Financial Accountability & Management, 5(2), Summer 1989 0267-4424 82.50

LOCAL AUTHORITY CAPITAL ACCOUNTING - TOWARDS REFORM

JOHN PARKES’

When I was Humberside’s Director of Finance, I put my signature on a Balance Sheet which, under the heading of Fixed Assets, told its readers that ‘capital and other long-term outlay, less debt redeemed, revenue contributions etc. ’ totalled f136M. A footnote gave the gratuitous information that ‘the Council insures its property, other thar roads for f600M, which gives a better indication of the value of its assets’, but there was no further attempt to account for the authority’s assets or to list their composition.

This opening is not intended as an act of personal contrition, but as an illustration of the limitations of local authorities’ capital accounts generally. These limitations have long been realised and various proposals made for change. This paper gives the background to the latest of them, under the aegis of CIPFA’s Capital Accounting Steering Group, of which the writer is Chairman. It also outlines our alternative capital accounting system which, deo (and others!) volente, will be operational in 1991-92.

WHY CHANGE?

A set of public sector accounts can be used for a variety of purposes. It is difficult to see that local authorities’ capital accounts adequately meet any of them. A few examples will show why. They were used in a paper given to C I P F A ’ s Annual Conference in June 1988, and are based on that body’s Capital Expenditure and Debt Financing Statistics 1986-7.

My starting point was a consideration of the assets for which local authorities are properly accountable - surely of vital interest given that they are financed by taxation and controlled by democratically elected representatives. According to their accounts, authorities’ assets totalled E44 billion but this figure - representing essentially debt outstanding - understates both historic cost and, by a dramatic margin, current value. As a very rough approximation to the latter, replacement costs are calculated as follows (at 1988 prices)

In defence of the present system of writing down capital assets as debt is repaid, it is said that since local authorities are creatures of statute, whose business is the long-term provision of public services, their current worth is of no interest or significance.

‘The author is Chief Executive, Humberside County Council

107

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Housing (3.9 million dwellings x €35,000)

Roads (30,000 Km of principal roads X f1.5 M , 260,000 Km of other roads x E0.3M)

Other property (source: Audit Commission)

f billion

137

123

100

Through its privatisation programme, the present Government has reminded us that nothing is for ever and that the most improbable public enterprise may be exposed to market disciplines. Capital valuations ‘may then be crucial to performance measurement (for services retained in the public sector) and to the determination of sale price, for those which are not.

A further defence of the present system is that it properly concentrates on the allocation of capital financing costs to service accounts, so that ratepayers can see the true costs of services. The following examples show just how selective this ‘truth’ can be.

Imagine first the case of a 240 place primary school costing today (ignoring land) about f700,OOO. If financed from revenue, it could increase the apparent annual cost of the education service by that amount. But, if financed from capital receipts, then there would be no charge to revenue at all. This is a measure of the potential distortion of service revenue costs by differing capital financing policies.

But even with common policies, both revenue accounts and management information can be dramatically influenced by the timing of capital spending. In 1968 our same primary school would have cost about E120,OOO. If we then imagine both schools financed from loan at the same interest rate, then apparent costs would be:

Debt charges f’000 Per pupil f

I988

71 300

1968

12 51

It may be said that in this case, the authority’s revenue accounts would properly be reflecting the reality of its transactions with the outside world, so ensuring proper accountability to ratepayers. But this is not necessarily so. In the table below, two neighbouring counties have broadly similar debt charges per head. Yet there is no similarity at all in their published debt:

LOCAL AUTHORITY CAPITAL ACCOUNTING 109

f per head L incolnsh ire Hum berside

Debt charges Debt

28 2

27 109

What on earth is going on? A clue to the answer lies in the authorities’ financing of new capital spending in the same year:

f per head Lincolnshire Humberside

Loans Capital receipts Internal funds

1.2 8.6

20.2

29.4 -

Thus Lincolnshire is actually borrowing virtually nothing and its ‘debt charges’ largely reflect repayments by service accounts of sums advanced internally, rather than the reality of external cashflows.

Of course, these limitations of published accounts are widely perceived and cognoscenti will be wary about using them as measures of comparative performance. Indeed, within the authority below the line financing costs are typically disregarded, and managers held accountable only for current operating costs. But this carries the unfortunate implication that capital is free, with the service manager receiving no signal of its cost or incentives to its better utilisation.

