Finance Committee

Meeting date: Wednesday, September 25, 2013

Official Report 523KB pdf

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Financial Reporting

Our third item of business is to take evidence on the Auditor General for Scotland’s report “Developing financial reporting in Scotland”. I therefore welcome to the meeting Caroline Gardner, the Auditor General for Scotland, who is joined by Gemma Diamond and Mark Taylor from Audit Scotland. I invite Caroline Gardner to make a brief opening statement.

Thank you convener, and thank you for inviting us to present this report to the committee. It obviously covers a number of areas that are central to the committee’s role and responsibilities, and we are glad of the chance to be here today.

The devolved Scottish public sector manages and delivers public services that are crucial to almost every aspect of the lives of Scotland’s people. The public sector spends more than £45 billion a year, which comes from a variety of sources, including the Westminster block grant and council tax. Comprehensive, reliable and transparent financial information is necessary to help politicians and other decision makers to make good decisions about how that money is used, to hold public bodies to account for their spending, and to ensure that there is public confidence in the management and sustainability of public finances.

As the committee is aware, the Scotland Act 2012 will shortly give ministers new tax and borrowing powers that are aimed at increasing autonomy and strengthening accountability. Those powers also raise the prospect of more variable revenues in future. That will increase the importance of managing and accounting for public finances in a way that demonstrates financial stability and potentially builds investor confidence on the bond markets in future.

It is important for me to stress that there is a lot that is good about public financial management in Scotland at the moment, but the changing environment will bring new demands. Currently, much of the Government’s financial reporting and the Parliament’s own consideration focus on spending against annual resources and capital budgets. That is undoubtedly a critical area, but the Scotland Act 2012 will bring a new focus on revenue and the report also highlights the importance of comprehensive, transparent and reliable information on the assets and liabilities that the Scottish public sector holds.

Understanding the risks and opportunities that are associated with those assets and liabilities is essential to sustainable public finances. The report that is in front of the committee pulls together information from about 100 sets of accounts of Scottish public bodies for 2011-12 to illustrate what assets and liabilities are held, and the opportunities and risks that they present. We found that the devolved Scottish public sector has assets of approximately £86 billion including hospitals, schools and investments in loans and shares, and liabilities of approximately £94 billion including pensions and borrowings.

It is important to note that the valuation of assets and liabilities always represents a snapshot at a single point in time, and it often requires significant judgment and use of best estimates. Effective financial reporting helps such complex issues to be understood so that the financial risk can be well managed.

There is room for improvement in two broad areas. The first is that there is currently no published picture of the assets and liabilities of the Scottish public sector as a whole, although ministers do have powers under section 20 of the Public Finance and Accountability (Scotland) Act 2000 to prepare consolidated public accounts that would provide that. Scotland’s increasing financial autonomy with the implementation of the Scotland Act 2012 offers a good opportunity for Parliament and the Scottish Government to consider whether such accounts should be introduced.

Secondly, we also suggest four specific areas in which financial reporting could be developed.

The first of those is how best to report the long-term consequences of investment decisions, including the use of borrowing and public-private partnerships to fund investment in assets. Secondly, the Scottish Government will also have to consider how best to report on how its forecasts and other estimates are made as the new tax-raising powers are used. It is important that the Government can show that those forecasts are soundly based and explain the reasons for any variance between actual and estimated tax receipts, and the impact that that variance has on public finances.

Thirdly, audited accounts include the identification of potential future liabilities. We think that there is scope for the Scottish Government to ensure that there is clear monitoring and reporting on those potential liabilities so that the associated risk can be managed. Fourthly, the Scottish Government could provide more transparent information on some complex accounting areas that can be difficult for the Scottish Parliament and the public to understand, such as adjustments to the block grant.

The report highlights the importance of transparent, comprehensive and reliable financial information in building public trust and investor confidence, supporting accountability and providing the information that is needed to make sound decisions. The changing financial environment in Scotland means that now is a good time for the Government and the Parliament to consider how financial reporting could be further developed, and the report is intended to be a constructive contribution to that debate.

Convener, we will do our best to answer any questions that you and your colleagues have.

Thank you for that interesting opening statement. As is normally the case with the Finance Committee, I will ask some opening questions and then open up the questioning to colleagues around the table.

One of the points on which you touched was forecasting. It is important that the Government and the Office for Budget Responsibility can show that forecasts are soundly based. In May this year, the Cabinet Secretary for Finance, Employment and Sustainable Growth indicated that Scotland would require its own independent forecasting unit. Is that the appropriate vehicle for forecasting and what role do you see for yourself in that?

We responded to the committee’s consultation on that question earlier this year. In broad terms, the vehicle that the Government chooses to put in place for forecasting is a matter of policy rather than one on which we would have a direct view. However, a separate body of the nature that has been proposed would certainly be in a good position to fulfil the requirements for forecasting.

The way in which such a body works in practice, the transparency of its forecasts and the way in which it builds the capacity to fulfil that critical function in future are the issues that now need attention. They could be fulfilled in various ways; they could certainly be fulfilled through the body that the cabinet secretary has envisaged. We will keep a close eye on the development and establishment of that body to ensure that it is in a position to provide those forecasts effectively.

Forgive me for asking you to dip your toe into policy. It is a sneaky thing that politicians do, and your predecessor was always very wary in that regard, so it is understandable that you are too.

