Auditors are taking a close interest in the accounting for companies owned by councils. David Green looks at the elements that attract attention.
Council-owned companies have been in the news a fair bit over the past year, usually for the wrong reasons. Falling commercial property rents, the tight domestic energy market and a mismanaged housing company have all elevated the profile of local authority subsidiaries.
Auditors are among those taking a renewed interest, as a result, and accounts preparers will need to be on their best form this year.
Subsidiaries usually appear in the council’s accounts in two places: the equity investment representing ownership of a company’s shares, and the loans that provide the cash enabling a company to carry on its business.
Equity investments are usually shown on a local authority’s balance sheet at their fair value, i.e., the estimated market value. This not a simple calculation, and if a company is of any size, a professional valuation will be needed to avoid the risk of materially under- or over-stating the value.
Where an authority produces group accounts, there is an option to show all equity investments in subsidiaries at their cost less impairment.
This may seem an attractive way of avoiding expensive valuations every year. However, measuring the recoverable value of the investment to demonstrate it is not impaired involves a similar calculation so a valuation will probably be required anyway.
Loans
Loans to subsidiaries are accounted for in exactly the same way as loans to unrelated entities. If they have been lent on standard terms and the council doesn’t plan on selling the loans, they will be shown on the authority’s balance sheet at amortised cost, which is usually equal to the principal outstanding plus accrued interest to date.
But loans to subsidiaries often contain terms that you wouldn’t see in a commercial loan between unrelated parties. Loan repayments may be optional, or only due when the company is making a profit or has sufficient cash from the sale of property.
Any of these generally mean that the loans must be shown at their fair value in the lender’s accounts, requiring another calculation. Even where loans are shown at amortised cost, the fair value must still be disclosed in the notes to the accounts.
The fair value of a loan depends on the contractual cash flows and the credit quality of the borrower, i.e., the likelihood of those contractual payments actually being made.
This involves a rather different calculation since credit risk only has a downside whereas equity price valuations also look at the potential upside.
Loans held at amortised cost must be shown in the accounts net of an impairment loss allowance that also reflects the credit quality of the borrower; this uses a similar calculation to fair value.
Defaults
Note that the fact the local authority owns the shares and may have issued a guarantee does not contribute to the company’s credit standing in this case—only third-party guarantees count here. And there have been several examples recently of council-owned companies defaulting on their loan repayments back to the local authority, so no one should claim they are zero risk.
Further entries will be required in a local authority’s accounts if loans have been made at below market interest rates, so-called soft loans. Soft loans to unrelated parties result in an implied grant being made to the borrower to cover their interest payments, but for subsidiaries that is treated as an additional equity investment by the owner instead. That adds to the cost of equity for the cost less impairment calculation.
Undrawn loan facilities, where the authority is contractually committed to lending further money also need accounting for, as will guarantees issued by local authority over third-party loans.
Finally, both equity investments and loans usually count as the local authority’s capital expenditure and so the appropriate capital financing entries and disclosures will also need to be made.
That may all sound like a lot of work for the finance department. But getting things right first time round will lay the path for a smooth audit over the summer.
David Green is strategic director at Arlingclose Limited, treasury advisors to UK local authorities.
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