Claire Morris: Sense needed in the debate on the prudential framework and investment code

Concerns are emerging over the consultation on the prudential framework, the investment code and MRP. Claire Morris argues implementation should be deffered until 2019-20 to enable a proper review of the proposals.

The consultation of the prudential framework on capital finance has been out a couple of weeks now so most of us have probably read it, maybe attended a conference where someone spoke about it and are starting to get to grips with the proposals or, more importantly, the impact of the proposals on our budgets and medium term financial plans.

I have not come across many who fundamentally disagree with the general principles of what DCLG are trying to achieve; openness, transparency, governance and accountability are the bedrock of what we do.

I also haven’t met many in our profession who would not say that the prime purpose of local authorities is to deliver statutory services and exercise stewardship of public funds.

That said, there are a number of things about this consultation that make me think the proposals are a rushed, knee-jerk reaction to lobbying from the commercial property sector without government quite understanding the situation.

Discouraging

Government says that it does not want to discourage local authorities from investing to deliver local economic regeneration; I also presume that they don’t want  authorities to stop being innovative in service delivery either, but I fear that these proposals, as they stand, will do exactly that. So, what is wrong with the consultation?

Firstly, the concern that some local authorities have become overly dependent on commercial income as a source for delivering statutory services. Is the government having a laugh? So, central government completely withdraws the revenue support grant (e.g., Guildford has no RSG from 1st April 2018), begins reducing our business rates income through an “additional tariff” (or introduces a negative grant, if you see it that way, a trajectory that I can only assume will continue) and then complains we are becoming too reliant on locally raised commercial revenue? The hypocrisy is outstanding.

I appreciate that commercial activity brings risks and that values, and therefore income, go up as well as down, but government grant seems to have only gone down and we do not appear to have any hope of it going back up. I would argue that the biggest risk to Guildford’s budget is further changes to the business rates retention scheme and possible funding reduction following the fair funding review implementation in 2020.

The important thing is that councils should understand the risks of commercial activity and have appropriate governance and monitoring arrangements around commercial activity and mitigation and exit strategies in place.

Secondly, I feel that the commentary around capacity, skills and culture is somewhat offensive. How many chief financial officers do not have sufficient knowledge and expertise to take sensible decisions? Do they really think that we just completely rely on our treasury management accountants and advisers to make investment and borrowing decisions?

Contradictory

Thirdly, the changes proposed regarding MRP are contradictory. The key principle that provision for borrowing should be made over a period bearing some relation to that over which the asset continues to provide service is widely accepted.

At Guildford, we have always taken care to align the useful life of assets for depreciation purposes with that used for the calculation of MRP. The useful life of individual other land and buildings is provided to us as part of the annual valuation we complete. The useful lives are therefore assessed by a RICS qualified valuer; in Guildford’s case this is the government’s own District Valuation Service.

I cannot therefore fathom out why it is necessary to state maximum lives for each category of asset within the MRP guidance, especially when I think the proposed maximum useful lives bear little correspondence to the valuation of individual assets.

For example, freehold land for depreciation is deemed to have an infinite asset life, so it could be argued that it should not be subject to MRP, but that would not be prudent. In our asset portfolio, we have pieces of land let out for telecommunications purposes and new surface car parks, which are judged by the valuer to have remaining asset lives of between 60 to 79 years in our last valuation. Similarly, some of our other land and buildings, particularly residential houses, are deemed by the valuer to have asset lives in excess of 40 years.

Investment property is not depreciated under accounting practice as it is valued at fair value on the balance sheet and revalued annually, gains or losses on revaluation are recognised through the Comprehensive Income and Expenditure Account.

Again, this could be an argument for not charging MRP as the financing cost is highly likely to be recovered on disposal. However, many local authorities will have no plan to dispose of the assets, as they are held for income purposes.

At Guildford, we match the asset life for MRP on investment property to that which we use on other land and buildings. However, as investment property is revalued every year, surely it wouldn’t be too hard for councils to ask the valuer to assess the remaining useful economic life as part of that revaluation and then charge MRP accordingly over that life?

So, instead of arbitrary maximum lives, surely the better approach would be to stipulate that the useful economic life of an asset for both MRP and depreciation (if relevant) should be based on the professional opinion of an independent valuer? That way, authorities will have solid evidence to support their judgements to auditors.

Sense

On the acquisition of share or loan capital, the maximum asset life is proposed as 20 years. Yet loans for capital expenditure by third parties and expenditure on assets for use by others are recommended to have an asset life equal to the useful economic life of the underlying asset.

In the case of acquiring share or loan capital for property based companies, why not apply the useful life of the underlying assets? Those councils that have housing companies, regeneration xompanies, energy companies or commercial property companies may possibly find this is the proposal that may have the biggest impact.

In my own case, Guildford has a housing company, the core reasons for us setting it up links to our housing strategy and trying to meet identified housing needs in our borough. The fact that it should generate a relatively modest income stream for the council’s general fund was an added benefit.

The company invests the equity and loan capital provided by the council in housing. Thus, it makes prudent sense to me to charge MRP on the capital expenditure we have invested as equity in the company, over the life of the underlying assets of the company (i.e., the residential property).

If we have to change MRP on the equity that the council has invested over 20 years then the business plan of the company is highly likely to become unaffordable for the council and the idea of meeting housing need in the borough can be forgotten.

Should the implementation be deferred until 2019-20? Yes, absolutely in my view, because we are less than two months away from setting our 2018-19 budget and some sense needs to be brought back in to the debate.

Claire Morris is head of financial services and chief financial officer, guildford borough council