Is the OBR’s forecasting on the taxes that have been devolved through the Scotland Act 2012 robust? That is one of the reasons that the cabinet secretary has given for setting up the proposed independent body.

You are right that, as Auditor General, I must always be concerned not to overstep the mark and comment on policy.

At the moment, we do not have the evidence that would be needed to draw any conclusions about the quality of the OBR’s forecasting of the future Scottish devolved taxes under the Scotland Act 2012. It is obviously critical that those forecasts are robust and transparent so that the Parliament and others with an interest can test and challenge them.

We are fortunate that the implementation of the act gives us a good run-up to test out the forecasts in practice before the Scottish Government’s finances start to rely on them. We are keeping a close eye on that as well as on the Scottish Government’s plans for establishing its own forecasting capability in future.

You talked about clarifying complex accounting issues. As you mentioned, the Scottish Government deals with several complex areas, such as the accounting treatment of student loans. In paragraph 16 of your report, you say:

“While the Scottish Government and other public sector bodies produce audited accounts, they do so individually. It would require the consolidation of over 100 sets of accounts, with appropriate adjustments for transactions between public bodies, to determine the assets and liabilities of the devolved Scottish public sector as a whole.”

How long would such a process take and what would be the cost implications of carrying it out?

In a moment, I will ask my colleague Mark Taylor to come in to give you more information about that, but it is worth noting that, currently, the UK Government produces whole-of-Government accounts to which the Scottish Government makes a significant contribution. Therefore, much of the groundwork is already in place, although the comprehensive picture for Scotland has not been pulled together until now.

Mark, could you take us through the issue in a bit more detail?

11:45

The starting point is that a number of mechanisms are already in place to prepare whole-of-Government accounts at a UK level. They provide some vehicles to get consistency of accounting approach and reporting to allow aggregation and consolidation. However, there would undoubtedly be additional costs on top of that to prepare public accounts for Scotland. I guess that the issue in question is the cost benefit analysis of that work.

We are clear about the real benefits that public accounts could bring in a changing environment with the introduction of the powers in the Scotland Act 2012, but we are also clear that the purpose of the Audit Scotland report is to start a discussion about the costs and benefits and for us and the Scottish Government to continue and maintain that discussion.

You touched on assets and liabilities. In paragraph 20 of your report, you state:

“councils currently value local roads at their historical cost, whereas Transport Scotland values its trunk roads at depreciated replacement cost. If councils were to value local roads using the same methodology as Transport Scotland, they estimate that the value of these assets could increase from £5 billion to £55 billion.”

That would clearly have a significant impact on Scotland’s perceived asset base. Should there be consistency in that regard?

You are right—the different accounting frameworks have a significant impact on the valuation of the assets in that particular case. That is why we have been careful to put forward our estimate of the total assets and total liabilities as just that—an estimate that cannot be taken further in the absence of full whole-of-Government accounts for Scotland.

The accounting profession in general and across Government is working towards greater consistency on the accounting standards. Mark Taylor might have more to say to you about the specific application in relation to roads.

I would just add that the roads issue is well understood and work is well under way to address it in time. The estimate that we use in the report came from the profession, which is well aware of the issue and is working hard to address it. We expect it to be addressed in time, which will bring consistency.

I will open up the session to colleagues in a moment—I already have four colleagues wanting to come in—but I want to ask one more question.

In paragraph 68, you state:

“The Scottish Government could look to examples from around the world to see how it might further develop its financial reporting.”

You mention some examples in the report, but will you speak to that for a minute or two, for the record?

Certainly. As I said in my opening remarks, it is clear that, here in the UK and in Scotland, we do a lot of the financial reporting very well. For example, Government financial statements are produced on an accruals basis, which means that they actively match income and expenditure in time, and they now use the same financial reporting standards that are used for large corporations in the private sector. We do a lot of things very well.

We are keen to promote a debate about how that approach can develop in the context of further financial autonomy for Scotland to give the whole picture of assets and liabilities and to draw out the things that you need as politicians, decision makers and people who scrutinise the Scottish Government’s performance to understand the implications of decisions that are made.

New Zealand is one country that is seen to do this work well, and there are other exemplars that either do most things well—Australia is one—or have pockets of good practice. We are certainly not pointing to any one model and saying, “This is the way it ought to be” as it is important that there is a dialogue with the Government and the Parliament, but there are things that we can learn both from countries that are seen as exemplars of good practice, such as Australia and New Zealand, and from countries that have had a particular experience that has highlighted their concerns.

An example that we mention in the report is the experience of the Spanish Government. We have all heard a lot in the news recently about the problems that the Spanish Government is facing with the level of indebtedness that it has built up. The problem was not the borrowing that the Spanish Government itself undertook, but the borrowing that regional Governments had entered into, which was not clear and transparent and was not brought together anywhere. It suddenly became unaffordable when the financial crisis hit and local tax revenues fell sharply.

That is a good example of the risks that any country can run if it does not have a clear picture of the overall assets and liabilities that it might have to manage. We think that there is scope to learn from such international experience in taking the debate forward.

Thank you for that. I open up the session to members. The first person to ask questions will be Malcolm Chisholm, to be followed by Gavin Brown.

Your example of the international experience was interesting, Auditor General. I wondered whether the fact that there has been no published picture in Scotland is a function of our constitutional arrangements. Obviously, it is not entirely due to that, but I wonder whether it is partly related.

