funded in a similar manner and will not create a funding burden on future generations.
• Major capital developments - in many instances, major developments are funded by user charges, development contributions, or targeted rates. Often, there is a major timing difference between the depreciation expense and the point where revenue is recognised.

7.29
Our review considered whether any year within the LTCCP had an operating deficit, and assessed whether the local authority had passed a resolution after considering matters in section 100(2), as listed in paragraph 7.21.

7.30
There were several instances where local authorities were forecasting deficits in a particular year, and at least two instances where local authorities were forecasting deficits in most years of the LTCCP. All these local authorities had passed a formal resolution explaining why they proposed to operate deficits, and had explained in the LTCCP how their approach was financially prudent.

7.31
One-off deficits or minor deficits were typically easily justified, especially where they were the result of using reserves and cash balances established during previous years. However, where surpluses or losses were recurring, the local authority's level of scrutiny needed to be considerably higher.

7.32
A local authority presenting an unbalanced budget in the LTCCP needed to be able to demonstrate that the plan complied with section 100(2) by having regard to three factors:

• achieving and maintaining the predicted levels of service;
• equitable allocation; and
• financial prudence and operating surpluses.

Achieving and maintaining the predicted levels of service

7.33
Local authorities are required to set out details of the intended levels of service they will provide to their communities for each group of activities carried out⁴ and the costs of the identified levels of service, including the estimated expense associated with maintaining the service capacity and integrity of the assets.

7.34
The LTCCP has a minimum 10-year planning horizon. However, section 100(2)(a) requires that the local authority have regard to expenses associated with maintaining service capacity and asset integrity throughout the useful life of its assets. Therefore, local authorities need reliable asset information and must consider the levels of service and costs associated with the assets beyond the 10 years covered in the LTCCP.

Equitable allocation

7.35
In the context of the Act, equity is viewed as addressing the balance of interests between groups currently within the community and between current and future community members.

7.36
Through the equity provision, the Act imposes an obligation on the local authority to consider the pattern of costs to be incurred now and in the future. This is required to maintain a specified level of service and to ensure that these costs are forecast to be met by those members in the community who will receive the service (either directly or indirectly).

7.37
The core question is whether current ratepayers are paying an appropriate level of rates bearing in mind the services they are receiving.

7.38
The concept of equitable allocation was one of the main reasons for introducing the balanced budget test, initially through the 1996 amendments to the Local Government Act 1974. Although the focus of the balanced budget provisions of that Act ultimately became linked to funding depreciation, the thrust of the provisions was on intergenerational equity and moving away from a simple cash funding approach. The intention was to foster consideration of how the costs of services should be equitably funded over time, based on a sustainable level of service and asset replacement.

7.39
Depreciation is considered to be the proxy for the costs associated with the use of assets during the year. If operating costs, including depreciation, are not covered by operating revenues, it is arguable that the current users of the service are not paying the full cost for the benefits they receive.

7.40
One aspect of this approach of operating revenues not covering operating costs (including depreciation) was that, in periods where cash expenditure was lower than the average over time and local authorities considered it was appropriate to collect only enough revenue to cover cash operating and capital expenditures, ratepayers in the future could be faced with significantly higher relative costs with no corresponding increase in quality or level of service.

7.41
In paragraphs 7.55-7.62, we provide an example of a local authority that received a non-standard audit opinion around financial prudence so we could draw attention to the deficits forecast and the implications that this may have in future years.

Financial prudence and operating surpluses

7.42
Within the Act, the balanced budget aspect focuses on deficits. While an operating deficit may indicate that the local authority's levels of service and/or financial operations are unsustainable and result in current costs being shifted to future generations, a surplus does not necessarily mean that the LTCCP is financially prudent.

7.43
It is conceivable that a local authority could be financially imprudent by running high surpluses. Excessive surpluses could also be an indicator of intergenerational inequities where costs are being disproportionately funded by current generations. Therefore, in addition to reviewing for operating deficits, we also considered the level of, and rationale for, operating surpluses and the prudence of the local authority's overall financial forecasts.

7.44
Our focus was not simply on surpluses but also on the resulting Statement of Financial Position and Statement of Cash Flows. In several instances, we identified local authorities running substantial surpluses that were apparently contributing to increases in cash and investments but that did not appear to be required during the LTCCP. Other elements noted included decreases in debt levels in later years of the LTCCP.

7.45
In combination, factors such as high surpluses, increasing investment levels, and/or decreasing debt levels caused us to query the local authority's funding approach and whether the approach was prudent, considering intergenerational equity.

7.46
Local authorities with financial forecasts reflecting these elements were asked to explain their financial strategy in the LTCCP, just like those local authorities that were forecasting deficits. The explanations typically cited various factors - for example, that the accumulation of depreciation funding was to be spent on renewals beyond the end of the LTCCP planning period. In some instances, the explanation of the financial information included in the LTCCP indicated that local authorities needed to more fully consider whether the financial forecasts in the later years of the LTCCP were consistent with their overall financial management approach.

7.47
Of the non-standard audit opinions issued for financial imprudence, none related to the forecast level of surpluses or the strengthening of a local authority's overall position. However, the LTCCPs were enhanced by providing information that explained the rationale behind surpluses, and cash and investment increases.

7.48
The main point with either scenario of operating deficits or surpluses is that they should not be viewed in isolation when assessing financial prudence. A reader of the financial statements should not unduly focus on the operating surplus produced by a local authority in assessing that local authority's financial management strategy. The reasons for this include:

• A significant amount of a local authority's operations are focused on delivering a capital programme. The asset addition is included in the Statement of Financial Position, while, in many instances, some or all of the revenue is included in the Statement of Financial Performance, creating a large surplus. Important contributing factors may be development contributions, vested assets, and grants and subsidies. The extent to which these sources are used and are reflected in the operating surplus of the local authority depends on the local authority's funding approach.
• The Statement of Financial Performance includes unrealised changes in value, such as in investment properties, forestry, and financial instruments. Items such as these need to be considered when assessing any surplus or deficit.
• The Statement of Financial Performance is only one of three crucial financial statements. Information on the state of the local authority's finances is reflected in the Statement of Financial Position (the focus should especially be on cash, investment, and loan balances) and the Statement of Cash Flows.

