Part 3: Financial trends in the annual reports of local authorities

3.1
In this Part, we outline our observations on the financial trends arising out of local authorities' audited financial statements for the year ended 30 June 2010. We set out why we are reporting this information and the information that we considered, before discussing:

• operating revenue;
• operating expenditure;
• capital expenditure;
• borrowings;
• indicators of financial sustainability; and
• group financial information.

Summary

3.2
Local authorities³ collected $5.5 billion in operating revenue and spent $5.0 billion on operating expenditure for the year ended 30 June 2010. They spent a further $1.9 billion on capital expenditure.

3.3
The revenue collected was in line with that budgeted in local authorities’ long-term plans. Operating and capital expenditure was different from that intended.

3.4
Operating expenditure was 3% higher than budgeted. Common reasons for the variance were higher-than-budgeted depreciation costs and/or losses incurred because of the disposal or impairment of assets.

3.5
Capital expenditure was less than anticipated, with only 78% of local authorities’ budgeted expenditure for the year being spent. Many local authorities deferred their capital work. This could indicate the sector’s inability to carry out its capital expenditure programme (for example, because of cost or the unavailability of suitable contracting staff ) or that the sector is holding back on capital expenditure during the recessionary period.

3.6
As at 30 June 2010, local authorities had borrowings of $3.9 billion. The level of borrowings incurred by local authorities was $673 million higher than the previous year. This shows a greater reliance by local authorities on using external debt to fund their activities.

3.7
The local government sector comprises councils and entities controlled by councils. Some local authorities have large group structures, and some council-controlled organisations (CCOs) operate core services on behalf of local authority shareholders. Our financial analysis largely considers parent-only or council-only financial information. Readers should note that some CCOs have significant asset holdings and generate significant revenue and expenditure. We briefly discuss some aspects of CCO financial information in paragraphs 3.56 to 3.61.

Why are we reporting this information?

3.8
From now on, we intend to report each year on the financial trends throughout the sector, and our analysis of them. This information will provide readers with a financial overview of the local authority sector and the main trends.

3.9
We extracted the information that we have reported in this Part from the annual reports of local authorities. This information is publicly available to Parliament and the community. We recognise that this may limit our observations. However, it may also help identify how local authorities’ external reporting could improve.

3.10
Because this is the first year that we have completed this analysis for the local authority sector, our comments and observations are descriptive. We expect to report more fully on trends in future years.

The information that we considered

3.11
We collected all the information used in the analysis from the audited financial information in annual reports for the year ended 30 June 2010 (2009/10). We have mainly considered results and forecast results for 2009/10, and the previous year’s comparative figures (that is, for 2008/09).

3.12
For the reasons noted in paragraph 2.11, we have not considered the former Auckland local authorities or the new Auckland Council in this analysis.

3.13
We have tried to be consistent in compiling and categorising the financial information. Because local authorities disclose information in different ways, this was not always possible. However, we do not expect any inconsistencies in the way we have compiled the data to materially affect the information in this report.

Operating revenue

3.14
In 2009/10, the local government sector collected $5.5 billion in operating revenue. This was in line with budgeted revenue and is a 7% increase on the previous year. Most of this increase was through rates.

3.15
Local authorities collected $2.9 billion in rates revenue, an increase of $167.5 million or 6% on the previous year. This increase was largely in line with budget (actual rates revenue was 1% or $19.5 million more than budget).

3.16
The increase in rates revenue is greater than the increase in the consumer price index. The reason for this varies from council to council, but includes increased:

• costs in maintaining existing services;
• provision of services because of community expectations or enhancement of amenities to attract investment; and/or
• costs for upgrading infrastructure.

3.17
The budget variance also incorporates the effect of rates collected on new properties, which could not be built into budgets at the time of their preparation.

3.18
Other sources of local authority revenue were income from user fees and charges, government subsidies (for example, revenue from the New Zealand Transport Agency (NZTA)), dividend income, development contributions, and the recognition of assets vested in a local authority.

3.19
Development contributions (2009/10: $93 million) and vested assets (2009/10: $206 million) were respectively 5% and 9% less than the previous year. We expected this, given that many local authorities are experiencing less growth because of the recessionary period.

3.20
Those local authorities that have experienced a decrease in development contribution revenue may still be committed to carrying out their capital expenditure programme. They may need to find other ways to fund this capital. Therefore, some local authorities are likely to seek other funding avenues, such as increasing their debt.

Operating expenditure

3.21
Total operating expenditure for local authorities in 2009/10 was $5.0 billion. This represents a growth of 3% from the previous year and is 3% higher than budget.

3.22
Many reasons exist for the increased expenditure and reflect those noted in paragraph 3.16. We have considered some of the more significant reasons below.

