Results of the 2015/16 Crown research institute audits

Letter sent on 31 January 2017 to Dr Jian Yang MP, Chairperson of the Education and Science Committee, House of Representatives.

“LOOKING FORWARD – INSIGHTS FROM THE 2015/16 CRI ANNUAL AUDITS”

I am writing to the Committee with the summary results of our annual audits in 2015/16 for the Crown Research Institute (CRI) sector, for your information. I also draw your attention to some insights from the 2015/16 audits and analysis the Office has done of CRIs’ financial performance over the last eight years. We look at how this data might be helpful to CRIs in anticipating future risks to their financial sustainability.

I had intended to send this letter to you late last year but the disruption caused to our office by the Kaikoura earthquake caused a slight delay in our work. The Committee may find this information useful in its examination of accountability and performance of agencies in the sector. We are happy to meet with the Committee to discuss it. We will publish this letter on our website and copy it to CRIs, the Ministry of Business, Innovation and Employment (MBIE), and the shareholding Ministers.

I encourage the chief executives to seek input from their senior management teams and staff, as well as independent comment and advice from their audit committees, on how they might use these insights in the changing science and innovation environment.

The fundamentals are sound

I consider that the fundamentals are working particularly well in the CRIs. All have sound management and financial control environments. The rating for the management control environment for 2015/16 for all seven CRIs was “Very good”. For their financial information systems and controls, three were rated “Very good”. The remaining four were rated “Good”, and we made recommendations about improving their project accounting and monitoring and IT/information system controls.

CRIs generally have good controls in areas of sensitive expenditure. There was only one risk noted of overspending and approving expenditure outside policy, which the CRI concerned agreed to review and address.

Our own analysis, which we summarise later in this letter, also shows that the sector’s financial vulnerability to unexpected changes in revenues and expenses is reasonably low.

Reporting by the CRIs is usually well inside the statutory deadlines.

Challenges for the sector

CRIs face three particular challenges:

  1. As Crown-owned companies, there are inherent tensions in the governance arrangements for CRIs. In 2014, I noted that these tensions can cause significant problems for the CRI boards, raising questions about:
    1. the balance of profit-seeking and long-term strategic interest and social responsibility;
    2. appropriate benchmarks for the performance of Crown-owned companies; and
    3. whether there should be competition between Crown-owned companies when this might result in duplication of infrastructure or capability.1
  2. The science and innovation sector is changing rapidly. However, the core funding2 of CRIs has been static for several years, and changes made in the 2016 Budget to the CRI funding streams do not immediately change that.
  3. Science capability is vulnerable to an ageing workforce in the sector, to international competition for science skills, and to shifts in research focus and funding. Collaboration between research entities for science skills is increasingly important. At the same time, there is reliance on core funding to retain science capability in areas of medium to long-term research of value to the economy.

In my view, CRIs have generally risen well to these challenges. In 2015/16, we noted that:

  • Collaboration is increasingly an expectation for CRIs. However, this may not resolve the inherent tensions for CRIs between social responsibility, and commercialising intellectual property to achieve revenue and capital.
  • CRIs are making changes to business models and organisational structure, both to replace suboptimal legacy systems and structures, and to anticipate the research and financial sustainability environment of the future. At least two CRIs have put in place arrangements to ring-fence funds for particular projects and counter the possible effects of changes to the MBIE core funding contract.
  • CRIs are well aware of the risks to science capability. For example, with its major structural changes, AgResearch potentially risks loss of science expertise, and it is taking steps to address this risk.

    We have reviewed the data included in CRIs’ annual reports on staffing levels for scientists, science technicians, and research support staff. The most comprehensive information available on staffing categories over time was for AgResearch. However, due to variability in the data reported across the sector we are unable to make a sector-wide comparison. This variability is in part the result of a re-categorisation of staff from 2011/12, which affected the comparison of staffing categories. Total full-time equivalent staff data can however be validly compared. MBIE’s data for the sector shows that total aggregated CRI full-time equivalent staff numbers have fallen since 2008/9 by 560 (14%). The reductions affect some CRIs – notably AgResearch, Landcare Research, and NIWA – and not others.

    In my view, there should be more transparency around changes in science capability, and it is good to see the transparency in AgResearch’s reporting of staffing numbers. Reduction in science staffing can reflect a number of factors in the operating environment and is not, in itself, a measure of the quality and relevance of the research concerned. However, transparency about the changes is a useful basis for considering such issues as the continuity and sustainability of the science workforce, and the implications for training and recruitment of science and research staff.

