Its financial overview of the sector for 2006-07, published yesterday, says the 39 incorporated colleges have moved from an overall operating deficit of pound;6 million in 2002-03 to an overall surplus of pound;17 million in 2006-07.

It has done so by a combination of increased funding over the period (up by pound;79 million in revenue and pound;67 million in capital), better management, peer support and learning lessons from past difficulties.

But seven colleges are forecasting deficits in at least one of the next three years, although this may change.

Audit Scotland also warns of smaller funding increases from the Government in future, and a 50 per cent reduction in European Union funding, from pound;22 million last year to pound;11 million by 2010.

To meet these challenges, Audit Scotland calls on colleges to improve their operating surpluses and financial forecasting.

It points out, too, that staff costs have risen above the inflation rate in each of the past four years.