3.23
Wellington City Council increased its provision for settling claims arising from the Weathertight Homes Resolution Services Act 2006 and related civil proceedings by $14 million. The provision relates to potential net settlement costs of known claims at balance date. It does not allow for claims yet to be lodged.⁴ The unbudgeted increase was because of a revised actuarial assessment of the previous provision to take account of more up-to-date information about settlement costs and the percentage share of costs that the Council is being found liable for. The increased provision also includes, for the first time, provision for the legal costs associated with settling the claims. For more information about the costs that local authorities face to meet leaky building claims, see Article 8 in Section 2.

3.24
Waitomo District Council wrote off its investment of $8.4 million in the wholly owned subsidiary Inframax Construction Limited (Inframax) because of the financial difficulties that Inframax faced. The write-off was not budgeted. The write-off was made as at 30 June 2010. Inframax was in serious financial difficulties and in breach of its borrowing covenants. As a result, Inframax included in its financial statements disclosures about the risks to its ability to operate on an ongoing basis. The audit report for Inframax and Waitomo District Council also drew readers’ attention to the uncertainties with the going concern assumption (see also paragraph 6.38).

3.25
The variances for these two local authorities contribute 18% of the expenditure movement against budget. The remaining variance was spread across several local authorities. Common reasons for the increase in expenditure against budget include:

• higher-than-budgeted depreciation costs arising from revalued and vested assets; and
• significant losses because of the disposal of assets or impairment of assets. These movements were not foreseen at the time of setting the budgets. The losses or the change in value are a result of local authorities collecting better information on their assets, both in terms of replacement costs and the condition of the assets.

3.26
The total depreciation expense for local authorities for 2009/10 was $1.1 billion or 21% of operating expenditure.

Capital expenditure

3.27
Local authorities spent $1.9 billion on capital work in 2009/10. This was consistent with 2008/09 but only 78% of the $2.4 billion budgeted.

3.28
District councils spent only 73% of the $1.4 billion capital expenditure budgeted. City councils spent 84% of the $1.0 billion capital expenditure budgeted.

3.29
Many of the annual reports do not disclose effectively why only 78% of budgets was spent. It may be that efficiencies were made as projects were completed. However, it also appeared that many local authorities either deferred or reprioritised their planned capital expenditure.

3.30
Capital work can be deferred for a number of reasons, including cost saving, availability of suitable contracting staff , the recessionary environment affecting development, or other delays.

3.31
Some local authorities disclosed in their annual report that they had not completed some of their forecast capital expenditure programme for roading because they had received a different level of funding from the NZTA than anticipated.

3.32
Land transport activities delivered by local authorities are part funded from the national land transport fund (administered by the NZTA). In 2009, the Government Policy Statement for land transport was revised to identify roads of national significance. The purpose of listing those projects as nationally significant is to ensure that the NZTA takes them into account when it develops the national land transport programme. As a result, the national land transport fund was reprioritised to reflect the list.

3.33
Because of this, as well as the deferral of some roading works, some local authorities have had changes made to the level of funding they had received or were expecting to receive when they set their budgets. This has resulted in some local authorities not proceeding with planned roading works, further deferring capital works, or reprioritising the services delivered. We know of concerns within the sector that these decisions may affect the level of services that some communities receive, particularly in the long term.

3.34
Seven roads of national significance have been identified to date. The Christchurch motorway project is the only South Island project identified. We considered the effect on South Island local authorities and their communities. The 19 South Island local authorities received $19 million less in funding than they had budgeted (or 83% of budgeted revenue) and $37 million less than the previous year (a 28% decrease in revenue). Other local authorities may have received more funding than budgeted.

Borrowings

3.35
Local authorities use debt mainly to fund the acquisition of long-life assets. This helps to provide equity between different generations of ratepayers. Generally, local authorities should not use debt to fund operational expenditure.

3.36
Local authorities had borrowings of $3.9 billion as at 30 June 2010, compared to total assets of $79.0 billion. This level of debt must be matched with affordability considerations and community expectations about traditional rating levels.

3.37
As at 30 June 2010, the district councils had borrowings of $1.9 billion, as did city councils. This was less than that forecast by $347 million for district councils and $136 million for city councils.

3.38
The level of borrowings held by local authorities was $673 million higher than the previous year. District councils had an increase of $316 million compared with the previous year. City councils had a similar increase ($315 million) compared with the previous year.

3.39
The extent of debt use is closely aligned with the affordability of rates across communities and the level a community is prepared to pay. Below, we look at some of the indicators of what councils and communities are prepared to consider as prudent debt levels.

Indicators of financial sustainability

Debt to total revenue

3.40
The percentage of debt to total revenue compares borrowings (current and non-current) at year end to total annual revenue. The higher the percentage, the less able the local authority may be to cover the borrowings from the revenue it generates.

3.41
Debt to total revenue increased significantly during 2009/10, from 63% to 71%.

3.42
Figure 4 shows that city councils had higher debt to total revenue percentages than district councils. Regional councils had low debt to total revenue percentages. As a subsector, regional councils do not have such significant borrowings.