I wanted to ask mainly about liabilities, but I have what might be a rather naive question about assets. I think that everyone will understand the importance of having knowledge about liabilities. However, given the wide discrepancy between valuations of the roads assets, how significant is it to know about assets if there is a variety of ways to describe them?

As Mark Taylor said, the valuation of roads is an evolving picture. There is now an agreement for how we will move the valuation of roads on to a consistent basis in future. That will make the value of the road holdings more transparent and help to put in context, for example, the amount of backlog for maintaining the roads, which we need to manage over time.

Perhaps a better example is that of an asset for which there is not as much transparency as we would like to see: the valuation of student loans. That is a significant asset of the Scottish Government, although it is not always obvious as an asset to lay people. We would like to see clarity about what the loans are worth, over what period of time they are likely to be paid and therefore the income stream associated with them, and the extent to which they might be reduced in value by changes in the economy. That is another example of where greater transparency would help better decision making and give a better picture of what the financial sustainability of the public finance is looking like.

The student debt is an interesting example. Do you think that account is taken of that in the Scottish Government’s finances? Obviously, there is quite a risk of bad debt in student loans. Is that debt likely to be over a very long period of time and could it be quite significant?

I will ask Gemma Diamond to pick up the question and tell you more about the way that student loans are currently accounted for.

Certainly, account is taken in the accounts for the potential that the debt will not be repaid by the student. Quite a complex assessment is done at the start when the loans are made, which runs through a number of different factors. It is based on a system that the UK uses to model what loans might not be repaid, so that an immediate write-down is made of the debt when the loans are made. All that is taken into account in the accounts.

What we are saying in the report is that student loans have a very complex accounting mechanism and they appear in the accounts in lots of different places, so it can be very hard to follow how they flow through the accounts. Greater transparency in that complex area on exactly how the debt works, what the provision is and how it has been calculated, and some of the assumptions that were made when making the bad debt provision, would enhance transparency of how the student loans work and enable better scrutiny of them.

Moving on to liability, Auditor General, you mentioned pensions and borrowing, both of which are interesting and important. Your Spanish example was quite interesting. I do not know whether anybody in this country keeps an eye on the borrowings of local government, although the Treasury probably does. Does the Scottish Government keep an eye on that?

The Scottish Government takes a series of financial returns from each local authority each year that gives a range of information about their finances, including borrowing. Obviously, the Accounts Commission, through the audits of local authorities, also keeps a close eye on that and its overview report each year gives a picture of how borrowing is moving.

The question is a very interesting one in terms of the potential risks that come with assets and liabilities; the way in which the prudential framework lets local authorities decide how much borrowing they are going to enter into, over what time period and with what interest terms; and the way in which all that comes together to provide a picture of Scotland’s public finances as a whole.

To be clear, we are absolutely not saying that Scotland is in anything like the position of Spain, but that example is a useful reminder of why it is important to have an overall picture. If a local authority did get into financial trouble, the Scottish Government would likely have to step in to provide support, even if only to keep essential services running in the meantime.

The pension liability is obviously a big one. I am not trying to entice you into constitutional areas, but do you think that the assets and liabilities issue could become a feature of the debate on the constitution? Obviously, there is much discussion about the future economics of Scotland. I suppose that this has already happened with pensions, but do you foresee assets and liabilities becoming an area of discussion in the constitutional debate in the next year?

As you say, it is already part of the debate. Going back to the convener’s caveat, we need to be careful about how we play into that.

Earlier this year, we provided evidence to the Scottish Affairs Committee about the public sector pension schemes. Interestingly, most of the pension liabilities and pension scheme members are already in schemes that are devolved to Scotland—the local government schemes, the teachers scheme and the national health service scheme. It is really only the civil service pension scheme that is run on a UK-wide basis.

Therefore, that issue is not a particularly large one in the independence debate or the debate about further devolution of financial responsibility. Nevertheless, given the direction of travel that we are seeing with the Scotland Act 2012, which is already on the statute book, an understanding of the liabilities and what the implications are for future expenditure and revenues is important for all of us.

I want to focus on the second main point in your summary, which related to forecast estimates and the revenues that are collected. Do you have any preliminary views on what financial oversight there ought to be? How frequently should revenue collection be reported? Should it be transparently reported in real time, monthly, quarterly or annually? Do you have any preliminary views on how that might work with the new taxes that are coming in?

Mark Taylor, who leads on the Scottish Government annual audit, is staying very close to that on my behalf and I ask him to talk you through it in a bit more detail. Our starting point is that there is scope to talk about good practice in terms of that real-time reporting, but it is unarguable that we will need to have annual reporting of how the receipts match the forecasts and what that means for the Government’s annual outturn—whether it is above or below the budgets that it expected to have—and, therefore, for future spending and tax-raising plans. We will need to have that anyway. I ask Mark Taylor to talk you through where our thinking has got to on the level of reporting beneath that unarguable annual level.

