PART 1
(OPEN TO THE PUBLIC)
ITEM NO. 8
REPORT OF THE HEAD OF FINANCE
TO THE BUDGET SCRUTINY COMMITTEE ON WEDNESDAY, 7 MARCH 2007
TITLE:
PROPOSED NEW ACCOUNTING ARRANGEMENTS FOR FINANCIAL INSTRUMENTS
RECOMMENDATIONS:
Members are invited to comment on the contents of the report.
EXECUTIVE SUMMARY:
Over the last few years, there has been some debate over the proper accounting
treatment of LOBO Loan Interest and Premiums on Debt rescheduling. In response
to requests for clarity from both sides, CIPFA issued a new draft Statement of
Recommended Practice with an Invitation to Comment (the SORP ITC). Draft
regulations were also issued by DCLG in support of the SORP ITC. The Council’s
formal responses to these documents were submitted in February.
There remains an element of uncertainty about the practical impact of the draft rules
until they are finalised. However, the Council’s interpretation, supported by an
indication of comfort from DCLG, is that the treatment adopted to date will be allowed
to continue for existing loans and premiums. There should therefore be no
retrospective impact on the revenue account. New rules and policies, which will
apply from 1 April 2007, clarify the treatment of premiums and restrict the usefulness
of LOBO loans as a treasury management tool.
BACKGROUND DOCUMENTS:
Available for public inspection:
 LOBO Loan Interest and Premiums on Debt rescheduling, a report to the
Lead Member for Customer and Support Services, 10 October 2005
 SAS610 Reports 2004/05 and 2005/06 to Accounts Committee (Audit
Commission)
 Final Accounts Reports 2004/05 and 2005/06 to Accounts Committee
 SORP 2007 Invitation to Comment (CIPFA)
 Salford CC Response to ITC
 GMAMT response to ITC
 Draft Local Authorities (Capital Finance and Accounting) (Amendment)
(England) Regulations 2007
 Guidance under s12(2)(b) of the Local Government in Scotland Act 2003
 Various working papers
Commercial in confidence:
 Advice and guidance from the Council’s external treasury management
advisors
CONTACT OFFICERS:
Chris Hesketh Tel. 793 2668 chris.hesketh@salford.gov.uk
John Spink Tel. 793 3230 john.spink@salford.gov.uk
Elaine Marks-Parker Tel. 793 3224 elaine.marks-parker@salford.gov.uk
ASSESSMENT OF RISK: Medium to Low
The Council adopted an accounting policy in 2004/05 that reduced the immediate
impact on the revenue account of LOBO Loan Interest and Premiums on Debt
rescheduling, accepting a risk that the policy would be overturned and the Council
forced to make retrospective charges to revenue. Up to 31 March 2007, the
maximum retrospective adjustment for LOBO loan interest would be approximately
£2.3million.
The 10 October 2005 report judged the overall risk to be “ medium”, largely because
of the size of its potential impact. While there is still an element of uncertainty over
the new regulations until their finalisation, the likelihood of occurrence is now felt to
have reduced.
SOURCE OF FUNDING: Revenue Resources
LEGAL ADVICE OBTAINED:
The previous SORP guidance and accounting policies adopted in 2004/05 and
2005/06 were discussed with the then Monitoring Officer, Alan Eastwood.
FINANCIAL ADVICE OBTAINED:
This report concerns key aspects of the Council’s revenue finances and has been
produced by the Finance Division of Customer and Support Services.
WARD(S) TO WHICH REPORT RELATE (S): None specifically
KEY COUNCIL POLICIES: Budget Strategy; Treasury Management Strategy
REPORT DETAIL
1 Background
1.1 CIPFA’s annual Statements of Recommended Practice (SORPs) govern local
authority accounts.
1.2 The SORPs up to 2006 have not provided clear and prescriptive guidance on the
accounting treatment of LOBO loan interest and premiums on rescheduling of
debt. The Council has adopted accounting policies in line with its interpretation
of the SORP, while the Audit Commission has held a different view that would
have had the effect of increasing the charge to revenue in the short to medium
term. Both methods would have equalised over time.
 LOBO interest. The Council has accounted for actual interest payable. The
Commission’s view has been that the charge should be based on an interest
rate average over the life of the loan (estimated at 12 years). The additional
revenue charge would have been c.£1m up to 2005/06 had the Commission’s
approach been adopted.
 Premiums. The Council has spread the cost of premiums over the life of the
replacement loan. The Commission’s view has been that the costs should be
spread over a shorter period (estimated at 12 years). The additional revenue
charge would have been c.£1.9m up to 2005/06 had the Commission’s
approach been adopted.
1.3 The draft SORP 2007 has been issued with an invitation to comment (ITC). It
contains proposals to integrate Financial Reporting Standards FRS25 and
FRS26 into local authority accounting. The proposals are intended to be clearer
on the treatment of both LOBO loan interest and premiums.
1.4 The Draft Local Authorities (Capital Finance and Accounting) (Amendment)
(England) Regulations 2007 were issued in support of the draft SORP. Their
intended effect is to mitigate the retrospective impact of the SORP changes.
2 SORP 2007 ITC
2 New Rules
2.1 This section discusses the treatment of transactions from 1 April 2007. All new
loans and premiums will follow the new SORP rules. Section 3 discusses
transitional arrangements for loans and premium balances in existence at the
time of transition, ie which are currently accounted for under old rules and
accounting policies.
2.2 The SORP 2007 ITC contains the following guidance for accounting for loan
interest (including LOBOs) and premiums on rescheduling of debt.