Audit opinions focusing on financial prudence

7.49
To demonstrate financial prudence, a local authority must have established a mechanism to show the effect of financial management decisions on current and future community interests. This mechanism must consider not just the 10-year period covered by the LTCCP but also future periods where the effects of current financial decisions will arise.

7.50
Any assessment of financial prudence requires an understanding of a local authority's financial management strategy, which is documented in the funding and financial policies (as detailed in section 102 of the Act) and the results displayed in all the forecast financial statements. An important element of assessing a local authority's financial prudence and financial strategy for current and future community interests is to see whether the forecast finances of the local authority are realistic and achievable.

7.51
The most challenging aspect of the 2006-16 LTCCP audits for our auditors was trying to determine from the LTCCP whether a local authority was managing its finances prudently.

7.52
A qualified audit opinion on an inability to demonstrate financial prudence was one of the most significant qualifications that we issued on an LTCCP Statement of Proposal. It meant that, in our view, the local authority and the public could not use the document for meaningful long-term planning and decision-making.

7.53
Three audit opinions on the final adopted LTCCPs included specific reference to, or qualification on the grounds of, inability to demonstrate that the plans were financially prudent.

7.54
In the following three examples, there were different reasons each local authority was issued a non-standard audit opinion on financial prudence. In each example, we highlight the rationale for the audit opinion and the implications for the LTCCP and the local authority.

Example 1: Porirua City Council - intergenerational equity ("emphasis of matter" audit opinion)

7.55
Porirua City Council elected not to set operating revenues at a level to cover all operating expenses. The council budgeted for enough cash operating revenues to cover cash operating expenses and a portion of the non-cash depreciation expense. As a consequence of this approach, the council forecast deficits in each year of its LTCCP Statement of Proposal. The deficits ranged from $1.7 million to $4.5 million, totalling $29.1 million.

7.56
The council articulated the rationale for its approach in the LTCCP Statement of Proposal. First, it drew a distinction between the accruals approach taken in the balanced budget and cash funding, showing that - during the 10 years covered by the LTCCP - the council's financial position remained sound, with small increases in overall debt levels and small decreases in cash and investment levels. During the 10 years, cash and investments decreased by $2.6 million to $21.9 million, while debt increased by $3 million to $20.8 million. Debt levels remained within the council's liability management policy limits.

7.57
In terms of the replacement of assets, Porirua City Council's infrastructure was relatively new, with most assets constructed between 1950 and 1975. The council expects that its wastewater, water, and stormwater assets will not require major renewal work until 2025 at the earliest. The council noted that its LTCCP included enough funding to maintain the levels of service of the assets, with no major funding increases immediately outside the life of the LTCCP.

7.58
The council estimated that a likely result of its approach would be an increase in rates of 9% from 2025, followed by a further 6% in later years. However, if a balanced budget was set, the council would have been debt-free by the end of the LTCCP period, with about $25 million surplus cash in the bank. The council considered that it could not justify that to its community.

7.59
The main risk we identified in Porirua City Council's approach was the issue of intergenerational equity. We were satisfied that the levels of service for the assets would be maintained during the plan. However, the council's forecasts showed that there would be reasonably substantial lumpy rates increases in the future that would be less likely to occur had a balanced budget been set in the period covered by the 2006-16 LTCCP.

7.60
Porirua City Council's reasonably sound financial position and clear disclosure of its approach and potential implications were all factors that we considered in forming our view about whether the approach was financially prudent. We evaluated the arguments proposed by the council about its funding approach and concluded that the approach was financially prudent but with potentially significant risks that current and future ratepayers should be aware of.

7.61
We decided to draw particular attention to Porirua City Council's approach in our audit opinion. We issued an "emphasis of matter" opinion on the LTCCP Statement of Proposal, which, while unqualified, included an explanatory paragraph that clearly highlighted the issue for ratepayers' consideration.

7.62
The council received a number of submissions on its draft LTCCP within the LTCCP Statement of Proposal on the prudence or otherwise of the funding approach. While no change was made, the council resolved that, in preparation for the 2009-19 LTCCP, the chief executive would report on a strategy for funding the replacement of stormwater and wastewater reticulation.

Example 2: Waitomo District Council - financial viability

7.63
Unlike Porirua City Council, Waitomo District Council presented an LTCCP where each year forecast an operating surplus. However, the resulting audit opinion issued was a qualification that the plan was not financially prudent.

7.64
Waitomo District Council has aging and failing infrastructure, in part attributable to a focus on low rates levels in the short term in previous years. The council is now faced with a significant amount of capital works to continue to provide existing services. This is in addition to day-to-day operating costs and any new requirements such as drinking water standards.

7.65
In the LTCCP Statement of Proposal, the ratepayer was left in no doubt as to the position of Waitomo District Council. The LTCCP clearly signalled the need for ratepayers to bear a substantial and increasing burden of costs to pay for catch-up work and increased levels of service.

7.66
The LTCCP Statement of Proposal included six alternatives that Waitomo District Council had considered to remedy this situation. The preferred option resulted in the level of debt increasing from $29.1 million to $69.1 million, being 19% of equity by the end of the LTCCP. Rates increased from $9.2 million a year to $15.3 million during the term of the plan - an increase of 66%. By the end of the 10 years of the LTCCP, interest costs were forecast to be $5 million a year. A third of rate income would directly service debt. The financial viability of the council also depended on the investment in its subsidiary, Inframax, which was expected to substantially increase in value and continue to provide dividends.

7.67
Our concerns centred on the sustainability of the funding strategy. The council's LTCCP Statement of Proposal did not provide assurance that adequate revenue was available to cover all expenses - both operational and capital - notwithstanding the increase in rates that were forecast in the plan. The funding strategy also required a substantial increase in debt, and there was no certainty that the annual increase in borrowing would decrease after the life of the LTCCP. We also questioned whether Waitomo District Council would be able to raise the level of debt outlined in the plan.

7.68
We concluded that the LTCCP Statement of Proposal was not sustainable and therefore not financially prudent, and that Waitomo District Council had not made adequate and effective provision to meet the expenditure needs identified in the LTCCP Statement of Proposal.

7.69
After the LTCCP was adopted, the Department of Internal Affairs appointed an advisory panel to develop specific proposals to assist Waitomo District Council and its community to address identified issues for ongoing financial sustainability in advance of the 2007/08 annual plan round.