I do not think that we have formed a view on how frequent the reporting should be, but we can ask what it should try to achieve. First, it should help our understanding of the quality of the forecasting and the level of uncertainty and risk that goes with that. Secondly—this is of fundamental importance to the report that we are discussing today—it should help us to understand the implications for the budget of how the forecast and the block grant impact on the budget and how differences between forecasts and actuals impact on the budget. It should also help us to understand those implications alongside the implications of other things that impact on the budget—the budget exchange mechanism, any capital moneys that, with agreement, have been carried over from one year to another, and borrowing—including how all those things interact. Fundamentally, the reporting is about getting clarity about that. It is an annual process and, to my mind, one that impacts both at the budget-setting stage and at the budget outcome stage—the annual report stage. There are at least two areas where it is worth reporting on that.

Thirdly, the reporting should enable a whole-system picture of things such as borrowing and the impacts of revenue and tax, placing those individual things—for example, how the forecast affects the amount of money that is available to spend—in the context of the wider position of what the aggregate borrowing is and what the aggregate liabilities are.

I ask the question because, with income tax in particular, although we can predict how much we think we will collect over the course of the financial year, it is inconceivable that we will collect one twelfth of that amount in each calendar month. I imagine that there will be peaks and troughs, with the end of January and the end of the financial year being particularly busy, and that, in other months, we will collect much less. In terms of the level of sophistication that is required, is there merit in having either monthly or quarterly reporting against what was predicted so that we, as parliamentarians and members of the Finance Committee, have a good picture of how we are doing? After nine months of the year, we might think, “Great. We’ve got three quarters of what we expected to get.” However, if the last quarter was predicted to be a bumper quarter and turns out to be a weak quarter, we will end up in difficulty at the end of the year. Do you have any further thoughts on that?

12:00

That is exactly the sort of question that the committee ought to be exploring at this stage. We certainly expect the Government and revenue Scotland to have in place very detailed monitoring that is increasingly informed by a good understanding of the pattern of tax collection, how much one would expect to collect in each month of the year, and what action needs to be taken if there is slippage. That is particularly important in relation to the Scottish rate of income tax, which is by far the biggest of the new taxes that will be collected by HM Revenue and Customs on behalf of the Government. Having that really clear line of sight will be key.

I do not think that much attention has been paid yet to what information the Parliament needs or what information should be publicly reported in-year as opposed to at the end of the year and as part of the budget-setting process, as Mark Taylor said. I do not have a strong view on that at this stage, but the committee and other committees of the Parliament should focus on it.

You mentioned the value of assets in your opening statement, and you talked about financial assets in response to a question from Malcolm Chisholm. Paragraph 23 of your report specifically considers physical assets. It says that the public sector needs

“to consider how demand and usage of physical assets affect their condition and future maintenance requirements.”

Paragraph 24 of the report says:

“Public bodies may decide to delay short-term expenditure on maintaining assets. If they do, they must be aware of how this might affect the long-term condition of the assets and the way they are used to support service provision.”

Are you aware of an increase in such decisions?

At the moment, we are not. It is clear that there is a risk of that happening, which is why we made that point in the report.

I think that one of the reasons why that evidence does not exist is that public bodies are becoming more transparent in reporting their maintenance backlogs. In paragraph 23, we report on the NHS maintenance backlog, which is based on a very detailed survey that the NHS carried out of its assets. The maintenance requirements were broken down by category, and more recently, an amount for lower-priority work has been separated out, as the buildings concerned are likely to be disposed of within the next 10 years.

The information is improving, which is a good thing, but it is not yet good enough to highlight whether the maintenance backlog is increasing because people are deciding to delay repairs or investments and are running the risk of storing up problems for the longer term as a result. That is exactly why we think that the information is needed on a consistent basis. The bodies themselves can then spot things, and the Parliament can see the impact.

From what you have said, I assume that it must be important to get a baseline so that, when maintenance costs are taken into account later on, that information can be contrasted with what the maintenance costs would have been when a decision was deferred.

That is exactly right. The baseline is developing. We have a range of examples that relate to NHS assets, the road network and other things. The baseline is there and we now need to use that baseline information in individual public bodies, the Scottish Government and the Parliament to look for patterns in what is happening to the costs of the maintenance backlog that we know we have, what the plans are for meeting those costs and how the issue fits into things such as planning for reconfiguring services to move from reacting to problems to preventing them. All that information is necessary in making those decisions.

Paragraph 47 in part 3 of the report talks about the audited accounts. It says that they are a

“key way of reporting financial information. International accounting frameworks and standards help to ensure that they are prepared objectively and can be compared across different organisations. However, this can mean that they are hard”—

if not impossible—

“to understand by a lay reader”.

That is not just an issue for the public sector, is it? It is absolutely an issue across all accountancy. Accountants have failed to make accounts understandable, have they not?

I know that Mr Mason is aware that there is a very topical debate on the impact that the international financial reporting standards have had on making accounts more comparable and consistent, and on making them less understandable and perhaps less useful in some contexts. Many people would argue that that has happened.

Clearly, Governments across the world have had to make a major investment of time and resources to bring their financial reporting into line with IFRS, and there are some benefits to that. However, there is a strong school of thought, which I understand, that that has made their accounts less comprehensible. I am an accountant, but when I pick up a local authority’s accounts I may need to spend quite some time working out what they are really telling me.

“Developing financial reporting in Scotland” is intended to be a contribution to a discussion on what the most important things are that users of accounts need to know. A second step is how we get those in place. My sense is that arguing for a change in the international financial reporting standards will be a long and slow process, but there are things that we can do, such as providing commentary on the accounts and linking financial statements to Scotland performs. There are a range of things that can be done to build on the existing foundation to make the accounts more useful and approachable for lay users rather than run the risk of adding to the complexity, which would put people off.