To sum up, the deficiencies of the present conventional system of capital accounting are that

- the nominal costs of services are dependent on financing decisions, rather than the actual use of assets

- they still do not necessarily reflect financial reality, in that ‘debt charges’ may relate in part to the repayment of internal funds

- there is poor accountability to ratepayers, since the size of the capital stock is almost inevitably understated because of the omission of debt- free assets from the accounts

- misleading signals are given to managers, without any encouragement to better asset management.

THE HISTORY OF REFORM

There is nothing new in criticisms of local authority capital accounts. Indeed most of the above points have been made in a continuing debate which can

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be traced back to at least 1975. Since that time - and in addition to a few local initiatives - CIPFA has sponsored various developments to devise a better system. There were also several ‘external’ developments. These were summarised by Gordon Beacock (1988). They include: 1975 ‘Local Authority Accounting 1 - Accounting Principles’. This was an

exposure draft produced by a group chaired by Jack Woodham, a past president of CIPFA. It recommended a system of depreciation accounting, but saw as a necessary precondition the repeal of that provision in the Local Government Act 1972, which arguably requires that debt repayment provisions must be charged to service accounts.

1977 A working party under Brian Tanner reviewed the above exposure draft in the middle of the general debate on inflation accounting. It concluded that a system based on historic cost depreciation did not show sufficient advantage over the conventional system, but that further research should be undertaken into valuation.

1980 The Government introduced a legal requirement for local authorities to produce current cost accounts for their direct labour organisations. These require both calculation of depreciation and rate of return to be based on the current cost of assets.

1982 Again Jack Woodham was involved in undertaking research into the application of current cost accounting to local authorities. It recommended the adoption of such a system, based on SSAP 16.

1983 CIPFA issued a report ‘Capital Accounting in Local Authorities’ produced by a working party under Nigel Pearce. This advocated a system of asset rentals as being preferable to either the traditional debt charge system or a depreciation-based alternative. A second report in 1984 produced after initial experiments with such a system concluded that further research was needed.

1987 The Code of Practice on Local Authority Accounting was produced voluntarily by CIPFA and the local authority associations as an alternative to a Government-imposed regime. Generally it ducked the question of capital accounting but does require more information to be given in authorities’ published accounts on their capital assets.

This necessarily perfunctory survey may give the impression both of disunity within the accounting profession and of precious little to show for 13 years of effort. This is to overlook firstly the growing consensus that the traditional capital accounting system was scarcely defensible, secondly that any alternative must involve consistently-based charges to revenue for the use of capital assets. These earlier efforts, together with the present Government’s insistence on public sector accountability have created a climate for change which our present Steering Group hopes to exploit.

LOCAL AUTHORITY CAPITAL ACCOUNTING

THE PRESENT CAPITAL ACCOUNTING STEERING GROUP

1 1 1

The Group is representative of both the accounting profession, through CIPFA, and local government, through the Associations. It also includes representatives of the Audit Commission, universities and of Government.

Its formation follows CIPFA’s conclusions in late 1987 that

- ‘the present system no longer fully serves the objective of accountability

- a new system should separate accounting for financing, from accounting

- a new system could be achieved which met these requirements and which

for the use of capital

for capital assets and the cost of services

was both practicable and cost effective.’

OUTLINE OF A NEW SYSTEM

Local authorities’ accounts have several potential audiences and uses. In developing a new system of capital accounting, the overriding aim has been to improve accountability and ease of understanding through authorities’ published accounts. It is hoped that this will also lead to the production of accounts more useful to management, but recognised that no single set of accounts can meet all users’ requirements and that authorities will wish to devise their own management accounts.

The new system rests on the following fundamental principles

- the revenue account should measure adequately the economic cost of services. Inevitably this means divorcing financing decisions from the calculation of service operating costs.

- the balance sheet should identify the value of fixed assets by category - charges to ratepayershentpayers for capital should not necessarily be

affected by a new system and should be shown separately from the economic cost of service. In this way, services can be seen as operating at arms length from the body corporate, in a relationship analogous to that of bankedclient or landlordhenant.

The Group was fortunate to inherit (from an informal working party) the outline of a system to deliver these principles. Its brief was to test and refine it, prior to the issue of an implementation manual and with a view to full implementation in authorities’ 1991 -2 accounts.