Example 3: Timaru District Council - non-inflation of financial forecasts

7.70
Timaru District Council's scenario differs from both previous examples. The council did not provide cost-adjusted information in its LTCCP Statement of Proposal. Instead, it showed the information in constant dollar values. This non-cost-adjusted information showed surpluses in each year and an increasing level of debt but overall a relatively sound financial position at the end of the 10-year planning period, with debt levels within liability policy thresholds.

7.71
Cost-adjusting of financial forecasts was a point of significant contention between us and local authorities in the earlier stages of the LTCCP process. In our view, the failure to inflate or cost-adjust the primary financial information included in the LTCCP is a departure from FRS-42, which requires prospective financial information to be based on best-estimate assumptions for events that are reasonably expected to occur. Price change is a best-estimate assumption.

7.72
Our evidence shows that the value of money changes over time and that this will probably occur in the future. Moreover, the price change rate can be forecast and - even if the forecast rate differs from the actual rate - the inclusion of some element of price change will be closer to reality than not including it.

7.73
From a financial management perspective, we were concerned that, by not including price change, the operational and capital costs would be materially different. For example, even assuming that price change was 3% a year on average, in the fourth year of the LTCCP (2009/10) costs would be understated by 9%. In the tenth year of the plan (2015/16), costs would be understated by about 30%.

7.74
Significantly different information may result in the local authority choosing different financing mechanisms. Just because costs are expected to increase does not necessarily mean that revenue streams, such as interest and grants and subsidies, increase in the same manner. The main variable income streams that local authorities manage are rates and user charges, with the main other financing mechanisms being debt and/or cash and investments. If Timaru District Council had had better information on estimated costs, the council could have been better placed to consider the amount of funding changes necessary and whether those increases would be acceptable to the community.

7.75
Consequently, our audit opinion was qualified on the basis that Timaru District Council's LTCCP could not be financially prudent because the best estimate of costs was not included and because, if it had been included, different funding mechanisms may have been chosen.

7.76
The council included an Income Statement adjusted for future price change as supplementary financial information to the LTCCP Statement of Proposal. However, the assumption of future price change had not been consistently applied to the supplementary information, and the flow-on effect of future price change on balance sheet items had not been considered in the preparation of the supplementary information. Consequently, the supplementary information was incomplete and, in our view, could be misleading.

7.77
In the final LTCCP, Timaru District Council corrected the supplementary information so that it reflected price change appropriately. The clear disclosure of the additional price change information showed that the council's financial strategy was sustainable, so the qualified audit opinion in relation to financial procedure was removed.

Other examples

7.78
We know of at least two other local authorities that originally prepared their financial information on a non-cost-adjusted basis. When they included price change, it significantly altered the level of rating and debt relative to other funding sources. In one situation, the forecast rates increases were considered unsustainable, so other options were considered.

Future focus

7.79
Financial prudence was an important focus of our review of the LTCCPs. It is a particularly complex area resulting from the many decisions that a local authority makes around the services it provides and how these services will be funded. There is a level of subjectivity inherent in assessing the financial prudence of any plan. Nevertheless, one of our main focuses in any future reviews of LTCCPs will be on financial prudence - in particular, to try and further differentiate between LTCCPs.

7.80
Our audit opinions on the 2006-16 LTCCPs identified those situations where local authorities were not clearly demonstrating financial prudence - effectively creating two categories of plans. However, we consider that there is likely to be a spectrum of plans from the financially imprudent to prudent. Our focus for the 2009-19 LTCCPs will be to distinguish more perceptively between plans and to report on local authorities that have heightened risk around their financial management strategies.

Our conclusions

7.81
The balanced budget test is only the starting point for assessing whether a local authority's financial management strategy is financially prudent. Financial prudence needs to be considered after viewing the financial information included in all the financial statements and after understanding the local authority's financial management strategy, which includes the funding and financial policies prescribed in section 102 of the Act.

7.82
For future LTCCPs, we consider that local authorities need to explain their financial strategy and summarise how they have given effect to their policies in the resulting financial information to stakeholders - irrespective of whether surpluses or deficits are forecast.

7.83
As noted in paragraphs 7.54-7.76, the final LTCCPs of three local authorities received a non-standard audit opinion because we wanted to highlight matters of financial prudence for the public to consider as part of consultation. In future, we will focus on providing more insightful comment on an LTCCP's financial prudence to give more meaningful information to the community, stakeholders, and to the sector.

The revenue and financing policy

7.84
The revenue and financing policy is the main policy for understanding a local authority's decisions about funding its operating and capital expenditure. The policy underpins the construction of the financial information within the LTCCP, including explaining which, how, and why individuals and groups within the community will pay for providing the local authority's services.

7.85
In reviewing the LTCCPs, we noted a diversity of approaches to presenting the revenue and financing policy. Some policies were extremely detailed, and others provided information at a very high level with limited specificity. In our view, some of the approaches that were adopted substantially limited the usefulness of the policies to the reader of the LTCCP, although the policies complied with the provisions of the Act.

7.86
In the following paragraphs, we examine the requirements of the revenue and financing policy and provide examples of the policies adopted.

Background

7.87
The relevant provisions of the Act are section 101(3), section 103, and clause 2(2)(d) of Schedule 10.

7.88
Section 103 requires the revenue and financing policy to state the local authority's policies for funding operating and capital expenses from a list of sources, which explicitly includes general rates (including choice of valuation system, differential rating, and uniform annual general charges), targeted rates, fees and charges, interest and dividends, borrowing, grants and subsidies, and any other funding source.

7.89
Section 103(3) requires the policy to show how the local authority has, for the sources identified in the policy, complied with section 101(3).

7.90
Section 101(3) states that the funding needs of the local authority must be met from those sources that the local authority determines to be appropriate after considering the:

• community outcomes to which the activity primarily contributes;
• distribution of benefits;
• period during which benefits are expected to occur;
• how the extent of action or inaction by individuals or groups contributes to the need to carry out the activity;
• costs and benefits, including consequences for transparency and accountability, of funding the activity distinctly from other activities; and
• overall effect of any allocation of liability for revenue needs on the current and future social, economic, environmental, and cultural well-being of the community.

7.91
The only other relevant provision is clause 2(2)(d) of Schedule 10, which requires a statement for each group of activities of the estimated revenue levels and other sources of funds, and the rationale for their selection in terms of section 101(3).