Is that the kind of thing that is being done in New Zealand? Are the improvements there more on the commentary or presentational side, with the actual content being much the same as elsewhere?

Absolutely. New Zealand still applies the international financial reporting standards, but people there have become very skilled in providing commentary and a long-term look at financial sustainability based on what is known from the current year’s financial statements.

Transparency gets a good bit of coverage in your report, and on the whole most of us are keen on transparency. However, in making provision for contingent liabilities and so on, a balance needs to be struck if you are not to show your opponent your hand. Generally, our committee considers contingent liabilities in private because they are sensitive. How do we strike the right balance so that we do not say, “We are about to pay out £10 million for this claim,” which would just encourage the claimant?

You are absolutely right. The same issue relates to reporting the likely costs of large capital investments before the contract is committed. No one wants to show their hand to the person on the other side of the table before the deal is done. However, that does not mean that there cannot be more transparency about the likely liabilities.

On this difficult question, I do not want to give the impression that, with 20:20 hindsight, things that later became apparent should have been known at the time. Six years ago, none of us would have guessed that the UK Government could have such a large liability for the failing banks—we could not have seen that coming. Equally, given what we now know about the bank bail-outs, what has happened in euro-zone countries such as Spain where liabilities have fallen to Government and what is happening to some US cities such as Detroit, we need to consider what that means for the likely or possible liabilities that could fall to the Scottish Government or to Scottish public bodies. We need to consider whether we are monitoring those in ways that help us to manage them and whether we are disclosing them as contingent liabilities where it is appropriate to do so.

Of course, the benefit of contingent liabilities is that we do not have to put a number on them, because the likelihood of their crystallising is less than 50:50. Therefore, we are talking about the risk rather than the financial impact. The point that we are trying to promote is the importance of having a quite open discussion about what the possible liabilities might be before they crystallise so that we can take a prudent and responsible approach to managing the public finances.

A specific example that the report mentions is the equal pay cases, which primarily relate not to the Scottish Government or Parliament but to local councils and NHS boards. You do not make a particular recommendation on that—unless I missed it—but in that example is it the case that we are probably not legally responsible, although there is a potential liability down the line?

In a technical sense, that is absolutely right. The equal pay cases are a very good example of how difficult it can be to quantify what the liability is. As we all know, equal pay cases have been running for a long time right across the UK and every time that the bodies involved think that they are getting closer to being able to quantify what the liability is, a new legal decision emerges that changes the situation and takes it in different directions. The ability to hold something as a contingent liability and to be aware of what its impact might be without either revealing a negotiating position to lawyers or providing spurious accuracy about what the liability might be is very important in that context.

From his body language, I think that Mark Taylor has more to add on that point.

To flesh that out a little bit, a key point is the difference between showing a hand in individual cases and dealing with the aggregation of the sort of issues that may potentially lead to expenditure further down the line. I think that there are opportunities to be more transparent about some of the underlying issues.

On some of the niceties of equal pay, individual bodies make individual accounting judgments about whether to recognise that expenditure, and how much expenditure to recognise on a best-estimate basis. Different parts of the public sector have made different judgments, which are picked up and confirmed through the audit process.

There is an important point to make about audited accounts. A lot of information is in the public domain and made available to the committee and the Parliament, but the unique aspect of audited accounts is that they are audited, independently verified and prepared to an objective framework. In the case of contingent liabilities and provisions, that is one of the ways in which we as auditors test what should be reported against the rules, and what can be less transparent.

I take your point that we do not want to be totally transparent about what the liability might be in an individual transaction; it is more about the overall picture.

Recently, we have been considering the bringing together of the health service and the social work service. Once individual employees from those services start getting mixed up with one another, there is the potential for a lot of equal pay claims. On the one hand, we do not want to encourage people immediately to make an equal pay claim on day one but, on the other hand, we have a responsibility to be open and transparent about that. How can we get the balance right?

That example is one in which the financial reporting implications come quite a long way down the road. For me, the most important thing is being aware—as we already are—that equal pay can be a significant cost to public bodies. Of course, there is a real issue of social justice and the fair treatment of individual workers.

Planning now to understand what it means as we bring together people from different employment backgrounds, rules and grading structures and thinking through how to manage the impact on the service and on the cost of services should be central to planning for the integration of health and social care. If that is done properly, the liabilities will be much easier to manage than if the issue emerges as an afterthought once integration has taken place. It is a great example of why awareness of the potential liabilities is important; the financial reporting of those will follow further down the line.

We have talked about local authorities’ prudential borrowing powers. In paragraph 35 of the report, you talk about how the Scottish Government will be limited, especially by the idea of paying no more than 5 per cent of the estimated revenue and capital budgets in interest and loans.

I realise that there are policy issues in this question, but the 5 per cent appears to be quite arbitrary. I am more comfortable with the prudential approach. Will you make any comment on what our risks are in that regard?

I will make a broad comment. The important underlying point—as your question hints—is how we ensure that financing capital investment through revenue means is affordable in the long term. There is nothing wrong in principle with doing that—we all do it when we buy a house on a mortgage. There is no reason not to finance capital investments through revenue sources, but it ties up funding for a long time—20 or 30 years—and throws up questions about the affordability of future requirements and intergenerational equity.