Simply described, the proposed system is as follows:

- fixed assets are divided into depreciating and non-depreciating categories - charges for their use are included in service revenue accounts to show

the economic cost of service provision

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- these charges comprise depreciation, maintenance and a capital charge, representing interest on capital tied up in providing the asset

- at authority level, the above interest charge is reversed and replaced by net external interest paid to third parties. A ‘contribution to capital’ may be made to bring depreciation provisions (as a minimum) to the statutory level for debt repayment.

- fixed assets are shown in the balance sheet at their current value to the authority.

CHARGES FOR ASSET USE

Depreciation

In the past, it has been argued that since the level of local authority service provision is a matter for political decision and authorities enjoy (generally) unrestricted powers of taxation, the concept of capital maintenance is irrelevant and provision for depreciation is inappropriate in their accounts. The Group accepts that authorities’ taxation decisions are matters for political rather than accounting determination. But at service level, the consumption of capital is a proper element of the calculation of economic cost. It is therefore proposed that service accounts should generally include depreciation so as to allocate a fair proportion of an asset’s cost or valuation to each accounting period expected to benefit from its use.

But consideration of an authority’s asset stock raises major practical questions over this simple proposition. Plant and vehicles both wear out and lose their value: the case for depreciation seems clearcut. By contrast, land does neither and there seems no case for its depreciation. Between these extremes, it is an observable fact that buildings rarely lose their value (even if poorly maintained), whilst roads and other infrastructure immediately lose theirs - being generally unrealisable - but will last indefinitely if properly maintained.

The question of depreciation is obviously linked to that of maintenance and to the treatment of inflation. In the case of an appreciating ‘building’, part of its increase in value will almost certainly be due to rising land values, whereas if totally neglected the building would ultimately fall down and have no value except to the extent that the land on which it rests is indestructible. Similarly with roads where the carriageway itself is constantly wearing out and will ultimately need complete replacement.

SSAP 12 on depreciation is currently inapplicable to local authorities, but it is rigorous in allowing few exceptions to depreciation provision. They include

- assets having infinite service lives and enduring value - assets maintained to such a standard that their service lives are infinite.

LOCAL AUTHORITY CAPITAL ACCOUNTING 1 1 3

By contrast, the Group was initially inclined to exempt many local authority assets from depreciation. This was on the basis that

- buildings retain their value if properly maintained - in the case of infrastructure, depreciation would be replaced by a full

maintenancelrenewals provision.

However, it was always questionable how renewals provisions could be calculated. A County Council typically has several thousand miles of road of widely varying design, condition and usage. It would be extremely difficult to derive reliable renewals requirements. The Group was also uneasy about exempting buildings from depreciation when SSAP 12 specifically excludes a rising market value as being sufficient reason for exemption.

The debate is not yet resolved, but it now seems increasingly unlikely that wholesale exemptions from depreciation will be proposed.

Historic or Current Cost Depreciation

Here too the Group’s initial thoughts have been subject to modification. At first, historic cost was seen to have the attraction of simplicity and to be rooted in ‘fact’. Another pragmatic consideration was that since infrastructure has no realisable value, it offends commonsense to write its value up before charging current cost depreciation (assuming the alternative ‘renewals’ approach was abandoned). Rejection of the capital maintenance concept for local authorities could also be seen to justify historic cost.

However, use of historic costs sits ill with any notion of calculating the economic cost of service provision, or of putting services at arms length from the authority. In the latter context, the Government’s legislation for direct labour organisations specifically requires these to obtain a specified real rate of return on a CCA basis. This has accustomed local government to the use of current cost depreciation and it is scarcely deniable that in a period of significant inflation, use of historic costs would seriously understate the economic cost of service provision. ft therefore seems that CCA will win the day.

The Cost of Capital

The point of charging for the use of capital in revenue accounts is again to reflect the economic cost of providing services, but also to make managers more conscious of the capital they are tying up and more accountable for its efficient use.

Given that the charge is to consist of a rate of interest on capital employed, questions which are begged are what rate of interest, and how is capital employed to be defined?

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The first is very much bound up with the question of historic or current cost depreciation. If service managers are to be put at arms length from their authorities, then charges for assets should approximate to what the market might charge for their hire (assuming, loosely, a banker:client or landlord: tenant relationship). In this case, the ‘proprietor’ will want a return which either

gives him a market rate of interest on his money, whose nominal value is maintained

or give him a real rate of interest, together with maintenance of the real value of his capital.

