Cash Flow Statement
Note 47. Financial Instruments
A financial instrument is a contract that gives rise to a financial asset of one entity and a financial liability of another. The term covers both financial liabilities and financial assets and includes the borrowing, lending, soft loans, financial guarantees and bank deposits of the Council.
With effect from 1 April 2007 local authorities were required to adopt the accounting standards for financial instruments IAS 32, IAS 39 and IFRS 7. This means that most financial instruments (whether borrowing or investments) have to be valued in the Balance Sheet on a fair value basis using the effective interest rate (EIR) method.
In addition to help identify, quantify and inform on the exposure to and management of risk, financial instruments are required to be shown at fair value. Fair value is defined as the amount for which an asset could be exchanged or a liability settled,
assuming that the transaction was negotiated between parties knowledgeable about the market in which they are dealing and willing to buy/sell at an appropriate price, with no other motive in their negotiations other than to secure a fair price. In the following tables and notes the significance of financial instruments for the Council’s financial position and performance will be explained.
Financial Assets that have passed their due date have been impaired but all have been subject to a review and, where appropriate, provided for within the bad debt provision.
Types of Financial Instruments
The following categories of financial instrument are carried on the Balance Sheet.:
Long-term Current
31 March 2016
£000
31 March 2017
£000
31 March 2016
£000
31 March 2017
£000 Investments
Loans and receivables (Principal amount) Accrued Interest
Equity Investments
Available for sale financial assets
0 0 1 0
0 0 1 0
81,222 54 0 0
67,251 13 0 10,014
Total Investments 1 1 81,276 77,278
Debtors
Loans and receivables
Financial assets carried at contract amounts
1,433 0
1,484 0
24 27,047
22 34,136
Total Debtors 1,433 1,484 27,071 34,158
Borrowings
Financial liabilities at amortised cost (Principal amount)
Accrued Interest
310,706 0
326,826 0
29,635 3,551
17,212 3,623
Total Borrowings 310,706 326,826 33,186 20,835
Other long term liabilities
PFI and finance lease liabilities 186,559 177,994 8,609 8,354
Total other long term liabilities 186,559 177,994 8,609 8,354
Creditors
Financial liabilities carried at contract amounts
0 0 34,421 29,365
Total creditors 0 0 34,421 29,365
Under accounting requirements the carrying value of the financial instrument value is shown in the balance sheet which includes the principal amount borrowed or lent and further adjustments for breakage costs or stepped interest loans (measured by an effective interest rate calculation) including accrued interest. Accrued interest is shown separately in current assets/liabilities where the payments/receipts are due within one year. The effective interest rate is effectively accrued interest receivable under the instrument, adjusted for the amortisation of any premiums or discounts reflected in the purchase price.
Fair value of Financial Instruments
Some of the Council’s financial assets are measured on the Balance Sheet at fair value. The Council holds £10m in certificates of deposit with Tor Dom Bank and Rabbobank. The fair value has been calculated by using published price quotations.
Except for the financial assets carried at fair value (described above), all other financial liabilities and financial assets represented by loans and receivables and long term debtors and creditors are carried in the Balance Sheet at amortised cost.
Their fair value can be assessed by calculating the net present value of the cash flows that take place over the remaining life of the instruments (all Level 2) which provides an estimate of the value of payments in the future in today’s terms. The calculations have been made using the following assumptions:
For loans from the Public Works Loan Board (PWLB) new borrowing rates from the PWLB have been applied to provide the fair value under PWLB debt redemption procedures. We have assessed the cost of taking a new loan at PWLB new loan rates applicable to existing loans on Balance Sheet date (which could be viewed as a proxy for transfer value).
For Lender’s Option Borrower’s Option” (LOBO) loans prevailing market rates have been applied to provide the fair value under PWLB debt redemption procedures.
For loans receivable prevailing benchmark market rates have been used to provide the fair value.
No early repayment or impairment is recognised.
Where an instrument has a maturity of less than 12 months or is a trade or other receivable the fair value is taken to be the carrying amount or the billed amount.
