Select Committee on Defence Sixth Report

3  Consolidated Departmental Resource Accounts

Unqualified audit opinion

66. The Departmental Resource Accounts for 2002-03, which were examined by our predecessors[78], were qualified by the Comptroller and Auditor General because of concerns about the accuracy and reliability of MoD's stock management information. The move to Resource Accounting and Budgeting (RAB) from cash based accounting had created problems for MoD. On 7 January 2004, MoD's Finance Director, had told our predecessors that:

Resource accounting and budgeting is a very much more complex way of managing finance than the old cash system that we used to use…. I think that the unique nature of the Ministry of Defence and defence business makes the application of resource accounting to it, in some cases, slightly strange. We have to have certain work-arounds to make sure that resource accounting and budgeting works in relation to the Ministry of Defence.[79]

67. The Departmental Resource Accounts for 2003-04 and 2004-05 were given an unqualified opinion by the Comptroller and Auditor General. The fact that MoD's resource accounts for 2004-05 received an unqualified audit opinion for the second year running suggests that MoD's initial problems with Resource Accounting and Budgeting are being overcome.

Contingent liabilities

68. MoD's Financial Accounts show that quantifiable contingent liabilities have increased by £400 million from 2003-04 and that this increase was due to a new liability for site restoration and clean up of British Army Training Units in Canada.[80] This liability represents a substantial amount and we sought further information from MoD.

69. MoD told us that a Memorandum of Understanding for its use of training facilities in Canada was being re-negotiated and it expected that a revised agreement would be signed in July 2006. MoD expected this revised agreement to be "open ended, but subject to termination by either party".[81] MoD has no plans to stop training in Canada, but in the event that UK training in Canada were to stop, MoD would be liable to clean any sites up to the standards required by Canadian law. MoD also told us that "the estimated liability of £400 million is an approximate assessment of the likely costs of such environmental measures, including the removal of unexploded ordnance".[82]

70. A new contingent liability of some £400 million, relating to a liability to clean up training sites in Canada should the UK cease training there, has been included in the 2004-05 financial accounts. We consider this to be a substantial liability and expect MoD to re-assess, on a regular basis, the size of this liability and consider how such a liability of this scale would be funded if it fell due.

Losses

71. MoD identified £402 million of losses in 2004-05, of which £322 million had been reported as Advance Notifications in previous years' accounts.[83] Compared to 2003-04, when losses stood at £461 million,[84] there has been a decrease of £59 million or 13 per cent.[85] Losses identified in 2004-05 were £80 million.[86]

72. We asked MoD about the level of losses set out in its financial accounts and how MoD was seeking to minimise such losses. MoD told us that:

The losses statement provides a level of visibility and transparency not matched by commercial accounts as private sector organisations are not required to disclose similar information. The size of the MoD and its capital assets under active management, together with the range and complexity of defence business, means that the MoD also faces a scale of challenge unique in the public sector.[87]

73. MoD also told us that reported losses were not necessarily indicative of a failure of control, although it sought to identify those that were and the lessons to be learned. MoD considers that, with a large capital investment programme there:

will inevitably be cases where we decide not to proceed with programmes because of changed priorities or requirements reflecting the defence need, or judgements that the technical challenge is too demanding.[88]

In respect of equipment acquisition, as part of the Smart Acquisition initiative, MoD told us that it has sought to increase the level of investment in the concept and assessment phases which should limit losses arising from a subsequent project failure.[89]

74. We note that losses reported in MoD's 2004-05 Financial Accounts had reduced compared with the previous year, but consider that the sums are still substantial. We expect MoD to take appropriate action to minimise losses in the future.

75. We examined two specific projects where losses were reported in the 2004-05 Financial Accounts—the Landing Ship Dock (Auxiliary) programme and a building project at the Atomic Weapons Establishment Aldermaston.

LANDING SHIP DOCK (AUXILIARY)

76. We paid particular attention to two losses in the Annual Report and Accounts relating to the Landing Ship Dock (Auxiliary) programme, totalling £101.8 million. The programme is for four ships which are designed to provide tactical sealift as part of an amphibious group. A summary of the two losses is provided at Table 4.

