Australia Economy and regeneration , Finance , Transport and infrastructure

Are we using the right financial sustainability indicator to assess asset management performance?

Summary

  • In this opinion piece, LGiU Associate John Comrie explores the requirement for local governments in all states to report past and projected future financial performance using financial sustainability indicators. He suggests that while this is a good thing in principle, we need to ensure that the indicators and any associated targets are appropriate.
  • John makes the case that comparing expenditure on asset renewal with depreciation, as is required in most states, is problematic (such as in NSW the Building and infrastructure renewals ratio). In some periods it may be appropriate to expend more or less on asset renewal than the value of depreciation. John discusses an alternate approach that reports asset management performance by comparing renewal expenditure against what an asset management plan suggests is warranted.
  • This briefing will be of interest to those working in strategic finance and asset management, CFOs and councillors, as well as those planning professionals (including state agency staff) more broadly interested in local government financial and asset management planning and performance.

Briefing in full

Introduction

All Australian states require local governments to report financial performance using a range of financial sustainability indicators. This is a good thing providing that the indicator and any associated performance target range are appropriate. Indicator results allow for performance to be readily assessed without trying to wade through page after page of financial reports. Detailed financial reports are often intimidating and confusing for people without an accounting background. Even where people do have a solid financial management background, it’s easy to get bogged down by intricate details on minor matters. Instead, indicators can quickly and readily show the key messages. Monitoring indicator performance can help ensure decision making that achieves desired performance.

It is important to ensure that the indicators and targets used to measure successful performance are well thought through. A poorly selected indicator or target can effectively encourage poor outcomes.

History of the use of financial sustainability indicators

South Australia was the first state to initiate a local government financial sustainability inquiry, and its recommendations prompted a requirement for councils to report performance against financial sustainability indicators. South Australian councils were initially required to report on seven indicators.

These seven indicators attempted to assess:

  1. financial performance (operating revenue relative to operating expenses)
  2. the level of indebtedness (or net indebtedness) of a council relative to operating revenue
  3. asset management performance.

The asset management performance indicator used in South Australia was called the ‘asset sustainability ratio’ (See p. 108, South Australia Local Government Model Financial Statements, 2009). When introduced it required reporting asset renewal capital expenditure for a year with annual depreciation for the same period. All other states progressively followed by requiring their councils to report immediate past and planned (future projected) performance against financial indicators. All required preparation and publication of an indicator prepared on the same basis as the South Australian asset sustainability ratio, although some gave it a different name.

Should annual asset renewal closely match depreciation?

The South Australian Government always had reservations regarding the basis of its originally defined asset sustainability ratio. It knew that some local government infrastructure assets can be very expensive and last a very long time compared with others (think, for example, of road pavements, stormwater drains, and water storage dams and reservoirs, compared with sheeted road reseals, and plant and machinery). It anticipated that typical average annual renewal needs of many councils would be variable. In some years (or periods of years) needs would be higher than average (and therefore higher than recorded depreciation) and in other periods lower. Previous fluctuations in the rate of provision of original infrastructure (and historic settlement growth) would also contribute to this variability in replacement need timing.

The preference was for an indicator measuring actual asset renewal expenditure relative to what a local government’s asset management plans suggested was needed to be spent on asset renewal for the corresponding period. The problem was that, when the indicator reporting was introduced in 2007, most councils were still developing their asset management plans (which were not mandated until 2008).

In 2012, the South Australian Government undertook a review of local government experiences in reporting financial indicator performance and their use in guiding decision-making. It found very little correlation in the experience of councils between what they spent on asset renewal and their depreciation for the same period. In instances where councils were confident that they had established (and were following) reasonable asset management plans, it found – as anticipated – that some were spending considerably more and some considerably less on asset renewal relative to depreciation in any given period.

As a result, the South Australian Government decided to change the basis of calculating the asset sustainability ratio to what it had intuitively preferred originally – comparing renewal expenditure with that indicated as warranted in the corresponding period in the organisation’s asset management plan. To date, it has been pleased with the subsequent value of the modified indicator. (It was renamed as the Asset Renewal Funding Ratio in 2018/19 to be consistent with the name used in various Institute of Public Works Engineering Australasia (IPWEA) guideline publications.)

South Australian local governments in aggregate reported an asset renewal funding ratio result of 93 per cent in 2018/19. There can of course be peaks and troughs in actual expenditure relative to the asset management plan, as a result of issues such as project expenditure delays caused by wet weather, delayed projects carried forward to following budgets, and other operational factors. Looking at the ratio results on a rolling 3-year average can help smooth out these factors and enable more accurate assessment of performance (recognising that, for long-lived assets, optimal renewal timing cannot necessarily be pinpointed to a single year).

It is surprising that other states haven’t seen fit to review their approach to calculating this indicator. In its publications and training, IPWEA has always encouraged the updated South Australian approach and urged caution in comparing asset renewal with depreciation. It recently has produced the graph below to further draw attention to the issue.

Are we using the right financial sustainability indicator to assess asset management performance?

Source: IPWEA asset management and financial sustainability training powerpoint

Asset management staff understand the deficiencies of comparing asset renewal for a period with depreciation. It is not unusual for them to say that they are required to spend more or less on asset renewal than is currently warranted in order to ensure the council is as close to 100 per cent of comparable depreciation as possible when reporting asset sustainability ratio performance – so as to meet financial sustainability indicators. Spending more or less than warranted increases whole-of-life cost of services from assets, and must consequentially mean councils are being less efficient than they could be.

How can the system be improved?

It is inevitable that if state government proposed a shift to compare renewal expenditure with asset management plan projected need, some local governments may have concerns that the indicator results are misleading because their asset management plans may not be particularly robust. However, in most states, there has been significant progress by councils on asset management planning over the last decade that has improved the reliability of such plans. Changing the reporting of performance to be relative to the plan will reinforce the value of this effort while also putting the focus on producing more reliable plans. Councils are very, very asset intensive, so it is in their own interests to have sound and useful asset management plans – which can then be used as the basis for performance reporting.

Until the ratio methodology in other states is changed, local governments in those jurisdictions will be required to report results using the relevant state requirements. However, it is suggested that they not soley rely on the indicators to drive budget and expenditure decisions. Instead, budget and expenditure decisions should be based on adherence to their asset management plan. There is of course nothing to stop councils also publishing the results for the suggested revised indicator in their reports (as Tasmanian Councils and and Western Australia are required to do) and explaining why they believe it’s a better indicator of asset management performance than comparing renewal with depreciation.

Comment

There is no reason to think a local government’s optimal asset renewal spend should closely match depreciation in any given period. Assets were not acquired uniformly over time, and asset-useful lives can vary markedly.

In some periods, local governments should expect to spend more on asset renewal, and in other periods, less. As highlighted in this briefing, it is in a council’s own interests to prepare sound asset management plans and keep them up to date.

Local governments should plan and budget to spend each year on asset renewal a quantum consistent with their asset management plans.

State governments that require local governments to measure and report renewal expenditure compared with depreciation should review the basis of this requirement, as it encourages less-than-optimal expenditure by councils and increases whole-of-life cost of services from assets. At a time when council finances are increasingly being stretched, a process that reduces whole-of-life asset costs should be a priority at the state and local level.

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For more information on this briefing contact LGiU Australia by emailing mzierke@sgsep.com.au