Different approaches can be taken to ensuring financial sustainability. The prudential framework is the one that has been agreed for local government throughout the UK. The Scottish Government took the initiative of setting a 5 per cent cap. Setting the cap is a good move forward in terms of the ability to demonstrate financial sustainability. It is not the only approach that could be taken, but there is nothing wrong with it and it is a positive move.

The Government having made that policy decision, the next step that we would like it to take is to provide greater clarity about what counts against the cap and more transparent reporting about how it is used so that the Parliament and others with an interest can see what has been committed and what is still available for investment over the rolling period that the existing commitments cover.

As interest rates and inflation vary in future, that will have an impact on whether the 5 per cent cap is too high or too low.

Absolutely, depending on the way in which existing investment has been financed—whether the rate is fixed or variable and other aspects. Again, that is why transparent reporting of what is in the cap and what has been committed against it is important. Being able to take that 30, 40 or 50-year view of what is already committed and therefore what is available for investment is very important against that background of change.

That is great. Thank you.

12:15

Exhibit 6 sets out in graphics the assets and liabilities of the devolved Scottish public sector. Where do those figures come from? The source is given as Audit Scotland, but were you able to get them from a single register or did you do your own assessment and work to pull them all together?

I will ask Gemma Diamond to give you more detail but, in broad terms, the figures come from our work in pulling together the accounts of more than 100 public bodies in Scotland.

So Audit Scotland is the single source, essentially.

In terms of consolidating everything and pulling it together, yes. Gemma Diamond will say a bit more about how we did that.

In essence, it was a simple consolidation process of adding together all the different sets of accounts for the public bodies that are involved. We had a threshold in place whereby some of the smaller bodies were not included because they would not materially impact on the overall position. We used the audited accounts as well as some whole-of-Government accounts information, and basically we added them together to get the consolidated picture.

We made some adjustments where we knew that there would be some double counting in play. For example, we tried to remove Scottish Government lending to Scottish Water from the picture so that we were not double counting that. We know that we were not able to remove all double counting and transactions between public bodies, but we do not believe that that materially impacts on the picture.

Okay. That is helpful. Bear with me—my next question may be quite convoluted, and it probably comes from my lack of accountancy expertise as much as anything else.

Hmm.

I note that I have intrigued John Mason.

The question is about the definition of what constitutes an asset. From my lay point of view, my financial assets are my house and my car—my assets are my property, which I can either shift and realise a value through or borrow against.

In the report glossary, you set out how you define an asset. I presume that what I consider an asset to be is broadly speaking what you consider an asset to be in the terminology that you use. Given that, I am intrigued that roads are viewed as assets, notwithstanding the wide variations in the values that are given for them. I can see that they are economic and social assets, but in what way are they financial assets? No one is going to come in and buy Scotland’s road network any time soon, are they?

You are taking us all right back to our accountancy 101 courses—for some of us, that was a long time ago—on understanding what an asset is.

I am glad to have helped.

The definition of assets that we have used is standard right across the accountancy and auditing profession. An asset is anything you can use that you own or control and can use to produce value.

The roads network has a value in that it is a critical part of Scotland’s economic infrastructure for moving people and goods and businesses around. Perhaps the easiest way of quantifying that is to think that, if we had to build the roads network—if it did not go back for the 100 or more years that it does in parts of Scotland—there would be a real cost to doing that. We would be investing in building that asset, which could then be used to underpin the economy and the social connections that we all have.

The roads network is not an asset in the sense that I set out. I missed accountancy 101, I should say, but it is not something that can be borrowed against or anything like that.

You might be surprised. I ask Mark Taylor to take you through that.

Okay. Surprise me.

It is worth recognising that there are different types of assets. Assets such as the roads network provide public benefit, but that benefit is perhaps not in a potential to dispose of them and raise proceeds. Other assets are more of the financial type and they have a financial value. The balance sheet or statement of financial position captures both sorts of assets and puts values on them.

If we have better and more transparent reporting, it will help to give us a better understanding of those issues. For example, it will help us to understand where there might be opportunities to release cash and where there might be risks in relation to the need to fund and maintain assets.

That is a useful point and a helpful clarification, certainly from my perspective. You mentioned both assets against which we can realise value and the wider economic and social leverage. Some of the assets that I mentioned—or all of them, probably—will require maintenance, which is an on-going cost. In essence, could that be viewed as a liability and as such, in accountancy terms, are the costs that such assets are likely to incur on the liabilities side?

Again, I will ask Mark Taylor to take you through that. However, I note that one reason why we think that it is important to understand assets and have transparency around them is that they often give rise to costs and income. Over time, in order to keep roads in good order, we must incur the costs of maintenance and of bringing them up to date. The student loan book is an example of an asset—I remember scratching my head, as an accountancy student, over how a loan could be an asset—that brings in a revenue stream over time. It is important to have clarity around that.

I ask the expert beside me to take you through a bit more of the background to the issue.

I will try to avoid getting into a detailed lesson on accountancy. The broad point is that assets and liabilities come with risks and opportunities. Often, however, it is tempting to see the costs without seeing the benefits. That applies to assets as well as liabilities. Through improved financial reporting, the niceties of that for individual classes of assets can be better understood.

Sometimes, a liability is measured at a level about which there is some uncertainty. The result could be that the liability is less than was expected and some additional funds can be freed up. There are opportunities and risks associated with both assets and liabilities.

