But what has taken it by surprise is that rather than merely focusing on how it spent its money, auditors questioned whether it should receive government funding at all.

Although the Director of Audit does not give clear recommendations on whether it should or not, the report's third chapter spells out the background to the debate and provides pointers to the outcome of the government's review, observing the advantages the ESF enjoys over international schools. It calls for the review to be completed quickly, and says that if the subvention is withdrawn, there should be a phased approach to give time for the ESF and parents to plan for the consequences.

The report includes extensive submissions from both the Education and Manpower Bureau (EMB) and the ESF which shed light on the decade of policy-making and negotiations that have preceded the EMB's current review of the foundation's subvention.

The EMB argues in the report that the ESF agreed in 2000 that the subvention should be frozen as an interim measure, with the long-term objective that the foundation should become self-financing.

A government review in 1999 recommended a phased withdrawal from 2001, to be completed by 2006-2007 for primary schools and 2007-2008 for secondary.

The report states that the ESF's then chairman and chief executive - Jal Shroff and Jennifer Wisker - were willing to work with the government for the transition, with the ESF requesting permission for freedom to use its land to generate other sources of income, and more time.

But there are differences as to how firm any agreement was. The ESF told auditors that it did not regard the outcome of negotiations at that time as binding as the EMB did not agree to relax land use conditions, and did not fulfil its commitment not to cap subsidies for additional ESF classes. 'Its ability to derive income from sources alluded to in 1999 was no longer applicable,' the report states, quoting the ESF's views. The ESF also argues that circumstances changed, in particular the increasing number of local students it admitted to its schools.

In the report, the ESF puts forward its case for government support based on the historic parity of subsidy principle - which provides its students with funding not less than those in aided schools. Current government policy dates back to 1995 when the international school sector was reviewed and the Executive Council agreed schools should not receive recurrent subsidies, but could benefit from land grants at nominal rates and interest-free loans. International schools were defined as those that offered non-local curricula and whose students did not sit local exams.

The ESF, which was established by government ordinance in 1967 as the main education provider for the English-speaking community, was not included in that review. But many, including other international schools that did not enjoy the same benefits, argued it fell under this category.

The desire for 'rationalisation' to level the playing field prompted the 1999 review, according to the report. This concluded that ESF schools were indeed no different from other international schools but had an unfair advantage in the subvention. The lower fees they could offer meant they could fill more places, and gain more subsidies for expansion.

By September 2003 its 15 schools had more than 11,000 students, accounting for around 40 per cent of all the places in international schools. The EMB also argued that after the handover in 1997 the government could no longer justify supporting a school body that offered only the British curriculum.

The EMB's submissions to auditors in August echo the 1999 policy. It said that when the ESF was created neither the local nor international school sectors had been developed. Today, there was a wide range of schools for English-speaking families to choose from, in both the local and international sectors.

The ESF has put forward many arguments why it should not be treated like other international schools, playing up what it claims to be the value it brings to Hong Kong as an international city and stressing the need for an affordable English-language education between the free and private education sectors.

Unlike international schools it has long been an integral part of the government-aided sector, taking over six government schools on the basis that they would continue to be subsidised. It also argues that it does not select students beyond them being able to be taught in English. About ten per cent of its students had special needs support.

It argues that its curriculum has been adapted to the Hong Kong context and that about 70 per cent of its its students are permanent residents, the majority from Chinese families.

Although the audit report gives substantial information about funding and government policy, it does not raise questions relating to the possible consequences of the subvention being scrapped. There is, for example, the question of whether families could afford paying school fees in the higher average range that they would fall in without the subvention, or whether there would be alternative local places.

At current costs, without the subvention, average ESF fees would have to increase from $64,000 to about $90,000 a year, which compares with $130,000 for the most expensive of the eight largest international schools and $64,000 for the cheapest, according to audit figures.

Parents have argued that many could not afford a major jump in fees. Even expatriates are said to be on less generous packages than before, with few receiving school fee allowances. They say non-Chinese-speaking permanent residents would have difficulty finding similar education in the local system or be able to secure places in top schools given their selective nature. Only a handful of Direct Subsidy Scheme schools have indicated they welcome applications from children not literate in Chinese - who include the large numbers of Chinese families returning from overseas who fill ESF schools.

The Legislative Council's Public Accounts Committee will now scrutinise the report and the ESF on the audit findings. Few will dispute the need for the ESF to act on the recommendations for improving its management, finances and governance. But debate will rage over the foundation's future, especially as Secretary for Education and Manpower Arthur Li Kwok-cheung has indicated that unlike his predecessor, he is ready to consider continued support for the ESF, if it puts its house in order and can prove to be cost effective.

It costs the government less to educate a child in ESF schools than it does in aided or DSS ones, according to the report. In 2003-04 the average ESF primary school student received $21,097 in subsidy compared with $23,597 for those in the aided sector. The difference is slightly more in secondary schools. The parity of subsidy has already been eroded by a freezing of the subvention since 1999 and subsequent cuts.

In its response to auditors, the ESF suggests a grim scenario for a subvention-free future. It says parents who could not afford the full cost would have to find alternative schools and the quality and stability of teachers would decline as it cut costs and student enrolment fell. Companies would have second thoughts about moving expatriates with children to Hong Kong if the costs of education were too high, and some expatriates would leave.

While quality schools would still attract students from wealthy families, it is questionable whether there would be demand for all 15 foundation schools charging higher fees, especially as they faced growing competition from cheaper Direct Subsidy Scheme schools promoted and funded by the government as alternatives for local students.

The irony is that several of these DSS schools, such as the planned Baptist University school in Sha Tin, will be as international as the ESF, not offering the local curriculum but, like the foundation's secondary schools now plan, the International Baccalaureate.

The international school sector is a changing beast that will test policymakers in Hong Kong as it has in the US, Australia and the UK, where government-funded schools can offer this curriculum. The IB is blurring the lines between local and international education.