Why infrastructure assets are the ugly ducklings of capital accounting
0Stephen Sheen offers an avian analysis of how to resolve the current local audit delays caused by a “major” issue involving infrastructure assets.
Photo by Kerin Gedge on Unsplash
Some of you may be struggling to understand why problems with infrastructure asset accounting have led to an effective embargo on signing off local authority audits. Room151’s recent news story set out the controversy, but I thought it would be helpful to explain exactly what the issue is. A little avian knowledge will assist.
Our story begins back in 1994. All across the land, accountants were busying themselves with the implementation of capital accounting …
At that time, assets were carried in the balance sheet at the amount of historical capital expenditure that had yet to be financed. This had some equivalence to depreciated historical cost (DHC), but with the significant qualification that assets would effectively disappear from the balance sheet when they had been financed from capital receipts or grants and developer contributions. A substantial part of the historical cost of the infrastructure assets held by authorities was therefore missing from the balance sheet.
An inalienable asset
Whilst other asset categories were given the gift of current value in the transition to capital accounting, infrastructure assets were left on this modified historical cost basis. This was because a fundamental characteristic of infrastructure is that it is inalienable – once it is in place, there is no prospect of digging it up and using it for something else or selling it. It was therefore decided that there was little purpose in telling people how much it might currently be worth.
Infrastructure assets are therefore the ugly ducklings of capital accounting.
Since 1994, authorities have developed strategies for maintaining the balance in accordance with Accounting Code requirements for DHC measurement. These strategies have recognised the opportunities provided by the interconnectedness of infrastructure items to account for them as single network assets made up of many parts. With the reasonable presumption that parts are not replaced until they are used up, the asset balance is maintained by adding the expenditure incurred in replacing parts and reduced by depreciation charges.
This simplification does depend on an effective depreciation policy for the whole asset that gives confidence that parts would have been fully depreciated by the time they are replaced (ie, their DHC is zero). The carrying amount does not then need to be adjusted for the writing out of derecognised parts.
This removes the problem of the impracticability of recording all the parts that might be replaced over the lifetime of the network.
There was an attempt in 2010s to upgrade the accounting basis for the highways network asset to current replacement cost, but this has not been accomplished. So, all through this wintertime infrastructure assets have hidden themselves away, ashamed to show their face, afraid of what others might say. Everybody seemed content that the poor ugly duckling was not worthy of attention.
What has basically happened in the last couple of months is that auditors have taken a look under the bush and found themselves disappointed not to find a swan.
But the poor ugly duckling is not a swan, was never intended to be a swan, and is incapable of ever being a swan. Unless and until we move to current replacement cost, it will always have feathers all stubby and brown.
What has basically happened in the last couple of months is that auditors have taken a look under the bush and found themselves disappointed not to find a swan.
Resolving the problem
The issue is therefore resolvable by acknowledging our ugly duckling and presenting it truly and fairly in all its stubbiness in the statement of accounts, avoiding any suggestion that it might be mistaken for a swan. The network accounting approach generally achieves this, though auditors will always be justified in asking questions about the necessary effectiveness of the authority’s depreciation policy.
But once these questions have been addressed satisfactorily, we have a reliable carrying amount for infrastructure assets in the balance sheet. Duck-shaped, but reliable.
There is a small residual technical problem, in that the Accounting Code expects an analysis of the carrying amount for infrastructure assets into gross historical cost (GHC) and accumulated depreciation (AD). For this analysis, derecognition of replacement parts would be important. For example, if a part that cost £1m were replaced, then a deduction of £1m would be required from both GHC and AD.
Without these deductions, GHC and AD will each continue to grow, with the eventual outcome that they will be materially overstated.
However, this issue is straightforwardly resolved. A proper consideration of GHC and AD would acknowledge the inherent incompleteness of data, the reducing usefulness of knowing the historical cost of long-lived assets (some of which potentially would be measured in farthings and thruppences) and the fact that capital financing does not depend on the outstanding undepreciated balance (as it would for commercial entities).
Users would be best served by not providing the analysis. No analysis – no material misstatement.
Not a major accounting issue
There is no prospect that this information could reliably inform any decision contemplated by a user of the accounts. Users would therefore be best served by not providing the analysis. No analysis – no material misstatement.
In summary, this is not a major accounting issue. It can be resolved by acknowledging the imperfections implicit in the current requirements for financial reporting and improving them by removing the disclosure of information that detracts from the key messages about an authority’s property.
You don’t need to love the ugly duckling, but with a little respect everything will be fine.
Stephen Sheen is the managing director of Ichabod’s Industries, a consultancy providing a technical accounting support service to subscribing local authorities. He was previously the senior technical manager for local government audit at PwC.
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