That is helpful but, for absolute clarity, where do the on-going maintenance costs feature? Do they feature in exhibit 6 at all?

I will have to drop into accountancy-speak for a moment. It is important to differentiate between liabilities, which are costs that have already been incurred because of the activities of Government, and future costs and commitments, which will feature as future expenditure in future years. Those are two separate things.

Your answer is no, then.

That is correct.

I thank the committee for indulging me in my personal accountancy class.

I have a supplementary question that is also a bit of an indulgence. I recall that, some time ago, some English local authorities were thinking about doing some sort of private finance initiative deals with their road network assets, which would see them borrow on the strength of an asset and then pay a company to maintain the road for a set period of time. Is that the type of thing that you are talking about here?

That is a great example. Assets can sometimes be used in those ways. I do not know of any examples in which English local authorities have, in effect, sold and then leased back the road network, but that has certainly happened with office buildings and other such assets, where a capital receipt comes in and there is a revenue cost to continue using the asset over a period of time. That is why it is important to have a picture of what is owned and what is owed.

My question is on the same theme of the clarity of financial reporting relating to assets and liabilities. The examples that we have talked about are recorded through local authorities and so on. What about assets such as those that are held by the Crown Estate? Do you look at those? Until about 10 years ago, the Crown Estate published Scottish accounts, but it no longer does that; it publishes accounts only for the United Kingdom.

Following on from that, in the committee’s experience, the OBR has predicted figures that were clearly not right. In the light of the new taxes and so on, do you have an opinion about that? Do you have a relationship with the OBR? How does that work?

I will start with the question about the Crown Estate and other UK-wide assets and liabilities. For the report, we deliberately stuck with the existing boundary of devolution—that is, what we have from the Scotland Act 1998 and the Scotland Act 2012, which is coming into force. It seems to us that that change is a good enough reason to consider the completeness, transparency and accessibility of the financial reporting that is available to you and more widely to the people of Scotland.

You are right to suggest that the Crown Estate is not part of the report, and we did not attempt to go into difficult issues such as Scotland’s share of the national debt or assets that are held on a UK basis. Depending on the outcome of the referendum next year, that may become necessary, but it is not my role to start that debate now, so we focused on the existing boundaries. However, it is worth saying that, whatever happens in terms of future financial devolution or autonomy, the report will provide a sound foundation for that. It is important both in its own right and as a foundation for future discussions.

On your second question, which was about the OBR forecasts, I cannot really amplify the answer that I gave to the convener. The OBR forecasts are central to the Scottish Government’s forecasting of the receipts from the new devolved taxes. Over time, we will get experience of how accurate the forecasts are and there will be an opportunity to supplement or replace them with specifically Scottish forecasts through the new fiscal forecasting body that is proposed.

The important question from our perspective concerns the way in which the committee and the Parliament more widely will be able to compare the forecasts with the actual receipts and understand why there is a difference. Is it because of poor forecasting or changes in economic activity that could not have been foreseen? A whole range of things will come into play. You will need to be able to explore the issue and understand what is happening to ensure that future forecasts are more reliable.

I have a supplementary question. On the basis of what you have said, it seems that the clarity that you achieve in auditing Scotland’s figures is not achieved at a United Kingdom level. The OBR’s figures make no distinction between Scottish, Welsh, Northern Irish and English figures for the landfill tax and so on. The fact that we cannot get the figures for Scotland suggests that there is not the same clarity in the accounting. Is that correct?

I would distinguish between financial reporting, which looks back at the assets that we now hold and our income and expenditure over the past year and ensures that that is reported in a comprehensive, transparent and reliable way, and forecasting. The whole-of-Government accounts for the UK Government provide that overall picture and are increasingly useful to the Westminster Parliament when it looks at matters such as the way in which clinical negligence provisions or nuclear decommissioning are being handled.

We do not yet have such a system in Scotland and it would be useful to start looking at how it should develop. We have not audited the OBR’s forecast for either the UK as a whole or Scotland but, as you say, that is becoming more important as the new taxes under the Scotland Act 2012 are implemented, and the financial reporting will help to inform that.

I pick up on your statement on greater clarity about what counts against the 5 per cent cap. Is there quite a lot of dispute about that or is this just at the margins? I think that, at the moment, the figure is 4.8 or 4.9 per cent. Is there scope for wide discrepancies or is there just a bit of detail that is lacking?

I think that it is the latter. The broad picture is clear, but there is a need to pin that out and make it explicit so that the Parliament and others with an interest can see it, and there is a need to report against it on a continuing basis so that we can see what is going on.

Are you saying that the information is not stated clearly in any one place in any document?

The reporting on the cap is not yet a formal part of the Government’s financial reporting. There was a big step forward in the budget announcement a couple of weeks ago, but the details are still emerging. The picture is evolving, but such reporting is the logical next step following the Government’s good first step of putting the cap in place.

Are the liabilities for the different public-private partnership deals just the sum total of however much is to be paid up over the 30 years? How does that compare with how you count traditional borrowing liabilities?

I ask Mark Taylor to take us through that.

I will give it a go. The way in which PPP accounting works is essentially that we add up the cost of a PPP scheme throughout its lifetime. It is not a straightforward and simple aggregation because we apply some financial modelling to take account of what will happen to inflation and the time value of money, but we are then able to estimate the liability. As the annual charges are paid by public bodies, we expect the liability to come down. That is how PPP works.

