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ANALYSIS: How the Town of Pelham ran out of cash

“Internal borrowing” explained by accountancy experts…for the rest of us

BY VOICE STAFF

She can see your eyes glazing over already. (The cake lady up there is watching your reaction.)

Municipal finances are so dull that most of us will read anything other than a news story about them.

Municipal finances are also of the utmost importance to town residents.

What a given municipality does with its money determines everything about life in that town—most fundamentally whether people want to move to it, or move away from it.

Because municipal money talk is so bloody boring, it’s easy for politicians to speak in bland soundbites, reassuring their constituents that all is well. After all, who will say otherwise?

We’ve once again called on our team of accountancy experts to help explain, in plain English, how the Town of Pelham got itself, and us, into the mess we’re in.

Why don’t we have any cash? Why are roads going unrepaired? Why are capital projects (i.e., new stuff) being delayed until 2019 or later?

In effect, the Town has robbed Peter to pay Paul—though don’t go calling the police just yet. The Town “internally borrowed” against its reserves. Now the reserves are essentially gone.

We’ve done our best to set out the following for the lay reader (and the lay editor). You’ll still have to wade through a few unfamiliar terms. But such is the price of knowledge. Here we go.

What is a reserve?

A reserve fund is a savings account set aside to meet future costs or unexpected events. The Town of Pelham has many reserve funds, from the water reserve, to the roads reserve, to the “physician recruitment” reserve.

The Town is supposed to use reserves to pay for future capital projects (new stuff) or to smooth out operating costs that can fluctuate (clearing snow in bad winters, etc.).

When reserves are dipped into, they are supposed to be replenished within a short period.

A reserve is supposed to be used for the purpose of its title. A Water Reserve is supposed to be used for water emergencies or future capital projects (new stuff, pipes, say) related to water. A Parkland Dedication Reserve is supposed to be on hand for parks.

What is meant by “Internal Borrowing”?

Internal borrowing is taking cash collected and set aside for one purpose, and spending it on something else. Borrowing internally means taking money from a reserve account (or something similar) and spending in a way that the reserve wasn’t intended for.

How much Internal Borrowing has the Town done?

Financial services firm KPMG, in its December report to Council, said that by of the end of 2016—13 months ago—the Town has internally borrowed some $11 million dollars. (Pelham’s entire proposed operating budget for 2018 is about $16 million dollars.)

Deposits and Deferred Revenue: $1.8 million
Deferred Development Charges and Parkland Fees: $3.4 million 
Reserve and Reserve Funds: $5.8 million

Total: $11 million

Town Treasurer Teresa Quinlin seemed to suggest in her presentation on November 29 at E.L. Crossley high school that this internal borrowing figure may be even higher at the end of 2017. We won’t know this, however, until the Town releases its 2017 financial statements several months from now.

Do reserve funds need to be repaid?

Yes.

At some point, actual money needs to be put back into each fund so that cash is in the bank to support the fund’s purpose. A reserve fund is supposed to be “liquid,” meaning that the money is readily available. The most liquid money is cash, since it can be gotten and spent at any time. Some investments, such as bonds, are also liquid since they can be converted back into cash easily. Real estate, roads, and buildings are not liquid and do not serve the purpose of a reserve fund.

Is “Internal Borrowing” specifically accounted for in the Town’s audited financial statements?

No.

The amount internally borrowed does not show up in any particular place on the Town’s audited financial statements. The amount internally borrowed is “offset” on the statements. This means that an asset (what the Town bought) and offsetting debt (where the Town got the money to pay for it) are “netted” against each other to make zero.

Hang on for some technical talk.

The reserves which are credit balances are fully shown on the balance sheet in the Liabilities and Surplus portion. The assets that the internal borrowing were spent on show up in the Capital Assets accounts (or other asset account they were used for), and the offsetting entry is simply shown as a reduction of the Cash balance on the balance sheet.

Back to English.

So the audited financial statements are correct?

Yes and no.