Table 4: Losses reported on the Landing Ship Dock (Auxiliary) programme

Losses	£ million
Advance notifications - notified in prior years Slippage in the construction programme for two Landing Ship Dock (Auxiliary) caused delay in supplying design information and equipment to a contractor. This resulted in a claim on the MoD relating to the associated delay and dislocation costs. In 2003-04, an amount of £40,000,000 was included in Advance Notification as an estimate of the likely amount of the claim.	63.8
Advance notifications - notified during the year HM Treasury has agreed an ex-gratia payment of up to £84,500,000 to Swan Hunter subject to completion of certain contractual conditions relating to the construction of two Landing Ship Dock (Auxiliary) LSD(A). Total paid to date is £38,000,000.	38
Total	101.8

Source: Ministry of Defence[90]

77. We asked why MoD was picking up the bill for these substantial losses on the Landing Ship Dock Auxiliary programme. Mr Jeffrey explained:

It is a programme where the contract was originally awarded in 2000 to Swan Hunter who were building two of these ships and BAE Systems were then brought in to build the other two. It is undoubtedly a project which has had problems arising from the fact, which I think Swan Hunter themselves would acknowledge, that the design that they intended to apply for these ships was less mature than had been assumed. The increases in cost are partly of course reflected in this Report, but there are broadly three elements. In December 2004 there was a renegotiation of the contract which allowed for up to £84.5 million more for Swan Hunter…. There was also, and this features also in the Report as something notified in a previous year, £63.8 million to BAE Systems arising from the fact that there was slippage in the Swan Hunter part of the operation. To these two elements there should be added to £62 million in addition to enable Swan Hunter to pass design information to BAE Systems, so it is classically one of these projects where the costs have escalated.[91]

78. We pressed MoD further on the total cost of the programme and we were told that the "total value of the contract now for Swan Hunter is £309 million and for BAE Systems £176 million".[92] The total value is, therefore, some £485 million. We were told that discussions were underway about "what would be required to completely deliver this project".[93] Mr Jeffrey did not want to discuss this in any detail during our public sessions owing to commercial sensitivity.

79. Mr Woolley told us that MoD had:

reached a stage where we had to make a judgement between starting all over again and continuing and paying more and we had to judge what in those circumstances was likely to provide best value for money, and the judgement was to continue.[94]

80. MoD's second memorandum states that Swan Hunter confirmed in September 2003 that it was unable to meet the original programme requirements and accepted that its initial programme was "optimistic and underestimated the extent of the development issues inherent in the building of a new ship".[95] The memorandum makes reference to additional cost increases and states that MoD "is currently in commercial discussions with both companies as a result of these declared cost increases".[96]

81. We find it hard to understand why the procurement of these four ships, which are not particularly sophisticated, is likely to cost in the region of half a billion pounds, substantially over the initial contract price. The Landing Ship Dock (Auxiliary) programme cannot be considered to have achieved value for money. MoD seems to have given the lead contractor on the programme an open-ended cheque book.

82. The first contract for two ships, on the Landing Ship Dock (Auxiliary) programme, was let in December 2000. While this was some time after the launch of the Smart Procurement initiative, this procurement cannot be considered 'smart'. It raises questions about how MoD assesses whether a contractor has the necessary skills to deliver a specific equipment programme. We expect the lessons from this sorry episode to be identified and implemented. We wish to be kept informed of the progress on this programme.

BUILDING PROJECT AT THE ATOMIC WEAPONS ESTABLISHMENT ALDERMASTON

83. Another matter of concern relates to a building project at Aldermaston. The Annual Report and Accounts states that "a loss of £65,000,000 has been incurred following the impairment of an Operational building". Mr Woolley told us that:

this is a building at the Atomic Warfare Establishment that was unable to meet the requirement after it was built for which it was designed. No other use for the building could be identified and therefore it had to be written off.[97]

84. We asked for further details of this loss. MoD's second memorandum stated that the loss related to "work to build a substantial facility for the treatment of radioactive liquid waste".[98] The memorandum also explained that a loss of £82 million in respect of plant and machinery, separately noted in the Annual Report and Account, was also related to the same building at Aldermaston. [99] A summary of these two losses is provided at Table 5.

Table 5: Losses reported on a building project at AWE Aldermaston

Losses	£ million
Advance notifications - notified in prior years A loss of £65,000,000 has been incurred following the impairment of an Operational building.	65
Advance notifications - notified during the year A loss of £82,000,000 has been incurred in respect of plant and equipment	82
Total	147

Source: Ministry of Defence[100]

85. MoD's memorandum notes that:

the Department acknowledges that this project was handled badly in a number of significant respects. Lessons have been drawn from the experience, procedures have been changed, and the Department is determined to avoid any recurrence.[101]

86. We are amazed at the scale of the losses relating to a building at AWE Aldermaston which could not be used. The total losses amount to some £147 million. MoD's acknowledgement that the project "was handled badly" is a considerable understatement. It is essential that the lessons are learned and we do not expect to see a repetition of such a debacle in the future.

87. We are concerned that the two losses relating to the building at AWE Aldermaston, one of £65 million and the other for £82 million, were listed separately in the losses statement in the Annual Report and Accounts, and that there was no way of linking the two losses from the information provided. In future, we expect MoD to provide sufficient information for related losses to be identified.