On how borrowing works, the amount of money that is owed to the bank is shown as a liability. Each year, interest costs will have to be paid and some of the borrowing will have to be repaid. There are two things to take account of when we look at how borrowing impacts on public accounting. The first is the amount that is still to be paid in aggregate terms, and the second is how much needs to be paid this year. The 5 per cent cap is about how much needs to be paid this year, and we are saying that there needs to be absolute clarity about what is in and what is out of that 5 per cent cap. It includes borrowing and PPP costs, but exactly which ones? There has been a helpful discussion about how that can be progressed.

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Which would tend to show up as a larger liability—a big project that was funded traditionally or one that is funded by PPP?

I think that I will avoid answering the question about which is more expensive—PPP or traditional borrowing.

Is that necessarily the same question?

Essentially, it depends on the mechanics of the individual contract for the individual asset and what deal has been negotiated. It is worth saying that traditional borrowing comes with the costs of servicing the debt, but PPP also comes with costs. In a PPP scheme, you are often paying for more than you would be under a traditional contract.

I understand that, but I just wondered about the liabilities.

On the 5 per cent cap, do we have any comparable figures for local government borrowings and so on? Does that vary widely from local authority to local authority?

It does. Exhibit 10 in the report shows by sector—for local government, the health service, public corporations and central Government—the known commitments for PPP charges, and the local government ones are the most significant. Within that, there is a good deal of variation between the 32 councils’ liabilities. That is transparent in their accounts, and the Accounts Commission pulls the information together, to an extent, in its overview report. Again, however, it would be helpful to get an overall picture for the Scottish public sector as a whole for all the reasons that we have been discussing.

Does exhibit 10 combine PPP charges and loan charges?

Our exhibit is for PPP charges.

Surely we need to know both. Presumably, the loan charges are bigger for most local authorities.

Absolutely. As Gemma Diamond explained earlier, it is possible to pull all this together to get that picture, but it has to be done as a one-off exercise.

Do we not really know? Is it likely that a lot of councils are above the 5 per cent cap?

The 5 per cent cap does not apply to councils.

I know that it does not apply to councils, but what about in practice?

I would not want to mislead the committee by taking a stab at that. The Accounts Commission is responsible for auditing local government and it has reported a significant amount on the issue. We can come back to you with more information if that would be helpful.

Okay. Thank you.

That concludes the questions from members of the committee, but I have a couple of questions that I would like to ask.

Going back to PPP, I note that paragraph 31 of the report mentions 93 assets that

“have a combined estimated capital value of £6.1 billion.”

Paragraph 32 goes on to state that the total of paid and to-be-paid charges for those assets will amount to £32.6 billion for that £6.1 billion in assets, and the total payment is 5.3 times the capital value. Over the page, you go on to mention public-private partnerships, the private finance initiative and the non-profit-distributing model, but you do not show any similar ratios for them. What is the ratio of payments to capital value for the non-profit-distributing model?

We used PPP as an umbrella term that includes PFI and NPD, so the figure that you mentioned combines information for projects of both sorts. Gemma Diamond might be able to provide a bit more information on that, but I suspect not. Our intention was not to audit PFI and NPD but to give an overall picture of the long-term commitments that reflects the investment in assets that has been made over a period of time.

But if the Government is choosing one measure over another, surely it would be helpful to have the difference in costs laid out.

We might carry out such a piece of work in future, but it is not the focus of the report. We have not audited individual PPP projects of whatever sort to investigate the relative costs and benefits. As Mark Taylor said, that would be a complex exercise because of the range of things that are included in different contracts across the different parts of the public sector. That is not what we have done for the report that we are discussing today, although it would be possible to do it in future.

Would it not aid transparency in public policy making?

It might, but the question is whether that is part of Audit Scotland’s role or the Government’s.

Thank you. I have one more question. Following on from our 90-minute session this morning on the national performance framework and how it links with the Scottish budget, is there any evidence on the NPF’s impact on the Scottish Government’s spending decisions?

At the moment, it is hard to see where that evidence would sit. We had a useful session with the Public Audit Committee a couple of meetings ago when it focused on the quality of data that is available to allow the Government to demonstrate the effectiveness of its policies. As a result of that, the Public Audit Committee has agreed that we will do some work with the Government to look at the data that is required to underpin the national performance framework so that we can link the outcomes with inputs and outputs. A key input is the spending decisions and the amount of money that is spent.

We are conscious that integrated reporting is a big development right across the accountancy and auditing world globally in both the public and private sectors. Further out, there is scope for much better reporting of performance and financial results in a way that allows that joining up. We are not there yet, but there is a real will to make progress on that.

Thank you. That concludes our questions. Are there any points that you want to make to the committee that we missed out in the questions that we have asked?

From our perspective, the discussion has been helpful, and it has been good for us to have the chance to sit down with the committee. My strong view is that this area needs to continue to evolve with the implementation of the Scotland Act 2012 and the discussion about further financial autonomy or independence in future. We would welcome the chance to stay engaged with the committee on what it would find useful and what further information we might be able to help with. Thank you for the chance to be with you this morning.

I thank you for your opening statement and your answers to our questions, and I thank my colleagues for asking them.

12:37 Meeting continued in private until 12:45.