Stephen Sheen: Public interest in Prudential Framework has provided a worrying wobble
0When the Prudential Code was being developed, there was no expectation that it was going to be a document that was going to change the world. Its function was largely to provide assurance to the four national administrations that proposals allowing local authorities to develop capital programmes wholly on the basis of whether their consequences were affordable out of future budgets would have a happy outcome.
As a compact between central and local government, guaranteeing the indulgence of the former and the good behaviour of the latter, the code’s contents do not generally move far beyond statements of the obvious. They were largely what any reasonable capital finance professional would come up with if asked to define the rules for prudent behaviour.
It is therefore possible for an authority to operate effectively under the Prudential Framework without any detailed knowledge of the code’s provisions. But since the foundation of the framework, it has been the understanding that if governments lose confidence in the code, the whole framework is at risk.
A number of recent news stories have caused the framework a worrying wobble:
- public worries about the use of capital receipts to fund redundancies
- MHCLG concern over compliance with the statutory guidance covering investment properties
- Peterborough City Council’s proposals for applying capital receipts to minimise MRP
What these wobbles have in common is an unusual level of public interest and some confusion as to how the Prudential Framework should operate, resulting in plenty of debate but much of it ill-focused.
One of the big advances of the Prudential Framework was to break down the distinction between revenue and capital resources. Previously, annual capital budgets were capped by a limit on the new borrowing that the government would allow to be taken out in a particular year. When the framework was implemented in 2004, all spending decisions could be made on an equal footing focusing on their impact on the revenue budget, with capital payments resulting in revenue charges established by cost amortising the cost over the life of the relevant asset.
The only substantial area that remains ring-fenced is capital receipts. The proceeds from asset sales are generally restricted to being applied to new capital investment or set aside to finance past capital expenditure. In the commercial world, entities would be able to treat any surplus of proceeds over undepreciated cost as unrestricted income.
To a degree this restriction makes sense, in that it prevents authorities from using one-off gains to cover ongoing service spending needs, but there are two issues with this:
- if the asset disposed of was surplus to requirements and its cost had been financed, what would be wrong with doing it?
- the policy can lead to the accumulation of capital receipts balances, whose use is limited by the fact that new assets will generate running costs that are not affordable from revenue budgets
In England and Wales, the flexible use of the capital receipts initiative was designed to restore some harmony. Newly-generated receipts can be used to fund revenue expenditure intended to secure ongoing savings or to transform service delivery to reduce costs.
In this context, redundancy costs are a prime candidate for consideration
— exceptional costs that will reduce the wage bill on a permanent basis. The idea of using capital receipts to meet these costs is wholly reasonable. Public worries about flexible use should therefore focus separately and more specifically on the appropriateness of the asset disposal or the acceptability of the redundancy proposals. Bringing the two together is not an escalation of either issue.
The greater risk will be in relation to circumstances where capital receipts are being used to support revenue expenditure without a proper assurance that savings will be generated. Without this assurance, there could be a double whammy of giving revenue an unsustainable one-off prop and not freeing any future revenue headroom to finance the capital expenditure that could otherwise have been met from the capital receipts.
Problems might also arise with the framework’s propensity to throw up capital receipts where they have no substance as a new resource, such as with certain capital loan repayments and sale and leaseback deals. If unsupported receipts were applied to revenue expenditure, they would fix a permanent black hole in an authority’s balance sheet.
The NAO’s Auditor Guidance Note for 2018/19 expects auditors in England to focus on the application of the scheme in their audits, so we may be in for several months of scrutiny of flexible use.
Tensions also arise under the Prudential Framework with the Government’s approach to statutory guidance. It is clear that the guidance issued in England and Wales has an objective of limiting the overall amount of borrowing that an authority takes out. For local authorities this is a secondary consideration, with borrowing being limited by the affordability of the consequential interest payments from future revenues.
In meeting their statutory duties to act prudently, authorities will commonly come across parts of the statutory guidance that are expecting them to be over-prudent and contrary to the fundamental “who benefits pays” principle. For instance, there is an expectation that loans to support capital expenditure will be financed even where there is no evidence that the loan will not be repaid in full, and even where it is secured by effective collateral.
Any authority complying completely with the statutory guidance will therefore, to a degree, be working to its own detriment.
With everyone aware that “MHCLG is watching you”, there is pressure on authorities to avoid departures or to have very strong grounds for doing something different. In this respect, the reported policy of Peterborough appears sensible – to reduce the MRP that would otherwise have been made in years when significant amounts of capital receipts have been set aside. This is based on an understanding that the proper measure of prudence should be where you arrive at at the end of the year (in terms of unfinanced capital expenditure), rather than what you have done during it.
However, there are plenty of other rumoured goings-on that don’t sound particularly sensible. I would reiterate the view I expressed in a previous article – the Prudential Framework is so complicated that there are no experts, just people who know a bit more than others. If you don’t understand what your authority is being recommended to do, don’t presume that the person telling you has that much more of an understanding.
If the Prudential Framework is going to thrive and the Prudential Code survive, then lashings of scepticism should be encouraged from members, officers, external auditors, the media and people’s auditors. But prudent good practice should always be defended, no matter how much explaining it might take.
Stephen Sheen is the managing director of Ichabod’s Industries, a consultancy providing technical accounting support to local government.