Aspects requiring attention

Apart from the sector-wide challenges, we noted the following matters that require attention:

  • Most CRIs need to consider the implications of the accounting standards that are to be put in place in the next few years, in particular the lease accounting and revenue accounting changes.
  • Estimates of project completion can affect the apparent profitability of an entity. CRIs manage a large number of contracts for multi-year projects. This results in complexity in accounting, especially for completion stages of projects. There is a heavy reliance on judgement, which affects the consistency and puts at risk the accuracy of the accounting for those projects.
  • Asset management was a particular focus in our 2015/16 audits of CRIs, as it was for other public sector audits. We have noted elsewhere3 that we would like to see a shift from reactive responses when there is an asset failure or the risk of failure, to proactive long-term planning and investment to maintain and enhance service delivery. This approach needs to feed into business planning and performance reporting.

    We noted some risks arising from large capital projects or valuations of assets for several CRIs. Generally, the CRIs concerned handled the risks effectively. However, in the large collaborative capital projects in the sector, we note the delays around business cases, particularly where several parties are involved in the development. In subsequent audits, we will continue to keep an eye on the ownership, governance, and management issues involved.

    We also made recommendations to CRIs about:
    • gaining tax advice about valuation for land purchase;
    • reviewing processes for depreciation; and
    • keeping the fixed asset register up to date.

Generally sound financial management and performance

CRIs respond to business and probity risks by applying remedial solutions. Appropriate fraud controls were generally in place. However, CRIs need to ensure the integrity of their IT systems. We advised three of the seven CRIs that they needed to ensure appropriate access controls for IT systems.

CRIs’ financial performance is generally sound and supportive of their service delivery. Positive features include good operational budgeting, reasonable levels of profitability and retained earnings, low level of liabilities, and good levels of working capital.

However, there is some variability across CRIs, and over the last eight years we have noted an underspending of capital expenditure budgets and a declining trend in capital expenditure compared to depreciation. These trends suggest the need for CRIs to carefully examine the budgeting process and the use of funds targeted to capital projects, and whether sufficient money is being spent on maintaining the sector’s asset base. We are aware that many CRIs have significant capital expenditure plans over the next few years. This may or may not affect the extent to which budgeted expenditure is reflected in actual expenditure.

Vulnerability to financial changes

We carried out some additional analysis on present and historical financial data for the CRIs. Our purpose was to determine how financially sensitive CRIs are to changes in commercial revenue, operating expenses, and capital expenditure, in terms of Return on Average Equity (ROAE), a measure used by MBIE to monitor the financial performance of CRIs.4 We consider that this would be useful to CRIs and the monitoring agencies in considering financial sustainability factors, and we will be discussing it at the next sector workshop.

Overall, our analysis showed that the sector’s vulnerability to changes in revenues and expenses is reasonably low. In general, CRIs are well able to manage financial risk and remain financially viable. This is expected, given the overall strength of the sector’s financial management indicators. Some CRIs are more exposed than others. Based on our analysis, for instance, if unexpected adverse changes in expenses and commercial revenues occurred, it is likely that both GNS Science and AgResearch’s ROAE would fall below zero.5 We have discussed this analysis with the monitoring department, MBIE.

Our analysis is in development. We used only three revenue and expense drivers and one measure of financial performance. There are many other financial measures that could be used. I encourage the sector to think about how to use more dynamic financial analysis techniques to help identify and understand the potential effect of uncertain events on CRIs. We welcome discussion of our findings with the sector.

In summary

Although noting some challenges that the CRI sector faces, I am, overall, pleased to be able to report that this group of entities has fundamentally sound financial and systems management.

Yours sincerely

Signature - LP

Lyn Provost
Controller and Auditor-General

1: Office of the Auditor-General (2014), Maintaining a future focus in governing Crown-owned companies.

2: The Government introduced core funding in July 2011 to give CRIs a much larger portion of stable, long-term funding. The amount of core funding granted to each CRI in 2011 was based on historic contractual commitments, largely from MBIE’s contestable funds. It was reviewed in May 2016.

3: Office of the Auditor-General (2016), “Joining the dots” – insights from the 2014/15 annual audits.

4: Average equity is calculated by adding the equity at 30 June 2015 and the equity at 30 June 2016 and dividing the result by two. ROAE is net income before tax divided by the average equity. This indicator was selected after consultation with MBIE. (see http://www.mbie.govt.nz).

5: See Appendix.