Content and focus of revenue and financing policies

7.92
When we started the LTCCP audit process, we had a clear set of expectations about the content and focus of a revenue and financing policy. The policy should enable ratepayers and other users of the LTCCP to determine who pays for what services and the local authority's rationale for selecting those funding sources, including its considerations. The policy should include funding thresholds or percentages so the reader can ascertain whether these have been applied in preparing the activity-level financial information.

7.93
Our expectations substantially differed from the practices used by many local authorities. In general, local authorities adopted one of two approaches to presenting information in their revenue and financing policies:

• A modification of the previous funding policies, showing the initial assessment of costs and benefits, modifications, and final position, typically in percentage terms, for each group of activities. This approach typically involved considerable narrative that explained the local authority's considerations in terms of section 101(3).
• A brief rationale for the use of the funding sources listed in section 103, followed by a table or narrative listing the sources applicable to each activity. This was not always accompanied by funding proportions or percentages and did not always explain consideration of the issues in section 101(3).

7.94
As a generalisation, the small to medium local authorities typically included proportion or percentage information. Some larger local authorities did not include this level of detail.

7.95
One local authority used descriptors to show the application of funding sources. The descriptors, such as marginal cost and full cost recovery, were defined and linked to the local authority's objectives for the activity.

7.96
The variability in layout and the extent of disclosure within revenue and financing policies was driven by different but acceptable interpretations of the Act. However, we questioned whether some of the approaches adopted achieved the intent of the Act, because they were at such a general level that the funding principles and considerations were unclear. Our concerns about the form and content of the policies for meeting the requirements of the Act include:

• discussion of considerations;
• specifying a level of the funding source to be applied;
• rationale;
• linking of policies with financial information;
• completeness of disclosure around funding sources; and
• disclosure of the funding of capital expenditure.

Discussion of considerations

7.97
Section 103(3) requires a local authority to show how it has complied with section 101(3), which, among other things, details considerations about community outcomes and the distribution of benefits. We expected a local authority to outline its considerations within the policy. This would provide a link between the rationale required by clause 2(2)(d) of Schedule 10 and the funding sources listed in section 103 to show why the local authority selected the particular funding source for the activity.

7.98
An alternative permissible position adopted by many local authorities was to acknowledge the content of section 101(3) and to advise in the revenue and financing policy that they had considered those requirements in developing the policy. We consider that this omits information important to understanding the policy and makes the policy less transparent. This was worse where funding levels were not defined or the rationale for selection of funding sources was not explained well.

Specifying a level of the funding source to be applied

7.99
The Act does not require a local authority to specify a threshold or percentage for a funding source. Therefore, a local authority can state that an activity is funded from general rates, targeted rates, and/or user fees without providing an indication of the level or nature of costs that the local authority intends to fund from that source.

7.100
One possible reason for a local authority to omit detail in its revenue and financing policy is to reduce the chances that it will need to change the policy, triggering an amendment under section 102 of the Act. However, we are concerned that some approaches make the revenue and financing policy essentially meaningless to the reader of the LTCCP. While the source of funding selected will be reflected in the Cost of Service Statement, the reader cannot understand the local authority's intent or whether the policy has been complied with in the absence of any description of the level or nature of the costs to be funded from that source.

7.101
In our view, some percentage range or descriptor is desirable, but it must be linked to the local authority's rationale and not be an end in itself. A local authority's approach to using the same types of funding may diff er depending on the section 101(3) considerations. As a simplified example, a local authority may set user charges for libraries to recover a marginal or nominal cost, reflecting wider objectives around education. In contrast, resource consents may be set for full cost recovery, reflecting the direct benefit to the consent holder. It is critical that any percentage included in the policy is always linked to the underlying objectives for the local authority's provision of the service.

7.102
A few local authorities provided excessive detail, such as percentages for funding sources for sub-activities within activities in a group. This level of information is not required, and significantly increases the risk of amendments for minor changes in funding approaches.

7.103
Many local authorities used a specific percentage. We suggest that a range of percentages would be appropriate, to provide useful information yet retain an appropriate level of flexibility in the policy.

Rationale

7.104
Clause 2(2)(d) of Schedule 10 of the Act requires a local authority to disclose its rationale for selecting funding sources for an activity. This content is typically included in the revenue and financing policy, rather than at activity level.

7.105
Most local authorities satisfied this requirement by listing their funding sources, explaining the circumstances where each funding source would be used, and listing the sources used for each activity. In general, the explanation of the circumstances where a funding source would be used could be enhanced.

Linking of policies with financial information

7.106
Ideally, there should be a clear link between the revenue and financing policy and the financial information included at activity level. We recognise that this is not always practical, because of the aggregation of multiple activities within a group. However, local authorities should try to link the policy and the group of activities financial information as transparently as possible.

7.107
In reviewing LTCCP Statements of Proposal, we noted instances where the proposed revenue and financing policy was not applied in the preparation of financial information. Where this was noted, the difference was corrected or explained. However, the discrepancies are a concern, given the importance of the revenue and financing policy to a local authority's overall financial management strategy. It suggests that financial information may be prepared in isolation from the policy in some instances.

Completeness of disclosure around funding sources

7.108
Many policies were silent or unclear on how non-activity-specific revenues (such as interest and dividends) were applied as funding sources, and the priority for their application in terms of activities and compared to other funding sources. For example, where council-wide revenues are allocated to activities, the policy should be clear how this is performed (for example, directly in proportion to the general rate) and why it is allocated in this manner. Where some activities have council-wide revenues allocated and others do not, this too should be explained.

Disclosure of the funding of capital expenditure

7.109
Funding sources for capital expenditure were generally poorly disclosed. Many local authorities advised that they used a pooled approach to funding capital expenditure or provided a general hierarchy of funding sources that would be used for capital expenditure. Few local authorities clearly articulated their rationale for using certain funding sources and what priority or hierarchy they would give to the selection of the relevant funding source in a particular situation. This was exacerbated where different funding approaches were used for different local authority activities. It was also unclear why some capital expenditure would be rated for, in contrast to when existing funds or borrowing would be used.

7.110
Typically, no distinction was drawn between funding for new assets and renewals. Both are capital expenditure, but local authorities use differing funding sources for each. Renewals, which replace existing assets, are more likely to be funded from rates and reserves/cash funds built up over time as the asset depreciates. New assets may be rated for, but it is also more likely that they will be funded, at least in part, from borrowing. This reflects that the benefit from the assets will continue into the future and that it would be inequitable to make the current ratepayers pay for the full asset cost now.

