Mandatory lockdowns of ‘non-essential’ businesses and the effects of the pandemic on both supply and demand have been mitigated by a wide range of measures to help businesses through these unprecedented times. The UK and many other governments around the world have used grants and financial loan guarantees as part of their response to the COVID-19 crisis. While grants and financial guarantees are not new accounting topics, the scale and timing of such transactions as a result of the pandemic have brought into sharp focus some specific financial reporting issues for the public sector.
Government grants – expenses
UK government entities apply International Financial Reporting Standards (IFRS), with some adaptations for the public sector, and have a year end of 31 March. When, in March 2020, large amounts of grants were being promised as part of relief packages, there were discussions about whether they should be recognised as a provision in government accounts as at 31 March 2020.
From the perspective of the grant provider (government), the relevant financial reporting standard is IAS 37 Provisions, Contingent Liabilities and Contingent Assets. Under IAS 37, the grant-provider recognises a liability, and the associated expense, when a present obligation to transfer the grant has been established. If a present obligation does not exist prior to the grant being paid, the grant is simply expensed when paid.
IFRS are principles-based standards and judgment will be required as to when a present obligation exists and thus whether a provision and expense should be recognised. As some government entities have discovered, this judgement can at times be difficult to determine.
As government entities now prepare their 2020-21 financial statements and COVID-19 relief packages continue to be made available, the following factors will need to be considered:
- Under IAS 37’s recognition criteria, the nature of the obligation may be either legal or constructive. Has the unprecedented government intervention led to a valid expectation that the government will provide financial assistance, thereby creating a constructive obligation at the reporting date?
- Pre-pandemic, ministerial announcements tended not to result in the recognition of provisions, but were the unwavering, almost unconditional, support measures announced by the government in March 2020 an exception to this? The consequences of any further relief package announcements will need to be carefully considered.
- To what extent do the eligibility criteria for grants play a role in the recognition and measurement of a provision? For example, where the threshold to obtain a grant is low, such as a company simply needing to exist, it becomes more probable that payment will be made, ie, that there will be an outflow of resources.
This last point is precisely what the Department for Business, Energy and Industrial Strategy (BEIS) had to consider in its 2019-2020 financial statements. These include a £10.8bn provision, based on a constructive obligation to pay out grants, which has contributed to the Department spending more than it was originally allocated. Due to the low eligibility threshold, the outflow of resources was more likely than not (ie, probable, not just possible) and hence a provision was recognised rather than a contingent liability being disclosed.
The International Public Sector Accounting Standards Board (IPSASB) is currently working on a new standard for grantors that will provide guidance on how to account for grant expenditure. Guidance for grant income already exists in both International Public Sector Accounting Standards (IPSAS) and IFRS, but producing guidance for the grantor will fill a gap in the current literature.
In the draft IPSASB standard, the timing of the recognition of grant expenditure by the grantor is driven by the terms – the performance obligations – the recipient has to fulfil in exchange for the grant. The recipient’s performance obligation plays a key role and is based on the binding arrangement (such as a contract) that underpins the grant transaction.
The grantor will initially recognise an asset, reflecting the right to have the recipient meet their performance obligation per the binding arrangement (which usually involves the grant recipient incurring eligible expenditure, for example, by providing vaccines to GP surgeries). Subsequently, the grantor expenses the asset as and when the recipient discharges their performance obligation.
If no binding arrangement exists, the grant expenditure is recognised at the earlier of when the grant payment is made or a present obligation is established. Since it is unlikely that a binding arrangement existed, applying these proposals to the COVID-19 support schemes would probably not have resulted in a different outcome as under IAS 37.
Financial guarantees
Ensuring businesses had adequate access to finance, often on favourable terms, was a key part of the COVID-19 response by policymakers, including government-backed loan guarantees to support banks in lending to businesses.
UK public sector entities account for financial guarantees by applying IFRS 9 Financial Instruments. In an arm’s length (ie, commercial) transaction, financial guarantees are provided in exchange for a fee, which is then used as the fair value of the financial guarantee at initial recognition. However, as part of the COVID-19 relief efforts, the government is not always charging a fee, making the initial measurement of financial guarantees much more challenging.
As noted above, the UK public sector applies a slightly adapted version of IFRS. Per IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors, alternative sources of guidance can be analysed to help develop an accounting policy for transactions not covered by IFRS. IPSAS is one such source and appears in the hierarchy of authoritative guidance that the public sector should consider in the absence of an IFRS.
IPSAS 41 Financial Instruments provides specific guidance on valuing financial guarantees issued for zero consideration, which is not replicated in IFRS 9. Paragraphs AG131-136 of IPSAS 41 state that an entity:
- first considers whether quoted prices are available in an active market for directly equivalent financial guarantee contracts; and
- where no such active market exists, the use of a valuation technique to provide a reliable measure of fair value is then considered.
Given the uniqueness of the support being provided, whether the government has the necessary information to determine a reliable measure of fair value is a key consideration; there is unlikely to be an active market with observable prices for these guarantees, and valuation techniques may rely heavily on mathematical models.
IPSAS 41 goes on to state that if no reliable measure of fair value can be determined, either by direct observation of an active market or through another valuation technique, then the financial guarantee contract is required to be measured at the amount of the loss allowance for expected credit losses.
Modelling the expected credit losses of the guaranteed loans will be a further considerable challenge. Loan agreements can contain many variables, including payment holidays and ‘pay as you grow’ terms and conditions, where borrowers only start paying back the loan once they make a certain amount of profit.
Public sector-specific transactions
The differences in financial reporting by the public and private sectors are sometimes overstated. However, as highlighted here, certain non-commercial transactions, such as grants and financial guarantees for no consideration, are more specific to the public sector. When considering the financial reporting for such transactions, preparers of UK public sector financial statements should remember that IPSAS may just provide that piece of additional and relevant guidance that IFRS does not.
About the author
Henning Diederichs, Manager, Public Sector Financial Reporting, ICAEW