Any alternative arrangement would lead to distortion of the financial relationship between the two parties. Thus, having provisionally, opted for current cost depreciation, a real interest rate seemed obvious.

A difficult question is whether the cost of capital should be calculated on the whole asset stock or whether infrastructure with no realisable value should be excluded. The latter treatment might be seen to be justified, on the basis that there is no opportunity cost to be signalled on what is essentially sunk capital. O n the other hand, this would invite service managers to make that same assumption that capital is free, which was one of the reasons for seeking an alternative system. Furthermore, it could invite discrimination in the budgetary process in favour, say, of roads against schools. O n balance the Group concluded that the cost of capital should be applied to the (written down) value of the whole asset stock.

The Basis of Valuation

An immediate practical difficulty about the introduction of almost any alternative to the present accounting system, is that it presupposes the existence of an up-to-date asset inventory. Many authorities simply do not have one. It must be accepted that a significant investment will be needed in its creation. But a comprehensive terrier is surely a sine qua non of good property management, regardless of the requirements of the accounting system.

Creation of an inventory will almost inevitably reveal that for many assets, historic cost is unknown. This automatically tends to rule out one possible basis of valuation - unless, perversely, ‘historic’ costs are to be invented! In any case, the use of historic costs would be quite inappropriate to a system which aimed to be measuring the economic cost of service provision and to be giving signals of current economic costs to managers. Use of some current basis of valuation is obviously inevitable, as already justified for the calculation of depreciation.

If we take as a priority the importance of signalling opportunity costs to managers, then it might seem that assets should be taken at their highest alternative use value. But this would bring great problems in that

LOCAL AUTHORITY CAPITAL ACCOUNTING 115

- alternative use value is subject to constant and unpredictable change and can often only be established by planning applications (which could involve conflicts of interest for the authority)

- assets with no alternative use would be written out of the balance sheet and generate no cost of capital charge, hence perpetuating some of the weaknesses of the present system.

Furthermore, it is arguable that the provision of management information cannot be a prime objective of a system of financial reporting to third parties.

On balance the Group therefore feels that alternative use is not an appropriate valuation base (except, perhaps, for assets held for sale). Instead it favours replacement cost as a proxy for the current value of assets to service provision. This should avoid some of the more difficult practical aspects of valuation and generally allow a desk-based approach, rather than an annual physical stocktake. Thus general office accommodation could be valued at Ex per square metre, primary schools at Ey per pupil place and so on.

Infrastructure again presents some potential problems. Intuitively, the value of an (unsaleable) stretch of road is zero. To ascribe to it a positive value smacks of imprudence, yet it certainly has a value to continuing service provision and in the context of a current accounting system. Here too logic points towards replacement cost. Again a formula approach will probably be appropriate. But there are two important caveats. The first is that at day 1 of implementing the new accounting system infrastructure (in particular) will be ‘worn out’ to varying degrees: there will be a structural maintenance backlog, which should be reflected in opening valuation (and which, when corrected, will lead to a higher valuation and capital charge). The second caveat is that practical experience of this approach is needed before it can be commended without reservation.

After the initial valuation, it should be possible to uprate annually for inflation by the use of specific indices, with a general revaluation, say, every five years.

FINANCING ADJUSTMENTS

Present legislation requires authorities to make provision in their revenue accounts for debt redemption on an individual asset basis. The Government has recently published a consultation paper on its capital controls system which - whilst proposing radical changes in other directions - retains this requirement. It would therefore be unrealistic to propose an accounting system which was incompatible with it.

In passing, it should be noted that authorities’ present systems typically break the link between individual borrowing accounts and external lenders. Loans are pooled in a Consolidated Loans Fund and constantly turned over within

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the financing periods for individual borrowing accounts to which they are ‘advanced’. It might have been hoped that the Government proposals would have broken the asset:loans link entirely, by simply requiring authorities to manage their debt within prudential guidelines, but this is apparently not to be. Even worse, it initially appeared that financing charges would have to be debited to individual service accounts, which would have struck at the conceptual roots of the proposed new system. Hopefully it will be possible simply to show them ‘below the line’ at authority level, to preserve the break between economic and financing costs.

