For those who are unfamiliar with them, an ‘ECL’, short for ‘Expected Credit Loss’, is an accounting charge that has to be made upfront for a probability that you may lose money on an investment. For local authorities, this was brought in under IFRS 9 in 2018, so it is certainly not something new. They are applicable to any investment where you have a contractual right to receive your money back, usually with interest. This includes bank deposits made as part of day-to-day treasury management, but it will also include loans you have made to subsidiary companies, local businesses, or charities.
When you make an ECL charge, you charge this as an expense to the Comprehensive Income & Expenditure Statement (CI&ES), with the double entry going to reduce the investment’s value in your balance sheet. If the ECL is higher than last year’s, then its increase in value will be an expense, if it is lower than last year’s, the decrease in value will be income. For investments made for regular treasury management purposes, or loans made for service reasons that are not considered capital expenditure, the ECL represents a genuine charge, or sometimes income, to council taxpayers. Fortunately, because treasury management investments are usually with very safe counterparties, the ECL for these is usually very small and often immaterial, so the actual impact on council taxpayers will either have been tiny or nothing. Also fortunately, service-related loans that are not considered capital expenditure tend to be relatively rare, although they are certainly not unheard of, with these types of loans more commonly being used to fund capital expenditure, so an impact on council taxpayers from these is uncommon.
Loans that have been made to fund expenditure that, if an authority spent it itself, would be capital expenditure, have to be treated as capital expenditure. These loans would be capital loans rather than revenue loans. Common examples are loans to housing companies to buy or build housing, or loans to a local sports club or charity to build a new building on their premises. These loans still require an ECL to be calculated, which will be recorded as expenditure, or sometimes income, in the CI&ES. However, due to the capital nature of the loan, if you are a local authority, the ECL is an impairment on a capital asset and therefore is not a charge to council taxpayers. The expense in the CI&ES gets reversed out of the general fund to the Capital Adjustment Account through the Movement in Reserves Statement. Therefore, to date, while calculating an ECL was still clearly important, in many cases there was no final impact on council tax.
This has, unfortunately, changed now. New guidance on Minimum Revenue Provision (MRP) in England was published in April 2024. This stated, amongst other things, that for capital loans made after 7 May 2024, MRP will be required to be made that is, at a minimum, equal to the loan’s ECL charge. MRP is a genuine charge to council taxpayers. So, this means that if you are an English authority, for new loans, the ECL will in all cases have a direct impact on your need to charge council tax or on the services that you provide.
For most authorities, the majority of their capital loans are still likely to have been made before the 7 May 2024 cut off, so in practice, the new impact may be small or non-existent this year. However, we expect that the new MRP guidance will have been noticed by auditors, who are likely to be picking up on it as an extra reason to scrutinise ECLs this year, particularly ECLs made for service-related capital loans. Welsh and Northern Irish authorities are not affected by this new guidance, but it is worth noting that it is common for these regions to eventually reflect guidance in England, and auditors in these regions will be aware of this, and therefore paying more attention to the area.
The ECL charge for capital loans made for service purposes can often be a reasonably sizeable figure. This is both because these loans can often be for substantial sums and because the risk of default for these types of loans is typically higher than for normal treasury investments, resulting in a larger ECL. Loans made for service purposes are often made to relatively newly formed companies, which are normally considered higher risk. Often, a local authority company will be seeking to provide something the market would perhaps not provide, such as affordable housing, because the market may deem it too risky or too expensive, this would typically also lead to a higher ECL value. Any argument that the ECL can be zero because the loan has no risk is unlikely to wash with auditors, particularly as we have seen a small number of authorities that have faced substantial difficulties due to defaults on loans made to subsidiary companies.
It is also worth noting that although the ECL will, by design, involve some estimation, it is supposed to be based on solid evidence and a robust estimation technique. The ECL should also be adjusted every year according to current market conditions, as well as changes in the borrower’s individual circumstances. Plucking a figure, such as 1% of the loan value, out of the air is unlikely to stand up to auditor scrutiny regarding whether accounting practice is being properly followed.
At Arlingclose we have an established methodology for calculating an ECL for a service loan that has stood up to auditor scrutiny. If you would like any further assistance in calculating ECLs please contact Laura Fallon at lfallon@arlingclose.com or on 07702 788303.
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