Valuing operational property has long been a thorny issue for public sector accountants and auditors alike. But as delays in local audit reach a critical level and with the approach to asset valuations touted as a factor in those delays, a Treasury thematic review, due to be published imminently, is asking whether changes to the regime might be needed. 

Michael Sunderland, Deputy Director of Government Financial Reporting at HM Treasury, says the time is ripe to think about the cost/benefit balance in producing this financial information, amid a growing consensus that current approaches to operational property valuations and auditing these valuations are disproportionate. In particular, the Treasury is revisiting the long-standing policy decision to hold property at current valuation within public sector accounts rather than historical cost. 

“What’s distinctively difficult about the public sector is that most of these assets are not cash-generating assets. So, it’s reasonable to ask whether it is right to hold all of these assets at current valuation, particularly when the costs incurred in being able to produce this information and get through the audit process are rising,” Sunderland says.

Jonathan Fothergill in the Global Valuation Team at the Royal Institution of Chartered Surveyors (RICS) believes that the excessive amount of time, effort and cost that goes into the audit of property assets is contributing to the bottlenecks and delays in the system that led to only 9% of 2020/21 local authority audited accounts meeting the 30 September 2021 deadline.

“Since 2018 some of our members working in this area advise there has been a noticeable increase in auditor scrutiny, which often seems disproportionate to the task at hand and sometimes in respect of what appear to be relatively low risk, routine operational assets. Some members advise that this means valuers are spending almost as much time dealing with auditor inquiries as actually undertaking the valuations,” Fothergill says. 

Ray Thomas, Assistant Director of Finance at the Countess of Chester Hospital NHS Foundation Trust,

explains the complexity of the regime across the NHS: “We have to pay capital charges on all of our assets, which means the higher the value of our property, the more we pay. It means there is incredible pressure to minimise the value of property as much as possible, within the bounds of the relevant accounting and valuation standards.”

A hospital is viewed as a specialised asset, which means that, in the absence of an open market value, a property is valued at depreciated replacement cost, using a modern equivalent asset basis. Thomas explains this can be interpreted in a number of ways, including approaches such as alternative sites or virtual builds. 

Potentially, a trust with a typical 1970s hospital, which has been added to piecemeal over the years, can value a modern equivalent asset that could be a theoretical four-block, six-storey configuration, for example, and even move it to a different location if that would be a more appropriate site. This approach can significantly reduce the value of the asset included in the accounts, although any assumptions made would still be subject to audit.

The complexity of the valuation rules requires the use of professional advisers, which has significantly increased the cost of producing valuations. This additional work also adds to what is a very time-pressured period and increases the amount of work the external auditors are required to do, which increases the cost of the audit to the trust, Thomas says. “It shows just how time consuming and unwieldy the whole thing has become. It has become intrusive to the real job in finance of keeping the cash flowing that allows the clinical staff to treat the patients.” 

The valuation of investment properties may often warrant additional auditor scrutiny, where there are viewed to be greater risks involved for local authorities, particularly where debt is secured and the potential for fluctuations in value from year to year exists. “However, the risk involved in the valuation of operational property, particularly specialised assets with no active market, is often perceived to be lower than many other aspects of public sector financial reporting because most public bodies do not have debt secured on their wholly owned property assets,” Fothergill says.

At the same time, the specialised nature of operational property assets, in particular the lack of a market and other potential users, has implications for their measurement. The primary objective of most public sector entities is to deliver services to the public, rather than to make profits and generate a return on equity to investors. Consequently, assets are held much more frequently for their service potential rather than their ability to generate cash flows.

While the valuation standards say that highest and best use of non-financial assets takes into account the use of the asset that is physically possible, legally permissible and financially feasible, the highest and best use is nevertheless determined from the perspective of market participants, even if the entity intends a different use. 

In the example of a city centre school, market participants may use the building as office space as that might achieve maximum economic benefits. This may make the application of fair value difficult in a public sector context, not only to calculate the value but also to interpret the result, Fothergill says. “Many believe that such information is not helpful to users of the financial statements since if an asset will never change its use, then why value it as something it is not being used for?” 

There is no silver bullet to solving the public sector property valuation conundrum, not least because the underlying causes are complex: a combination of increased scrutiny of auditors work on estimates including often relatively routine valuations, funding cuts, the effects of the pandemic in finance departments, and resource challenges in local authorities. 

Nonetheless, Fothergill says he hopes the review of operational property will result in HM Treasury requiring a much more targeted valuation approach focused on the real areas of operational risk for public sector bodies. “There is also a need to encourage auditors to have a dialogue with both the local authorities and their valuers earlier in the process to identify and agree appropriate approaches, assumptions and methodologies to reduce the areas of concern during the actual audit,” Fothergill adds. 

Sunderland says it is likely there will be an exposure draft of HM Treasury’s review of the valuation of operational property that will go out to consultation, but it is very unlikely that any changes would be implemented before 2024/25. “While changing the framework could help improve the timeliness of accounts, some people will rightly question whether we risk weakening the framework.” 

But financial information produced incredibly late is not by its nature high quality, Sunderland says. “People need to see the bigger picture in terms of how we can raise the bar in financial reporting. Arguably there’s no perfect solution to this. And without revealing where we’re landing, I think there is a lot to be said for having a balanced approach.”