OPERATIONAL RATION PACKS

88. One of the losses reported in MoD's Financial Accounts is for £1.4 million and relates to Operational Ration Packs:

A food component was withdrawn from Operational Ration Packs (ORP) following discovery in tests that deterioration of the product's packaging could over time compromise the safety of the contents. The Contractor accepted liability in principle for this defect and agreed to supply a replacement product utilising an alternative packaging arrangement, at no cost to MoD, subject to being able to develop a replacement product that could be warranted fully fit for purpose. This development work is continuing and if successful will substantially mitigate the overall loss to the Department brought about by a combination of loss of use of the original product and the cost of its removal / destruction.[102]

89. Shortly following the oral evidence session, a Departmental Minute from MoD "concerning the gifting of operational ration packs to the Government of the United States of America" was laid before the House of Commons on 6 February 2006.[103] It is normal practice when a government department proposes to make a gift of a value exceeding £250,000 to present to the House of Commons a Minute giving particulars of the gift and explaining the circumstances; and to refrain from making the gift until fourteen days (exclusive of Saturdays and Sundays) after the issue of the Minute, except in cases of special urgency.[104]

90. The Departmental Minute informed the House of a gift of 475,182 ORPs worth £3,114,845, delivered between 5-7 September 2005, at the request of the US Federal Emergency Management Agency, to assist the relief effort following Hurricane Katrina. The Minute stated that the gifting of humanitarian assistance, in the form of ORPs, was a case of special urgency.

91. We wrote to MoD to ask why it had taken MoD five months to inform Parliament of this gift; the total cost of the gift, including airlift costs; and whether reports in the media that the delivery of the packs had been delayed because of US Department of Agriculture objections to EU products were accurate.

92. MoD's response of 6 March 2006 states that the delay in informing Parliament was because there was:

some debate within HM Treasury on how best to account for the ORPs that MoD provided to the US…. The conclusion reached was to gift the ORPs, hence the Departmental Minute on 6^th February, and to write off the transport costs in the Department's 2005-06 accounts.[105]

We do not find MoD's explanation for the four month delay in informing Parliament of a gift of a value exceeding £250,000 sufficient and we call on MoD to report its gifts promptly in future.

93. MoD's response states that:

the cost of providing the ORPs to the Government of the USA was £5,130,971, of which £3,114,845 represented the value of the ORPs gifted and £2,016,126 was the cost of airlift.[106]

It states that MoD delivered some 475,000 ORPs between 5-7 September 2005 and the US Federal Emergency Management Agency then began to distribute the ration packs to the disaster area. However, this process was stopped on 8 September when the US Department of Agriculture realised that the ORPs did not comply with their regulations concerning the import of processed meat. MoD was not aware that there was a danger of the ORPs being impounded until after they had been delivered and, once informed of the problem, the UK stopped any further deliveries.[107]

94. MoD understands that some 330,000 ORPs were initially impounded in Arkansas, but that US Authorities have been in contact with various international and non-governmental organisations about how to make use of the ration packs outside the US. Some ORPs have already been given to non-governmental organisations for distribution "to populations in need and to the OSCE [Organisation for Security and Co-operation in Europe] for use in Georgia" (that is the country Georgia, not the US State).[108] MoD understands that "the US Authorities expect all the ORPs to be distributed this way".[109]

95. The UK sought to assist the US following Hurricane Katrina by gifting Operational Ration Packs at a total cost of some £5.1 million. We have no objection to the gifting of the Operational Ration Packs and only regret that they were not used to help the victims of Hurricane Katrina as intended. We are satisfied that this was for reasons outside MoD's control and hope that it has learned lessons for the future.

Flotation of QinetiQ

96. MoD's Financial Accounts provide details of MoD's shareholding in companies, including its shareholding in QinetiQ.[110] On 12 January 2006, the Secretary of State for Defence made a statement to the House announcing that the decision had been taken to float QinetiQ on the London Stock Exchange, some five years after it was first vested as a Government-owned company, and three years after The Carlyle Group became, through its minority stake, MoD's strategic partner.[111]

97. We asked when the flotation would take place and were told that it would be in February but that the size of MoD's stake to be sold could not be disclosed until the prospectus had been published.[112] We were also told that following the flotation, MoD would:

have a single special share and that will be designed to protect our security by giving us the ability to prevent the purchase of a significant stake in the company by any foreign body that we regarded as incompatible with our security.[113]

98. We were concerned about the possibility of a conflict of interest arising, given QinetiQ's roles as an adviser to MoD on research issues and a potential supplier. Mr Woolley told us there was a "compliance regime" in place which was designed to ensure that QinetiQ did not get into a situation where there was a conflict of interest.[114] In terms of letting contracts, MoD explained that there was a clear understanding that, in relation to QinetiQ, there was a separate shareholder interest from a customer interest. Mr Woolley explained that he represented the shareholder interest, but he and his team, were "not involved in any way in discussions about the award of contracts to QinetiQ or not QinetiQ, so to the outcome of competitions in which QinetiQ might be involved".[115]