3.43
Regional councils have significantly lower asset bases than other local authorities. In some cases, regional councils also have significant additional sources of income from their profit-making subsidiaries. The funding provided by this income may be used as an alternative to borrowing and rates.

Figure 4
Debt to total operating revenue

3.44
The increased percentage against previous years reflects the increase in debt held by local authorities, as noted above.

3.45
The highest debt to total revenue percentages for individual local authorities were 200% and 180%. Both of these were held by high-growth local authorities, where the intended funding mechanism for debt repayment is generally not rates but development contributions. Although these indicators are high, they are inside the financial policy limits of the respective local authorities. The indicators also reflect that these local authorities rely on future growth and development contributions to continue to meet their debt commitments. As noted in paragraphs 3.19 and 3.20, current conditions mean that budgeted contributions are at risk, with the consequence that alternative funding sources will need to be identified to meet debt commitments. This might mean further rates increases.

Liquidity

3.46
The liquidity ratio for the sector overall was 0.89:1 at 30 June 2010. This is consistent with the previous year. The liquidity ratio compares current assets to current liabilities. It measures whether a council has enough resources to pay what it owes during the next 12 months.

3.47
The highest liquidity ratio was 11.81:1 and the lowest was 0.16:1.

3.48
District and city councils often had low liquidity ratios. This reflects the loan debt profiles of these councils. Much loan debt is recorded as current because of how local authorities structure their loan renewals and their use of cash reserves to fund capital expenditure before drawing debt.

3.49
A ratio of less than 1.0:1 indicates that an organisation may have difficulty in meeting its liabilities as they fall due. We will continue to monitor this ratio for local authorities to determine any trends. The liquidity ratios achieved by local authorities are in line with those budgeted or anticipated in the local authorities’ 10-year plans, reflecting that this is typical of how the local authority sector structures its debt. Most local authorities anticipate few problems in rolling over or renewing their loans.

Capital expenditure/depreciation

3.50
The capital expenditure to depreciation ratio compares the rate of capital expenditure on assets to depreciation. A ratio higher than 1.0:1 indicates that capital expenditure is higher than the depreciation rate and suggests a level of reinvestment that is at least maintaining the assets’ performance capability, and even improving the nature of the service provided by the assets.

3.51
This is a long-term indicator, because capital expenditure can be deferred. Therefore, the indicator needs to be considered over time as well as in any one particular year. As noted in paragraph 3.29, many local authorities had deferred their capital expenditure.

3.52
The capital expenditure to depreciation ratio for all local authorities was 1.77:1. This is a decrease on 2008/09, when the ratio was 1.86:1.

3.53
The highest ratio was 5.68:1 for a local authority that had a large capital expenditure programme in 2009/10. This was due to a large one-off roading project. The lowest ratio was 0.62:1.

3.54
In future, we plan to collect information on investment in new capital projects compared with spending on existing assets through renewal or replacement. Currently, this information cannot be readily extracted from local authorities’ audited financial statements.

3.55
The Local Government Act 2002 Amendment Act 2010 amended a requirement for local authorities to disclose in their long-term plan the amount of capital expenditure they have budgeted to meet additional demand, improve levels of service, and replace existing assets. It also requires a local authority to report its actual capital expenditure in its annual report. If combined with reasons for variations of actual expenditure over that budgeted, it should provide readers of the annual report with additional information about capital expenditure for the year.

Group financial information

3.56
We have also considered selected group financial information for city councils only. Group financial information largely includes both parent and CCO financial information.

3.57
Each local authority structures its business differently. Some, such as Christchurch City Council, have large group structures with several CCOs. Others, such as Napier City Council, have no CCOs. Some councils have CCOs that run core operations. Other CCOs are held as local authority investments. The decision to set up or invest in a CCO must be made by a local authority in consultation with its community.

3.58
We have not considered the financial results of the former Auckland councils in our analysis. Auckland’s reorganisation will result in Auckland Council CCOs running major activities and services – including water supply, waste-water, and transport.

3.59
Total revenue collected by the 12 parent city councils that we considered was $2.2 billion. Their CCOs collected a further $653 million.

3.60
Parent city councils incurred expenditure of $1.9 billion. Their CCOs incurred a further $672 million.

3.61
Furthermore, city council CCOs held an additional $1.9 billion in assets and had $855 million of debt in addition to that held by their parent entities.

Next steps

3.62
We intend to continue to collect information from the audited annual reports of local authorities and report our observations on their financial performance and position. In future publications for Parliament, we expect to report more fully on the trends arising throughout the sector.

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3: For the reasons noted in paragraph 2.11, we have not considered the former Auckland local authorities or the new Auckland Council in this analysis.

4: Wellington City Council continues to acknowledge that it has exposures to future claims. Because of ongoing uncertainty, this part of the leaky home liability has been treated as an unquantified contingent liability.

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