Back to basics: What’s the point of accounting for depreciation?
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Local authorities, just like private businesses, have to account for the depreciation of their assets. Conrad Hall asks whether the current rules dictate inappropriate financial reporting.
What (with apologies to Monty Python) has accounting for depreciation ever done for local government?
Not much, one might argue.
Apart from compliance with accounting standards, and hence the corresponding unqualified opinions on our accounts.
Apart from the generally high regard in which financial management in the sector is held – which flows in part from following proper accounting practices.
Apart from, you could even try to argue, helping to sort out the mess back in the 1980s and early 90s, when some authorities almost routinely had years of unaudited accounts lying open.
Anyway, complying with the standards is a necessary but not sufficient condition for proper accounting.
If you really want proper accounting, then you should also want really proper accounting.
That means not just that you follow the standards – you also have to be satisfied that the standards are the right ones to apply.
As fixed asset accounting – and the associated depreciation charges and their subsequent reversal – takes time to calculate and tends to obscure the clarity of the presentation of local authority financial statements, it is fair to ask why we do it, not in the narrow sense of “because we have to” but by going back to first principles.
Distorted aims
This principles-based approach is necessary and, I would argue, overdue.
The discussion around the simplification of local authority accounts has to date largely focused on important but ultimately marginal improvements.
I don’t mean to decry the excellent work that has been done.
De-cluttering, removing notes, writing clear narrative statements and thinking more about presentation are all important in themselves, and have focused attention on an area that had previously received too little attention.
However, I now want to argue that our next step as a sector should be to build on these important improvements and collectively to pitch for a more radical approach.
Part of the underlying problem is that the framework for the local authority accounting regime is essentially based on private sector standards, although there have been some amendments and adaptations to these.
To make matters worse, legislative overrides have been introduced to avoid what have been perceived as adverse impacts on council tax.
The problem with this is made readily apparent by considering matters from the auditor’s perspective.
When you audit the accounts of a company, you are fundamentally concerned with two cardinal questions: is it a going concern, and do the accounts fairly present the value of the company?
The questions and the answers to them are driven by the needs of investors, and from the principles they represent flow the standards we all follow.
In the case of capital accounting you therefore depreciate your assets to help tell investors what your company is worth.
This could be either as a going concern, since it ensures that there’s provision for the replacement of necessary capital and hence that the profit accurately reflects this, or in an acquisition scenario so that the asset values reflect what a purchaser of the business might be able to sell them for.
You can’t buy a local authority and for practical purposes the going concern question is answered by reference to financial sustainability, the level of reserves and similar matters.
Furthermore, there’s a statutory framework – minimum revenue provision (MRP) – that provides assurance to taxpayers and government that a prudent approach is taken to ensure that debt is repaid, which is also important to financial sustainability.
Going further, whilst MRP is not the same as depreciation, one could argue that in several important respects it fulfils broadly the same accounting purpose.
Essentially, just like depreciation it ensures that there is provision for the replacement of capital, albeit it approaches the issue from the perspective of debt repayment rather than asset valuation.
Time for change?
So, is depreciation accounting necessary or even appropriate for local authorities?
If you had a completely free hand in designing the accounting standards that applied to the sector would you include it at all?
You spend considerable time creating capital accounting entries and reflecting them in the accounts.
There should be a reason for that.
I think most of us would agree that it doesn’t help with the clarity of the financial statements.
Some of us tried making the charges feel real by counting them against services’ cash limited budgets, but that approach was largely abandoned, I think because everyone knew in their heart of hearts that they were reversed out elsewhere in the accounts and so weren’t really real.
So, is the only remaining answer to my question “because we have to follow accounting standards”?
I’m certainly not arguing that we should ignore accounting standards.
As long as they exist we must and should follow them.
However, standards aren’t set in stone.
They can be changed – or at least their application to local authorities can, provided we can make a strong enough collective case to the relevant regulatory bodies.
You may not agree with me about capital accounting, but my wider point is that this principles-based approach is the one to take to make more dramatic progress on the accounts.
How about all the PFI notes about future cash flows?
They would be highly relevant if you were thinking about investing in a private company to know how much of its future revenue streams were committed to paying long-term contracts.
However, in a local authority you could argue that this is a bad case of measuring what can be measured rather than understanding what needs to be measured.
For authorities with social care responsibilities, any PFI commitments (which we analyse to death) are likely to be dwarfed by the social care commitments (which we don’t mention).
Whilst the contractual nature of those commitments is different, we are still guilty of allowing the standard to dictate inappropriate financial reporting rather than arguing for a standard that would require appropriate reporting.
I think that by applying this approach to each of the problematic areas of local authority financial statements and by focusing on principles, we can really improve local authority financial reporting.
It will take time and effort, and close working with the relevant regulatory bodies to demonstrate that we are on the same side.
We can win lots of incremental and individually-important battles in the long campaign to improve local authority accounts.
But if we focus solely on disclosures, notes and similar points, we might end up losing the war.
Conrad Hall is chief financial officer at London Borough of Brent