The fair value of trade and other receivables is taken to be the invoiced or billed amount.
The fair values calculated are as follows:
2015-16 Carrying amount
2015-16 Fair value
Fair value of liabilities carried at amortised cost at 31 March
2016-17 Carrying amount
2016-17 Fair value
£000 £000 £000 £000
288,925 380,497 PWLB Loans 288,888 394,528
43,137 54,289 LOBO’s 43,121 63,369
0 0 Other loans 400 400
3,551 3,551 Short term borrowing 3,623 3,623
3,523 3,523 Cash overdrawn 7,042 7,042
4,434 6,029 Other local authorities re joint services 4,256 6,201
322 322 Other 331 331
195,168 195,168 PFI and finance lease liabilities 186,348 186,348
34,421 34,421 Financial liabilities at contracted amounts 29,365 29,365
573,481 677,800 Total Liabilities 563,374 691,207
The fair value is higher than the carrying amount because the Council’s portfolio of loans includes a number of fixed rate loans where the interest rate payable is higher than the rates available for similar loans at the Balance Sheet date. This shows a notional future loss (based on economic conditions at 31 March 2017) arising from a commitment to pay interest to lenders above current market rates.
The Council has determined that for PFI scheme and finance lease liabilities the carrying value represents the best estimate of fair value, as the carrying value is based on the effective interest rate of the contract, which reflects the unique risks associated with the contract.
An alternative valuation technique for PWLB loans is where the value is calculated to be equivalent to the cost of the early repayment of outstanding PWLB debt. But if the Council were to seek to repay the loans to the PWLB, the PWLB would raise a penalty charge for early redemption in addition to charging an additional premium for the additional interest that will not now be paid. If this method of valuation had been used in 2016-17 the fair value would be calculated as £447.207m.
2015-16 Carrying amount
2015-16 Fair value
Fair value of assets carried at amortised cost at 31 March
2016-17 Carrying amount
2016-17 Fair value
£000 £000 £000 £000
7,238 7,238 Investments 11,011 11,011
74,038 74,038 Investments – cash and cash equivalents 56,253 56,253 1 1 Equity Investments -Integrated Bradford Local
Education Partnership (LEP) Ltd
1 1
1,457 1,579 Debtors – loans and receivables 1,506 1,646
27,047 27,047 Financial assets at contracted amounts 34,136 34,136
109,781 109,903 Total Financial Assets 102,907 103,047
The fair values for loans and receivables have been determined by reference to similar practices, as above, which provide a reasonable approximation for the fair value of a financial instrument and include accrued interest. The comparator market rates prevailing have been taken from indicative investment rates at each balance sheet date. In practice, rates will be determined by the size of the transaction and the counterparty, but it is impractical to use these figures and the difference is likely to be immaterial.
Short term debtors and creditors are carried at cost as this is a fair approximation of their value.
Gains and losses on financial instruments
The gains and losses recognised in the Comprehensive Income and Expenditure Statement in relation to financial instruments are made up as follows.
2015-16 Recognised gains and losses 2016-17
£000 £000
Recognised in the Comprehensive Income and Expenditure Statement Financial assets: Loans and receivables
-1,381 Interest income -1,060
-1,381 Total income in surplus or deficit on the provision of services -1,060 Financial Liabilities measured at amortised cost
20,290 Interest payable 19,947
18,753 Interest Payable on PFI and Finance leases 18,431
Recognised in Other Comprehensive Income and Expenditure
39,043 Total expense in surplus or deficit on the provision of services 38,378
Nature and extent of risks arising from financial instruments The Council’s activities expose it to a variety of financial risks:-
a. Credit Risk - the possibility that other parties might fail to pay amounts due to the Council.
b. Liquidity Risk - the possibility that the Council might not have funds available to meet its commitments to make payments.
c. Re-financing Risk – the possibility that the Council might be requiring to renew a financial instrument on maturity at disadvantageous interest rates or terms.
d. Market Risk – the possibility that financial loss might arise for the Council as a result of changes in such measures as interest rate movement.