99. On the issue of how much MoD would be allocated following the flotation, we were told that MoD had been given an indication by the Treasury of the sort of figure it might be allowed to retain, but it had not been finalised.[116] MoD subsequently told us that it had been agreed with the Treasury that MoD "will retain £250 million of the receipts from the QinetiQ IPO for reinvestment in the defence programme. The remainder of the receipt from the IPO will go to the Exchequer".[117]

100. The National Audit Office (NAO) is undertaking an examination into the privatisation of QinetiQ to assess whether the privatisation was good value for money. Among the issues that the NAO are planning to examine are expected to include: the choice of privatisation strategy; the price achieved; and whether the deal is likely to meet its objectives. The NAO expects to publish its report by the end of 2006.

101. We note that the flotation of QinetiQ has taken place and that £250 million from the sale will be retained by MoD to be invested in the defence programme. We look to MoD to inform us as to how its proceeds from the sale will be used. The NAO has announced that it is to examine the privatisation of QinetiQ to assess whether value for money was achieved: we await this report with interest.

Costs of operations

102. The Annual Report and Accounts provides only limited information on the costs of military operations in the Balkans, Afghanistan and Iraq.[118] We examined the adequacy of this information in our report on Costs of peace-keeping in Iraq and Afghanistan: Spring Supplementary Estimate 2005-06.[119] We considered that the information provided in the Annual Report and Accounts was insufficient and recommended that in future MoD's Annual Report and Accounts contain significantly more detailed information on the cost of operations. We welcome the Minister for the Armed Forces' positive response to this recommendation during the debate on the Report in the House.[120]

Laying of Annual Report and Accounts

103. The Annual Report and Accounts 2004-05 were published on 28 October 2005, some seven months after the end of the financial year to which the reported performance and financial accounts relate. Most government departments and agencies are expected to have their financial accounts audited and laid before the parliamentary Summer recess. Sir Kevin Tebbit, the former Permanent Under Secretary of State, told our predecessors on 12 May 2004, that:

We are progressively getting better at laying our accounts and reports earlier in the year. In 2000-01 we were back in December and we have come forward by a month each year. So by 2005-06 I hope I shall be in a position to lay our accounts with the report linked to them before the recess.[121]

104. We asked MoD about the likelihood of having its 2005-06 financial accounts audited and laid before the parliamentary Summer recess. We were told that MoD recognises that it will be a challenge to complete and lay the 2005-06 financial accounts prior to the Summer recess, but MoD is confident that this will be achieved. MoD is working with the National Audit Office and has set up an internal working group to identify and mitigate the known risks in order to ensure that the target is met.[122]

105. We note that MoD has put in place arrangements to ensure that its 2005-06 Annual Report and Accounts are published before the parliamentary Summer recess. We look to MoD to push forward with these arrangements so that the publication target is achieved.

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78   Evidence Session with MoD Permanent Under Secretary and Finance Director, 12 May 2004, HC 589-i Back

79   Defence Committee, Third Report of Session 2003-04, Lessons of Iraq, HC 57-III, Ev 305 Back

80   HC (2005-06) 464, p 180 Back

81   Ev 21, para xxii Back

82   Ibid Back

83   HC (2005-06) 464, p 190 Back

84   Ministry of Defence, Annual Report and Accounts 2003-04, HC 1080, p 161 Back

85   HC (2005-06) 464, para 107 Back

86   Ibid, p 190 Back

87   Ev 21, paras xiii and xiv Back

88   Ev 22 Back

89   Ibid Back

90   HC (2005-06) 464, pp 194-195 Back

91   Qq 32-33 Back

92   Q 34 Back

93   Q 34 Back

94   Q 40 Back

95   Ev 29 Back

96   Ibid Back

97   Q 101 Back

98   Ev 27 Back

99   Ibid Back

100   HC (2005-06) 464, pp 194-195 Back

101   Ev 28 Back

102   HC (2005-06) 464, p 195 Back

103   Ev 31 Back

104   Ibid Back

105   Ev 32 Back

106   Ibid Back

107   Ev 32 Back

108   Ibid Back

109   Ibid Back

110   HC (2005-06) 464, pp 167-169 Back

111   HC Deb, 12 January 2006, cols 11-12 Back

112   Qq 57-58 Back

113   Q 59 Back

114   Q 62 Back

115   Q 64 Back

116   Q 68 Back

117   Ev 31 Back

118   HC (2005-06) 464, p 188 Back

119   Defence Committee, Costs of peace-keeping in Iraq and Afghanistan: Spring Supplementary Estimate 2005-06, Fourth Report of Session 2005-06, HC 980, para 10 Back

120   HC Deb, 20 March 2006, col 70 Back

121   HC (2003-04) 589-i, Q 1 Back

122   Ev 20, para ix Back

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Prepared 20 April 2006