Our conclusions

7.111
The revenue and financing policy is the most critical policy for understanding a local authority's financial strategy.

7.112
We had a clear set of expectations about the content and focus of a revenue and financing policy. The policy should enable ratepayers and other users of the LTCCP to determine who pays for what services and the local authority's rationale for selecting those funding sources, including its considerations. The policy should include thresholds or percentages so the reader can ascertain whether these have been applied in preparing the activity-level financial information.

7.113
These expectations differed substantially from many of the revenue and financing policies included in LTCCPs. Some had such a limited amount of information that the reader could not determine the rationale for selecting the mechanism or what proportion of the activity the local authority intended to fund from that mechanism. The paucity of information made the policies of some local authorities essentially meaningless to an external user.

7.114
If the intent of the Act was to transparently show the rationale for selecting the funding sources, including a local authority's considerations and the amount or relativities of funding sought, the legislation as it is currently drafted is not achieving this. The local government sector needs to consider whether our views about the intention of the policy are correct and whether the Act requires revision or additional interpretation and guidance around the revenue and financing policy.

Cost of Services Statement

7.115
Since the Local Government Act 1974 was amended in 1989, local authorities have been required to show financial information about the costs and funding of each of their activities in their annual plans and annual reports.

7.116
The clear presentation of activity-level financial information or the Cost of Services Statement has not developed substantially since that time. The information presented is often complicated and difficult to understand. There remain examples where the presentation of information appears to reflect a lack of understanding of local authority funding.

7.117
The 2006-16 LTCCP provided an opportunity to improve the presentation and understandability of the Cost of Services Statement. In an effort to provide guidance in this area, in conjunction with SOLGM we produced principles-based guidance, which included a template, to show how the Cost of Services Statement could be presented. Although some improvement was made by the sector, it was not as significant as we had hoped.

7.118
We again noted concerns around the underlying understanding and presentation of funding decisions, the clarity and internal consistency of information included in the statements, and the links from the revenue and financing policy to the Cost of Services Statement information and the forecast financial statements.

Background

7.119
The statutory provisions for preparing the Cost of Services Statement are found in Schedule 10 of the Act. Under Schedule 10, local authorities are required to include information about each group of activities. That information includes:

• the estimated expenses of achieving and maintaining the identified levels of service provision, including the estimated expenses associated with maintaining the service capacity and integrity of assets (clause 2(2)(b) of Schedule 10);
• a statement of how the expenses are to be met (clause 2(2)(c) of Schedule 10); and
• a statement of the estimated revenue levels, the other sources of funds, and the rationale for their selection in terms of section 101(3).

7.120
This information needs to be provided in detail for each of the first three years covered by the LTCCP, and in outline for each of the subsequent financial years of the LTCCP. The financial information complements the levels of service information and performance measures included within each group of activities.

7.121
All local authorities sought to fulfil the provisions of clause 2(2)(b) and (c) by including a Cost of Services Statement (or equivalent financial statement).

7.122
The Cost of Services Statement reflects the operating and capital expenses of an activity and how those expenses will be funded. Disclosure of this information at activity level is important, as activities are typically funded differently. The Cost of Services Statement therefore provides the reader with activity-specific information. It usually most clearly reflects the relationship between the revenue and financing policy, which is set at activity level, and the local authority's financial information.

Cost of Services Statement issues

7.123
The difficulties with the presentation and understandability of the Cost of Services Statement arise from two sources:

• the application of GAAP; and
• the need to clearly distinguish and understand the dual focus of the statement, as it covers the funding of both capital and operating expenditure.

7.124
Within this second point, the transparent disclosure of funding decisions - in particular, the use of "funded depreciation", operating surpluses, and reserves - were recurring weaknesses in the presentation of information in the Cost of Services Statement.

Application of generally accepted accounting practice

7.125
Section 111 of the Act requires all information required by any provision of Part 6 or Schedule 10 of the Act to be prepared in accordance with GAAP if that information is of a form or nature for which there is a standard in GAAP.

7.126
GAAP prescribes accounting treatments for particular transactions and balances and the presentation of financial information. For the forecast information within an LTCCP, the relevant financial reporting standard is FRS-42 (see paragraphs 3.6-3.7).

7.127
FRS-42 provides that the prospective financial information must include a balance sheet, income statement, statement of changes in equity, and cash flow statement and notes, including accounting policies, significant assumptions, and other relevant underlying information. The standard also provides that "an entity shall apply the principles in this Standard to any prospective financial information published in conjunction with prospective financial statements."

7.128
GAAP includes formats for the core financial statements specified in FRS-42, but does not include any suggested presentation for the Cost of Services Statements that local authorities are required to present. Consequently, while GAAP principles apply to the preparation of the information, such as differentiating between operating and capital expenditure, the format of the statements (including the level of detail to be included within the statement) is at the discretion of the local authority.

7.129
The lack of authoritative guidance contributes to the diversity of approaches that local authorities have adopted to presenting this information.

Dual focus - income and expenditure, and funding

7.130
The Cost of Services Statement must reflect both capital and operating expenditure. To show how these expenses are met, the Cost of Services Statement must include operating revenues and other funding sources that do not affect the overall statement of financial performance, such as borrowing or the use of reserves - mixing accrual and cash accounting concepts.

7.131
The two distinct concepts can cause confusion with the reader of the financial statements, especially to those who focus on an activity's surplus without considering that the surplus may be used to fund expenditure of a capital nature. This could include capital expenditure such as asset purchases or debt repayment. In some instances, it also appears that those preparing the financial information are confused about how to transparently present the funding decisions made by local authorities.

7.132
The main concerns identified in this respect were in:

• cash funding - funded depreciation;
• transfers into and out of reserves;
• split disclosure of revenue items;
• inclusion of internal revenue and expenses within an activity;
• presentation of operating expenditure; and
• aggregation of funding sources.

Cash funding - funded depreciation

7.133
The Cost of Services Statement includes accrual accounting estimates for operating revenue and expenditure, and cash funding requirements for capital expenditure. Accrual accounting includes non-cash items such as depreciation. Where total operating costs (including depreciation) are at least met by cash operating revenues such as rates, user charges, cash development contributions, interest, and dividends, the depreciation is considered to be "funded". That is, on a cash basis, the operating results of the activity produce a cash surplus that can be spent to purchase assets, repay debt, or increase investments, or to lend to other activities as internal borrowing.