Overall procedures for managing risks
The Council’s management of treasury risks actively works to minimise the Council’s exposure to the unpredictability of financial markets and to protect the financial resources available to fund services. In July 2003 the Council fully adopted the CIPFA Code of Treasury Management Practices. Each year the Director of Corporate Services presents to the Governance and Audit Committee an Annual Treasury Management Report which covers the Council’s current treasury position, borrowing and investment strategies and performance and debt rescheduling.
The annual Treasury Management Strategy which incorporates prudential indicators was approved by Council on 22 March 2016 and is available on the Council’s website. Actual performance is also reported after each year.
a. Credit Risk
Credit risk arises from deposits with banks and financial institutions, as well as credit exposures to the Council’s customers.
It is the policy of the Council set out in the Annual Investment Strategy to place deposits only with a limited number of banks and building societies whose credit rating is independently assessed as sufficiently secure by the Council’s treasury advisers and to restrict lending to a prudent maximum amount for each institution. The Council also has a policy of limiting deposits and maturities with banks and building societies depending on an institution’s (such as Moody’s or Fitch’s) credit rating.
The credit criteria in respect of financial assets held by the Council are as detailed below.
Investment limits
The financial investment limits with the Government, Banks or Building Societies are linked to Moody‘s, Fitch and Standard and Poors (S&P) ratings, as follows:-
1. The Government through debt management office including deposits, treasury bills and bank government guarantee certificate of deposits – Maximum Investment with any one counter party – no limit.
2. Local Authorities: Maximum Investment with any one counter party – £20 million.
3. Money Market funds including government funds with a Moody’s, S&P or Fitch rating of AAA: Maximum Investment with any one counter party – £20 million.
4. Any other Bank or Building Society with credit criteria of Moody’s rating Aa3 or better, Fitch short term rating of at least F1 and a S&P short term rating of A1 or better: Maximum Investment with any one counter party – £30million.
5. Any Bank or Building Society with credit criteria of Moody’s rating A1 or better, Fitch short term of at least F1 and a S & P short term rating of A-1or better: Maximum Investment with any one counter party – £20million.
6. Lower limit with any bank or building society with at least one of the following; Moody rating of A3 or better, Fitch rating of at least F1, S&P rating of A-1 or better: Maximum Investment with any one counter party – £7million.
7. National Westminster Bank - maximum limit of £20m.
The full Investment Strategy for 2016-17 was approved by Full Council on 22 March 2016 and is available on the Council’s website.
Customers for goods and services are assessed, dependent on materiality, taking into account their financial position, past experience and other factors as appropriate. A bad debt provision has been included in the accounts, to take account of the risk of non-payment (see note 18). As at 31 March 2017, the Council had a balance owing from its customers (mainly service and rent) of £26.363m (£27.047m 31 March 2016). The exposure to default has been assessed and is reflected in a bad debt (or impairment) provision of £11.823m.
At the year end the Council held investments of £77.278m, made up of £21.025m Investments and £56.253m Cash and Cash Equivalents. The Council’s maximum exposure to credit risk in relation to the above balances cannot be assessed generally as the risk of any institution failing to make interest payments or repay the principal sum will be specific to each individual institution. A risk of irrecoverability applies to all of the Council’s deposits, but there was no evidence at 31 March 2017 that any losses were likely to crystallise. The Council has not suffered any historical experience of default on any deposits with financial institutions, and does not expect to suffer any defaults on any of its existing deposits and therefore there is no requirement for any impairment of financial assets to be made.
No credit limits were exceeded during the reporting period and the Council does not expect any losses from non performance by any of its counterparties in relation to deposits and bonds.
b. Liquidity Risk
The Council manages its liquidity position through the risk management procedures above and through a comprehensive cash flow management system. This seeks to ensure cash is available when needed.
If unexpected movements occur, the Council has ready access to a facility to borrow from the Public Works Loans Board to cover any day to day cash flow need. The Council is also required to provide a balanced budget through the Local Government Finance Act 1992, which ensures sufficient monies are raised to cover annual expenditure. There is therefore no significant risk that the Council will be unable to raise finance to meet its commitments under financial instruments.
