Tuesday, 8 August 2017

Depreciation pt 2: what happens to the money

In Pt 1 I outlined that calculating and funding depreciation is a mechanical accounting process that is common to just about every enterprise. I also mentioned that depreciation generates cash, so let's move on to what happens to the cash.

It's worth noting that what a ratepayer is paying for in depreciation is not really connected in any direct way to how the cash generated by depreciation is spent. Rates pay for service on a daily basis. Not wildly different to a mobile phone plan. When someone pays a water rate they pay for safe water flowing reliably out of the tap. As it happens part of the cost of making that possible is the wear and tear (depreciation) on the current physical assets in the water network. The cost of the wear and tear is added to all the other expenses when a council calculates its water rate. But what happens to that money after it is collected is not relevant to why ratepayers are asked to pay the money in the first place.

I labour this point because many people are convinced that rates "pay for" infrastructure and that it therefore follows that residents who have been paying rates for many years have some prior claim over newcomers. Nothing could be further from the truth: the ratepayer of 1 day and the ratepayer of 10 years have exactly the same claim (i.e. none at all).

Funding replacement assets

The first and best use for the funds that accumulate from charging depreciation is to pay for replacement assets. After many years use roads, pipes, buildings, plant etc will wear out and need to be replaced. If a council has been dutifully collecting the funds generated by depreciation it should have pretty much enough cash on hand for replacing aged assets.

In theory, once a council has all the assets in place to provide services to its public it can sustainably offer those services forever just through the cycle of charging depreciation and using those funds for asset replacement.

While the process of calculating depreciation may be pretty mechanical the application of the funds it generates requires judgement and some prudence. Adding new infrastructure to service growth or upgrading infrastructure to deliver higher levels of service (performance quality) does not qualify as replacement. Many modern projects actually end up combining aspects of all three and councils have to exercise judgement as to how much to allocate to each purpose for undertaking a project. The council must think very carefully about how much they will need for replacing worn assets in the future and make sure they don't dip too far into the reserves today.

Paying down debt

Surplus funds can also be used to pay down debt. So if some assets are debt-funded then the depreciation charged against them can be used to pay down the debt principal. In a simple model a council would have just finished paying off their asset when it was time to replace it. Actually there is nothing particularly wrong with renting infrastructure like this; it is easily the best way to allocate costs fairly across generations. It just costs more.

And there is no double dipping here. Unless a council has a compelling reason to do otherwise it will charge the same depreciation on an asset whether it is equity or debt funded. So ratepayers pay the same regardless. Although with debt funding ratepayers will also have to pay finance charges there is no need for any special rates or charges to pay off the loan principal.

As a bonus, inflation works in councils favour so that they can pay off debt and still build up some replacement reserves. Under current settings (finance charges=3.5% p.a., civil construction price index running at about 2% p.a.) an asset with a book life of 75 years will be paid off in about 45 years and will still attract depreciation for another 30 odd years which will help pay for replacement at a later date. And that is without doing anything special.

And in practice...?

Well that's the theory. Let's take another look at Hamilton City's books and see what they do in real life.

From their Ten Year Plan 2015-25 I am having a look at their Sewerage numbers. It's not that obvious but for the 2015-16 year they were budgeting for $9.9m operating surplus which was transferred immediately into the capital budget. Miles away in the footnotes they show depreciation for that activity at $8.1m so they purposefully collected $1.8m in surplus via rates and charges. Their Funding Policy declares that they may use rates income to pay off debt principal so that may be one reason for the surplus. But without having the real budget (enormous spreadsheets showing the real financials) it's pretty hard to see what's going on. There will almost certainly be recoveries for overheads like IT, HR and accounting built into these numbers but we can't tell how from the TYP.

Still, the point is that the vast majority of the surplus is depreciation. And what happens to that money? The primary source of funding for growth projects should be development and financial contributions but HCC's numbers show $5.5m being allocated to growth projects but only $2.9m of funding from those sources. Essentially some of the depreciation money is being used to fund new assets. This will be OK under a couple of circumstances:

1. HCC haven't split projects into growth and replacement components when they calculate how much they are spending on growth and how much on replacement. Most growth projects have an element of replacement as well.
2. There is no immediate need for replacement (i.e. the network is relatively young) so the capital can be put to better use now ( as long as they have done their homework and know when there needs to be money in the pot).

In real life funding capital projects is a bit messy. Hamilton City have chosen not to rely only on the designated funding stream for growth (financial and development contributions) and has dipped into some of their replacement funding. Bear in mind that there is no legal or accounting problem with that but they do have to think long-term about whether they will collect enough capital for replacing worn-out assets when the time comes. And, in places they have simply raised capital by rating for it.

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