7.134
We noted several examples where the activity depreciation expense had not been covered by cash revenues, but the full depreciation figure was shown as a funding source for capital expenditure even though there was not enough cash to do this.

7.135
Conversely, there were instances where a local authority's presentation of information in the Cost of Services Statement suggested that activities were being over-funded, and that funded depreciation had not been used or had not been clearly disclosed.

7.136
It is unclear whether this reflects a lack of understanding about how the funding works or is the result of attempts to simplify the presentation of information for the reader.

Transfers into and out of reserves

7.137
Local authorities maintain reserve balances for particular aspects of their operations that they keep track of differently, distinct from their general reserves. For example:

• rating reserves - where any excess of funds resulting from a targeted rate are retained separately, to be spent in that area or on that type of asset in the future (conversely, any overspending is recorded for future recovery separate from other revenue sources); and
• depreciation reserves - some local authorities use funded depreciation only for asset purchases, and will therefore maintain records showing the balance of depreciation reserves available for future asset expenditure.

7.138
The disclosure of the transfer of funds into and out of reserves in the Cost of Services Statement was generally poor. In some instances, it appeared that reserves were simply a balancing figure in the Cost of Services Statement, or that the information seemed to reflect substantial draw-downs from reserves where not enough reserves were available at the start of or during the year. The movements were also inconsistent with information reflected in the Forecast Statement of Financial Position and/or Forecast Statement of Cash Flows.

Split disclosure of revenue items

7.139
We noted instances where GAAP revenue items, such as rates and development contributions, were shown either as a funding source only for overall net operating and capital requirements or split between operating and capital requirements. Those who support this split approach argue that local authorities can show where the revenue is to be spent, which potentially links more clearly to the revenue and financing policy and also shows more clearly those revenues that will be spent on capital expenditure, such as development contributions and components of Land Transport New Zealand subsidy revenues.

7.140
A result of this style of presentation is that any operating surplus shown for the activity is lower than the surplus prepared on a GAAP basis, while the overall financial result is the same. This moves the focus from any activity surplus to the funding decisions taken by the local authority.

7.141
However, this approach is inconsistent with the presentation of the statements of financial performance and financial position included elsewhere in the LTCCP. The approach does not follow GAAP, and sometimes similar revenue items are treated differently depending on their funding use.

7.142
In our view, the presentation of the Cost of Services Statement should include an "income statement" section, which includes all revenues that would be included in the Statement of Financial Performance. We also consider that the problems inherent in understanding an operating surplus in a local authority context are better resolved through an explanation at the overall financial statement level than through presenting operating revenue sources in this manner.

Aggregation of funding sources

7.143
In many instances, general rates were aggregated with separate rates as an overall rates figure, or they were aggregated with other general income sources such as interest and dividends as a general funds figure. Neither approach is ideal as they are a combination of unlike items. This practice can also obscure links to any funding levels included in the revenue and financing policy, making it more difficult for the reader to ascertain how funding decisions have been applied in practice.

Other presentation issues

Linking of policies with financial information

7.144
Ideally, there should be a clear and transparent link between the revenue and financing policy and the financial information included at activity level.

7.145
We recognise that this is not always practical because of the aggregation of multiple activities within a group. However, local authorities should try to make the link between the revenue and financing policy and the group of activities financial information as clear and transparent as possible.

Mixing operating and capital expenses

7.146
We noted at least one instance where a local authority included capital expenses for asset purchases with operating expenses in the draft LTCCP Statement of Proposal presented for audit. This was amended before the document was released for consultation.

7.147
Under GAAP, operating and capital expenses are treated differently - operating expenditure is included in the Statement of Financial Performance, while capital expenditure creates assets, which are included in the Statement of Financial Position. In addition to the practice noted in paragraph 7.146 not complying with GAAP, operating and capital expenditure often use different funding approaches. Aggregating the different types of expenditure can mask this difference and make the links to the revenue and financing policy less clear and transparent.

Inclusion of internal revenues and expenses within an activity

7.148
Many local authorities included internal revenues and expenses in their Cost of Services Statement. The statements typically included internal interest costs but also included items such as internal rental charges from property units.

7.149
The overall financial statements, such as the Statement of Financial Performance, should include only revenues and expenses that are external to the organisation. However, from a funding perspective, these are legitimate costs that should be shown at an activity level because they represent the actual cost of the activity. They can be appropriately included in the Estimated Revenues and Expenses Statement, but should not be included in the Statement of Financial Performance. A reconciliation between the Cost of Services Statement and the overall financial statements assists in understanding how this information relates. We suggest that local authorities include this reconciliation in future LTCCPs to improve on current practice.

Presentation of operating expenditure

7.150
Local authorities adopted several approaches for disclosing operating expenses in the Cost of Services Statement within a group of activities. These were by:

• township or ward - in particular, where the funding approach for the activity differs depending on where the asset is located or the service is provided;
• type of expense (for example, operating expense, depreciation, and interest) - particularly useful for homogeneous populations where a single funding approach applies to the whole group of activities operating expenditure;
• activity - for example, sewerage reticulation and wastewater reticulation (functional expenses include all the relevant costs for that function, including depreciation and interest); and
• a mixed approach - where costs by activity or by ward were provided excluding depreciation, which was reflected as a separate line item.

7.151
While there is choice in which approach to adopt, some practices are better than others. For example, the mixed approach is not ideal.

7.152
The separate disclosure of depreciation is important, as it can then be linked to the funding used for capital expenditure. However, excluding it from the operating cost of the activity understates the expenditure, which is a particular issue when a group of activities includes multiple activities with differing funding sources. Where an activity or ward approach is adopted, depreciation could be disclosed in a note. Alternatively, an operating expenditure could be disclosed both by type and by activity or location.

Showing three-year and 10-year information in separate parts of the LTCCP

7.153
We saw examples where information on a group of activities showed three-year information only, with the balance or whole 10 years shown in a separate section of the LTCCP. Ideally, information on a group of activities should be provided in the same place, enabling the reader to see all of the information.