The basis of the financing items has been briefly explained. As a minimum, the authority must provide for Government-prescribed debt redemption requirements. To the extent that these exceed capital charges in service accounts, then an additional charge must be made below the line as a ‘ratepayer’s contribution to capital’. The authority may decide to make such a supplementary contribution in any case. Thus the ratepayer’s contribution to capital may be smaller or greater than depreciation and renewals provisions in service accounts. Its size will properly reflect the authority’s political decision on its Community Charge level. Similarly, interest payable to third parties may be more or less than has been charged by many of the ‘cost of capital’ above the line. It will almost certainly be calculated on a far smaller sum (because many assets will actually be debt free) but at a higher nominal rate of interest (market, rather than real).

Although this description is written as if one line entries would suffice for the financing items, in reality Government requirements are likely to mean the retention of a consolidated loans fund (or capital financing pool, as it is described in the Capital Consultation Paper) between the service accounts and the financing entries. This is to allow computation of the latter on an asset by asset basis, together with the ‘sterilisation’ of 50% of non-housing capital receipts for debt redemption only.

A PRACTICAL EXAMPLE

After the publication of the initial consultation paper on the new system, a number of authorities will test its practical implementation. In the meantime, the author has produced the following very simple exemplification for the Humberside County Council’s Library Service.

The service was chosen because it was expected to pose few problems and that turned out to be the case. Furthermore, it was an agreeable surprise to find that comprehensive management records were kept for all buildings, which included their floor areas. This would not always be the case. It was also helpful that the service has no vehicles of its own: these are rented at market rates from the Council’s Fleet Management Organisation - an alternative approach, incidentally, to the separation of operating from financing costs.

LOCAL AUTHORITY CAPITAL ACCOUNTING 1 1 7

The capital stock of the service then comprises the following libraries:

over 100 square metres 5

smaller libraries (owned) 47 500 square metres 6

smaller libraries (leased) 13

71 - -

together with some computer equipment. The book value of these assets is f.1.5M, that being total debt outstanding.

But this relates to a floor area of 23,000 square metres, with an implied value of only €65 per square metre. By contrast, the cost of building now is about 5900 per square metre, which in turn points to a total replacement cost of €20.7M, or 14 times the present ‘book value’.

We can now compare ‘before’ and ‘after’ revenue accounts as follows:

Operating costs (pay, supplies, etc.)

Capital charges -depreciation of computer equipment -cost of capital (5% real rate return

on replacement cost of buildings)

Financing charges

f’000 Present System New system

6926 6926

43

1037

466 - - 7392 8006 - -

Note that to this point the apparent cost of the service has increased by 50.6M. But if we look ‘below the line’ (i.e. at authority level) this difference disappears:

Reversal of cost of capital - 1037 Interest payable on outstanding debt Ratepayers’ contribution to capital 257.

166

- - 7392 7392 - -

*representing present revenue contributions to capital 155 principal repayments 85 capital element of leases 60

257

depreciation - 43 -

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Certain potential difficulties have been avoided in this simplified example. It will be seen that there is no charge for depreciation or renewal of buildings, and land value is ignored. This is because it predated latest thinking in the Steering Group. Nevertheless, it hopefully makes the points that

- the economic cost of providing services is likely to be significantly different

- yet this need not impact on the authority’s bottom line in determining

- application of the system need not be too difficult.

from presently stated revenue costs,

the levy on local taxpayers,

CONCLUSION

Local authority capital accounting cries out for reform. The present system is only defensible on the cynical bases that central Government’s published accounts are much worse, or that public sector capital accounts have no interest or significance anyway. Yet the road to reform is strewn with previous abandoned efforts, which have failed largely because of the lack of consensus on either the way forward or its justification on a cost-benefit basis.

It would be naive not to recognise that much work remains to be done before we can be convinced that the system described in these papers is a ‘runner’ and, more particularly, one which commands general support. Yet the omens are good, not least because there is now a different climate in which the need for improved public sector accountability is paramount. There is moreover a greater will towards change among those who have to be accountable - not just accountants, but service managers and elected members. I remain ‘yours optimistically’.

POSTSCRIPT

Since this paper was drafted various developments have occurred:

1. 2.

3.

CIPFA has now published the consultation manual. The manual opts for current cost depreciation applied to all assets other than land and certain structures with indefinite lives. The Department of the Environment has revised its proposals for capital controls and so it may not now be necessary for local authorities to maintain records showing how individual assets have been financed.

REFERENCE

Beacock, G . (1988), Public Finance &? Accountancy.