Loan interest
2.3 Following Financial Reporting Standards FRSs 25 and 26, the SORP prescribes
using the Effective Interest Rate method, over the contractual life of the loan, to
calculate the interest chargeable to the Income & Expenditure Account. In the
case of a simple fixed rate loan contract, this results in exactly the same charge
as the actual rate. For loans issued at a discount, or for “stepped” loans like
LOBOs, this has a “smoothing” or averaging effect. For most such loans this
means that costs that would otherwise have been deferred (because of a low
initial interest rate) are actually charged in the early life of the loan. This
effectively eliminates the usefulness of LOBO loans as a treasury management
tool.
2.4 This is the method that had been advocated by the Audit Commission, although
they had suggested using the expected (12-year) life of a loan as the averaging
period, rather than the full contractual life prescribed by the SORP. The effect is
actually more marked under the SORP; the retrospective impact up to 2006/07
would be £2.3m to the General Fund (£1.5m up to 2005/06 and £0.8m for
2006/07).
2.5 The Effective Interest Rate calculation is quite complex. In practice, the charge
will not be exactly the same each year, although the variation from year to year
will be relatively small. The calculation will mean some extra work for treasury
management accountants.
Premiums on rescheduling of debt
2.6 The SORP 2007 ITC proposal distinguishes between new debt considered to be
a replacement of existing debt and new debt considered to be a modification of
existing debt. For the new loan to be treated as a modification, it must be with
the same provider and have a net present value (npv), including the premium,
within 10% of the npv of the outstanding transactions on the old loan. It is
probable that most previous rescheduling arrangements would not have been
considered modifications.
2.7 If the new debt is a replacement, then any premium should be charged to the
revenue account immediately. If the new loan is a modification of the existing
loan, then the premium should be spread over the life of the new loan.
2.8 Rescheduling of debt will remain a valid treasury management tool, but the
requirement to charge premiums immediately in cases where the rescheduling is
not considered to be a modification of an existing loan will reduce its usability.
2.9 While the adoption will be effective from 1 April 2007, the effect will be from 1
April 2006, as any recognition/derecognition decisions relating to the comparator
year 2006/07 have to be charged to the general fund reserve.
2.10 Of concern are the SORP ITC’s comments on the treatment of “overhanging”
debt. They suggest that premium not directly attributable to an existing loan
should be charged to revenue immediately. Much of the Council’s £30million
premium is not directly attributable.
3 Transitional Arrangements
3.1 It is clear that the draft regulations issued by the DCLG afford local authorities
protection from the effects of the draft SORP as far as the treatment of premiums
is concerned, including overhanging premiums, by allowing them to be written
down over the life of a replacement loan.
3.2 What is less clear, however, is the treatment and impact of stepped LOBO loans.
The DCLG has recognised this following the closure of their consultation period
on their draft regulations and written to all local authorities indicating that they
will consider introducing additional regulations during 2007/08 that will resolve
this issue. The position has been helped by the issue of statutory guidance in
Scotland that allows the accounting for interest on stepped LOBOs to continue to
use the current method after the new SORP is introduced on 1st April 2007. The
DCLG is aware that replicating this guidance in England would meet local
authority concerns.
3.3 In view of the earlier uncertainty, treasury management officers, in consultation
with advisors, have been considering a number of contingency rescheduling
plans. The aim of these would be to achieve a transaction that counted as either
a modification or a replacement of an existing loan, whichever gave the biggest
advantage to the Council. These may yet be enacted, but only for sound
treasury management reasons. The risk of needing to enact them to protect the
Council's budgetary position now no longer appears necessary in view of the
assurances received from DCLG concerning proposed additional regulations.
4 Responses to the draft SORP and Regulations
4.1 The Council submitted a response to the SORP ITC 2007 on 14 February 2007,
answering approximately 40 questions on accounting treatment and
interpretation that were posed by CIPFA. The Council welcomed the attempt at
clarity and agreed with the ITC suggestions on many points. However, the
response disagreed and put forward alternative suggestions in other areas, as
well as criticising the ITC generally for a number of reasons, summarised below.
 Failure to adequately consider the budgetary impact on local authorities
 Poor timing, meaning a final conclusion could not be drawn for the 2007/08
budget process
 Failure to adequately consider the treasury management implications for local
authorities
 Lack of clarity
 Lack of co-ordination with the draft Regulations
4.2 The Council also signed up to a joint response submitted on behalf of GMAMT
authorities. This was a less-detailed response than the Council’s, but had a
similar thrust. The GMAMT submission contained the comment, "Salford City
Council is broadly in agreement with, and supports, this submission. It has also
submitted its own detailed response, emphasising the Council's concerns over
some of the proposed SORP amendments".
5 Conclusions and Recommendations
5.1 New rules apply for LOBO Loan Interest and Premiums on Debt rescheduling
from 1 April 2007.
5.2 The new rules eliminate the effectiveness of LOBO loans as a treasury
management tool. They change the calculation of loan interest in-year, although
the charge over the life of the loan is equivalent. They clarify the treatment of
premiums.
5.3 Most importantly, it is expected that there will be no retrospective impact of the
new rules. However, there is a risk that this view is incorrect. If it is necessary
to take action to mitigate the impact, this will be reported at the meeting following
any rescheduling or other action.
5.4 Members are are invited to comment on the contents of the report.
Appendix A: summary of changes
SCC treatment
AC view
New rule
Actual payment
Average
interest
over
expected life of LOBO (12
years)
Average
interest
over
contractual life of LOBO
LOBO loans
Interest charge
Approx additional costs
(*“Worst case”: expected
impact is as per SCC
treatment)
up to 2005/06
£0
£1m
£1.5m*
2006/07
£0
na
£0.8m*
Contractual life of new loan
Expected life of new loan
(ie 12 years if LOBO)
“Modification”: contractual
life of new loan
Premiums
Amortisation period
“New contract”:
immediately
charge