7.154
In some instances, the duplication of this information in two separate parts of the LTCCP added to the length of what was already a large document.

Suggested Cost of Services Statement layout

7.155
As previously noted (see paragraph 7.117), in conjunction with SOLGM, we produced a template and supporting guidance material to assist local authorities with disclosing financial information in the Estimated Revenues and Expenses Statement.

7.156
The template incorporates two distinct statements - an operating statement and a capital and reserves funding statement. The operating statement provides expenditure and revenue information consistent with GAAP-based recognition principles, while the separate capital statement is prepared on a cash basis.

7.157
One benefit from this layout is that the operating section is now consistent with the information presented in the Statement of Financial Performance. Physically splitting the two statements distinguishes between the accrual and cash funding approaches used in each section of the Cost of Services Statement, potentially reducing the difficulties that arise from combining the two different approaches in the same statement.

7.158
The layout of the statement and the principles behind it are also intended to make the disclosure of funding sources clear and transparent - in particular, for capital expenditure.

7.159
Some will argue that the prescriptive presentation and the additional funding disclosures proposed will be more onerous. However, the layout does more clearly present the activity's funding source.

7.160
We recommend that local authorities adopt our proposed Cost of Services Statement layout shown in Figure 22. If local authorities consider that our proposed presentation does not appropriately reflect their requirements, we would appreciate the sector developing alternative presentation options.

Figure 22
Our suggested layout for a Cost of Services Statement

Group/Activity – Operating Statement
Operating Revenue
Activity Revenue	$
Targeted Rates	$
Development or Financial Contributions	$
General Rates	$
Other General Sources (e.g. Investment Income)	$
Total Operating Revenue	$
Operating Expenditure
Expenditure (by Sub-activity/Type)	$
	$
	$
Total Operating Expenditure	$
Operating Surplus (Deficit)	$
Operating Surplus transferred to (specify) Reserve(s); or	$
Operating Deficit funded from (specify) Reserve(s)	$
Group/Activity – Capital and Reserves Funding Statement
Capital and Reserves Funding Requirements:
Capital Expenditure
Expenditure by Sub-activity	$
	$
	$
Total Capital Expenditure	$
Loans Repaid	$
Operating Deficit	$
Transfers to General and Special Reserves	$
Total Funding Required	$
Funded by:
Operating Surplus (via reserve)	$
Funding from Non-cash Expenses	$
Loans Raised	$
Transfers from General and Special Reserves	$
Total Funding Applied	$

Note:
The suggested format has been prepared consistent with GAAP-based presentation for a Statement of Financial Performance. We acknowledge that there is a view that the Cost of Services Statement should begin with expenditure. In our view, either approach is acceptable.

Examples of Cost of Services Statements

Example 1

7.161
Figure 23 is reproduced from an adopted LTCCP to highlight some of the concerns that we identified. In Figure 24, we show this statement transferred to our suggested layout.

Figure 23
Example 1: Cost of Services Statement from an adopted LTCCP

7.162
In Figure 23, rather than showing all operating revenues, the local authority splits operating revenues to show that the funding of both operating expenditure and capital expenditure are exactly the amount required to balance each area.

7.163
The operating section shows that all expenses are funded by cash revenues. Therefore, from a funding perspective for the 2006/07 year, there is $4,540,000 funded depreciation available to purchase assets, repay debt, lend to other activities, or invest.

7.164
The use of this cash should be reflected in the capital expenditure section of the Cost of Services Statement. However, in the example in Figure 23, there is no indication in the capital expenditure section of how the cash arising from the funded depreciation has been applied, including simply whether it had been included in a reserve. Although it is possible that the cash surplus is reflected in some manner through the internal loan in the loan line, this is not clear from the presentation. Additional disclosure to explain this would have been useful.

7.165
In Figure 24, the Cost of Services Statement has been set up in our suggested layout. The reformatted statement shows the surplus of $4,435,000 and how it has been applied to fund capital and reserves. In addition, the reader can also see the application of the cash-funded depreciation within the capital and reserves section.

Figure 24
Cost of Services Statement using our suggested layout

Operating Statement
	$000
Operating Revenue
Activity Revenue	253
Targeted Rates	-
Development or Financial Contributions	722
General Rates and other revenue	13,310
Vested assets	2,052
Total Operating Revenue	16,337
Operating Expenditure
Expenditure	5,894
Interest	1,468
Depreciation	4,540
Total Operating Expenditure	11,902
Operating Surplus (Deficit)	4,435
Operating Surplus transferred to (specify) Reserve(s); or	4,435
Operating Deficit funded from (specify) Reserve(s)
Group/Activity XYZ – Capital and Reserves Funding Statement
Capital and Reserves Funding Requirements:
Capital Expenditure
New assets	8,211
Renewal assets	1,473
Vested assets	2,052
Total Capital Expenditure	11,736
Loans Repaid	-
Operating Deficit	-
Transfers to General and Special Reserves	-
Total Funding Required	11,736
Funded by:
Operating Surplus	4,435
Funding from Non-cash Expenses	4,540*
Loans Raised	2,743
Transfers from General and Special Reserves	18
Total Funding Applied	11,736

* This layout shows the use of funded depreciation separately. It is possible that this remains in a reserve but is loaned back to that activity. However, the rationale for the use of funds in that way is unclear.

Example 2

7.166
Figure 25 is reproduced from an adopted LTCCP. The format is fundamentally the same as our standardised layout, except that rates are shown in the funding section rather than as a revenue item for the activity. This means that the operating section does not reflect GAAP operating revenues.

7.167
However, in this instance, the logic behind the funding mechanisms applied is unclear. The local authority shows that it is borrowing $2 million to fund aspects of the activity. This amount exceeds total capital expenditure for the year, and also, after considering other cash funding sources such as funded depreciation and the activity's operating surplus, results in a transfer into reserves of $832,852 - essentially borrowing to put the money into the bank. This same observation also applies to 2008.

7.168
As well as adopting an appropriate way of presenting the Cost of Services Statement, a local authority must transparently disclose its funding decisions and, more fundamentally, ensure that the funding decisions are understandable to the reader.

Figure 25
Example 2: Cost of Services Statement from an audited LTCCP

Example 3 - Alternative presentation options

7.169
At least one local authority (Far North District Council) included financial information in a Cost of Services Statement for years 1-3 of the LTCCP and provided operating revenue and expenditure, and capital expenditure and funding, as bar graphs for all 10 years for each activity. The graphs reflected all of the information within the Cost of Services Statement in a different form.