All trade and other payables are due to be paid in less than one year.
c. Refinancing and Maturity Risk
The Council maintains a significant debt and investment portfolio. Whilst the cash flow procedures above are considered against the refinancing risk procedures, longer term risk to the Council relates to managing the exposure to replacing financial instruments as they mature.
The Council has safeguards in place to ensure that a significant proportion of its borrowing does not mature for repayment at any one time in the future to reduce the financial impact of re-borrowing at a time of unfavourable interest rates. The Council’s policy is to ensure that not more than 20% of loans are due to mature within any financial year and 40% within any rolling five- year period through a combination of prudent planning of new loans taken out and, where it is economic to do so, making early repayments.
The following is an analysis of amounts owed to lenders at the year-end.
31 March 2016
£000
Total Borrowing 31 March 2017
£000 Source of loan and interest rate range :
288,925 Public Works Loan Board (3.7% to 10.25%) 288,888
43,137 Commercial Banks (3.2% to 4.5%) 43,121
0 Other - WYCA 400
332,062 332,409
Analysis of loans:
Short Term Borrowing
25,935 Maturing in less than 1year 10,000
Long Term Borrowing
38,431 Maturing in 2 - 5 years 33,942
43,715 Maturing in 5 - 10 years 55,088
57,396 Maturing in 10 - 15 years 52,857
166,585 Maturing in more than 15 years 180,522
306,127 Total Long Term Borrowing 322,409
332,062 Total Borrowing 332,409
The total borrowing shown on the Balance Sheet, page 23, of £336.032m, calculated by adding together short term (£13.623m) and long term borrowing (£322.409m), includes accrued interest of £3.623m, per accounting regulations. Accrued interest is not included in the above table.
d. Market Risk Interest rate risk
The Council is exposed to interest rate movements on its borrowings and investments.
The current interest rate risk for the Council is summarised below:
Borrowings at variable rates – the interest expense charged to the Surplus or Deficit on the Provision of Services will rise.
Borrowings at fixed rates – the fair value of the borrowing will fall (no impact on the revenue balances);
Investments at variable rates – the interest income credited to the Surplus or Deficit on the Provision of Services will rise.
Investments at fixed rates – the fair value of the assets will fall (no impact on revenue balances).
Borrowings are not carried at fair value on the Balance Sheet, so nominal gains and losses on fixed rate borrowings would not impact on the Surplus or Deficit on the Provision of Services or Other Comprehensive Income and Expenditure. However changes in interest payable and receivable on variable rate borrowings and investments will be posted to the Surplus or Deficit on the Provision of Services and affect the General Fund Balance.
The Council has a number of strategies for managing interest rate risk. During periods of falling interest rates, and where economic circumstances make it favourable, fixed rate loans will be repaid early to limit exposure to losses. The risk of loss is ameliorated by the fact that a proportion of government grant payable on financing costs will normally move with prevailing interest rates or the Council’s cost of borrowing and provide compensation for a proportion of any higher costs.
According to this investment strategy, if interest rates had been 1% higher at 31 March 2017 with all other variables held constant, the financial effect would be:
31 March 2016
£000
Effect of 1% increase in interest rates 31 March 2017
£000 0 Increase in interest payable on variable rate borrowings 0 -728 Increase in interest receivable on variable rate investments -597 0 Increase in government grant receivable for financing costs 0 -728 Impact on Surplus or Deficit on the Provision of Services -597
The impact of a 1% fall in interest rates would be as above but with the movements being reversed. The Council does not have any borrowings at a variable rate.
The treasury management team has an active strategy for assessing interest rate exposure that feeds into the setting of the annual budget and which is used to update the budget quarterly during the year. This allows any adverse changes to be accommodated. The analysis will also advise whether new borrowing taken out is fixed or variable.
Price Risk
The Council does not generally invest in equity shares and does not have any material shareholdings in joint ventures or local companies, and it is not therefore subject to price risk.
Foreign Exchange Risk
The Council has no financial assets or liabilities denominated in foreign currencies. It therefore has no exposure to loss arising from movements in exchange rates.