7.170
The approach met the requirement to provide information for years 4-10 as an outline and was also easy to understand, with trends and relative changes between years easily observed. This is another option that could be considered in presenting group of activities financial information.

7.171
Figure 26 shows an example of a Cost of Services Statement from the Far North District Council's 2006-16 LTCCP.

Figure 26
Example 3: Cost of Services Statement from Far North District Council’s adopted LTCCP

[Link to full-size version of top of Figure 26, opens in a new window]

[Link to full-size version of bottom of Figure 26, opens in a new window]

Our conclusions

7.172
There remain considerable opportunities to improve the presentation and ease of understanding of Cost of Services Statement information in LTCCPs. Many statements do not clearly and transparently show the operating and capital expenditure, and revenue and funding sources chosen and, therefore, do not aid a reader's understanding of how funding works within the local authority.

7.173
We suggest that the local government sector consider developing one or more standardised layouts and associated guidance for Cost of Services Statements, such as the one included in Figure 22.

7.174
The benefits from a more standardised approach include greater clarity around funding sources and links to the revenue and financing policy, increasing the likelihood that the reader of the LTCCP will find the funding choices to be logical, clear and transparent, and easy to understand.

Common issues with LTCCP Statements of Proposal

7.175
The majority of our audit work was undertaken in delivering our audit opinions on the LTCCP Statements of Proposal.⁵ Some other common issues arose at that stage involving:

• asset revaluations;
• price change; and
• adoption of NZ IFRS.

7.176
The majority of these issues were "fixed" by the local authority before finalising the LTCCP Statement of Proposal and associated draft LTCCP, so they did not carry over to the final adopted LTCCP.

7.177
We suggest that local authorities consider these common issues in the lead-up to the 2009-19 LTCCP. The issues arose in part because of pressures for timeliness, the breakdown of project control, and, in particular, the lack of internal quality review processes (see paragraphs 8.27-8.45).

Asset revaluations

7.178
For prospective information to be reasonable, local authorities had to consider the effect of the probable need to revalue assets - in particular, infrastructure assets - that are generally valued on a depreciated replacement cost basis.

7.179
Revaluations have a real effect on the main estimates, such as depreciation, and the assessment of sustainable funding of asset-based services.

7.180
Sixteen local authorities did not revalue correctly - either by not applying the revaluation process or by not estimating the effect of any revaluation requirement. A further 18 local authorities did carry out revaluations but did not disclose either the basis of the revaluation or that there were errors in the assumptions they made.

7.181
Revaluations are an integral part of compiling forecast financial information. While the current climate of a tight contractors' market and increasing asset replacement costs remains, local authorities will be required to actively align their revaluation policy and assumptions about future price change to ensure that they maintain the integrity of the forecasts. In the current environment, the need to revalue is almost certain.

Price change

7.182
The sector established the need to estimate the effect of price change when it considered matters that would affect forecasting. We recognise, in particular, the lead taken in this matter by the SOLGM Financial Management Working Party.

7.183
For estimates to meet the reasonableness test outlined in FRS-42, preparers of LTCCPs had to account for the effects of price change.

7.184
In an issue similar to that of revaluations, 28 local authorities had not adequately applied the assumptions of price change. The issues related mainly to the consistent application of price change factors to all financial information.

7.185
This was the first time that local authorities had prepared financial forecasts on this basis. While there was substantial debate within the sector as to how to actually apply the recommended rates when preparing the financial information, most local authorities capably dealt with the application of price change in the published information.

Adoption of New Zealand equivalents to International Financial Reporting Standards

7.186
Through our reports to Parliament on the effect of NZ IFRS, we have questioned the value of the changes in accounting standards ushered in by the adoption of these reporting standards.⁶ However, the LTCCP process has required the sector to adopt the NZ IFRS-based standards a year earlier than mandatory.

7.187
Our auditors considered that there would be a minimal real effect on forecast financial information for many local authorities.⁷ However, it was important that all local authorities considered the effects and adopted accounting policies consistent with NZ IFRS.

7.188
Thirteen local authorities had difficulty with this aspect of preparing the forecasts. This included not having a clear statement of the effects of conversion to NZ IFRS and not clearly identifying the changes in their Statement of Accounting Policies.

7.189
This matter should be less of an issue for the preparation of the 2009-19 LTCCPs, as the sector will have had three years' experience dealing with NZ IFRS. However, it does highlight that adherence to GAAP during preparation of the LTCCP is important for the successful compilation and audit of financial forecasts.

Disclosures

7.190
A number of minor disclosure matters arose. While they were minor in nature, this reflects the pressure of preparation on individual local authorities and often the inability to include adequate and timely internal quality review of the draft LTCCP.

7.191
Twelve local authorities did not disclose the forecast effect of their rates remission policy - including not disclosing the reasons for, and the forecast financial effects (ideally at an activity level) of, the application of the policy.

7.192
Seventeen local authorities overlooked the requirement in FRS-42 to separately disclose the estimate for depreciation and interest expense. While a matter of detail, both of these disclosures are important for understanding the nature of a local authority's cost structure (and therefore funding needs) and for understanding the changes in a local authority's balance sheet.

Summary

7.193
While these matters are related to GAAP, they do represent reasonably straightforward issues that were fixed by the respective local authority when our auditor raised them. However, such co-operation also reflects a transaction cost to the local authority that is higher than if its own processes had adequately dealt with the matters in the beginning.

7.194
As our auditors were also giving these messages, it often cast them in the light of being solely focused on compliance with the Act. The risk of seeing them in this light could have been avoided if local authorities had implemented and maintained sound project management practices for effective and timely internal quality review of the draft documents.

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1: Subpart 3 of Part 6 of the Act.

2: Section 101 of the Act. It is a statutory responsibility for a local authority to manage its financial resources prudently to promote "the current and future interests of the community".

3: Section 100 of the Act.

4: Schedule 10, clause 2(2).

5: Figure 15 in Part 4 outlines the extent of audit procedures carried out in the lead-up to providing audit opinions on the LTCCP Statement of Proposal.

6: For example, Local government: Results of the 2004-05 audits, parliamentary paper B.29[06b].

7: In auditor terminology, the appropriate term is "not material".

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