The amounts have been fully accounted for, so there is no technical misstatement. But it is difficult to judge the full extent of internal borrowing by looking at the statements alone.

The Town should have reduced the balances in certain reserves by the amount of money that was taken from them.

The Town could have—and likely should have—provided better explanations in the notes, specifying the amount of internal borrowing done. This way, anyone reading the financials could have easily seen what was happening.

The Town has said that the reserves are currently “represented by non-cash assets.” Is this an appropriate statement?

No.

If reserves are not represented by cash or similarly liquid assets, then the reserve balances cannot be used as reserves. They are essentially useless.

Is “Internal Borrowing” included in the Town’s long-term debt?

Officially, no. Practically, yes.

Money internally borrowed needs to be returned to the reserve account it came from. Otherwise, reserve accounts are useless. Rather than dip into reserve funds, if the Town had taken loans to pay for projects as had been approved by Council, then the Town’s official long-term debt would accurately reflect its total liabilities. Empty reserve funds are a liability.

How much debt did the Town have at the end of 2017, Including “Internal Borrowing”?

Adding the internal borrowing amount of $11.1 million provided by KPMG to the official long-term debt of $33.5 million, plus the Town’s 2017 line of credit of $3 million, the total comes to $47.6 milion dollars as far as we know now.

However, this figure could be even higher if additional internal borrowing occurred in 2017. The Treasurer has indicated that the Town did more internal borrowing in 2017 than it did in 2016.

Is the Town borrowing more money this year?

Based on loans already approved by the Region, the Town can receive an additional $15 million in 2018 to fund the remaining costs of the Community Centre. The 2018 budget currently being debated by Council does not include additional borrowing this year.

However, in December, Council approved an increase in its line of credit. More on that in a minute.

The budget does show that the Town intends pay off new radios it bought for the Fire Department. It will pay the City of St. Catharines $450,000 over 10 years—$45,000 per year from the operating budget. The Town has also entered into lease agreements on vehicles, rather than buying them outright.

These are non-optional payments. They will need to come from the operating budget each year, and may impact the Town’s annual debt repayment limit.

It’s not clear whether the Town will actually take the Region’s loan of $15 million, or how it will pay it back if it does.

The Treasurer’s cash flow report indicates that the current loans received for the Community Centre will run out at the end of January.

The Town hasn’t said whether surplus land on Highway 20 that was for sale late in 2017 has actually sold, even though bids closed on the property on December 14.

The Town had earlier said that the sale of surplus land would bring in $12 million dollars, and Community Centre fundraising would bring in an additional $3 million dollars. This would have allowed the Town to pay off the Region’s $15 million dollar loan (if it decides to take it) virtually immediately.

One fly in that ointment: Donations may be announced and “pledged,” but the cash doesn’t actually come in right away. Donations are to be collected over a multi-year period, and in any case the Town appears to be well short of its announced $3 million dollar goal.

Finally on the 2018 borrowing front, Council passed a resolution in December to increase its line of credit limit (a credit card on paper) from $3 million to $7 million.

This extra $4 million may be used to pay everyday operating expenses, or it may be used to fund the Community Centre project in lieu of taking more money from the Region. The Town isn’t saying.

How does the Town plan to pay back its “Internal Borrowing”?

In her presentation at E.L. Crossley, the Town Treasurer pointed to the following sources of cash to repay the internal borrowing:

Parkland Fees (from Developers): $3.6 million 
Stormwater Pond (from Developers): $1.4 million 
Wellspring Remnant Land Sale: $1.1 million
Summersides Road (Developers): $1.7 million

Subtotal: $7.8 million

Loans to be taken out in 2019: $9.9 million 

TOTAL: $17.7 million dollars

We have asked the Town and the Treasurer specifically which developers and over what timeframe the above amounts are expected to be recovered. No details have been provided.

Parkland fees likely will not replenish the Parkland fund amounts borrowed in 2016 and earlier. It appears that 1200 new homes would have to be built to recover $3.6 million dollars, and while contractors are out there beavering away, we will not see 1200 new houses constructed in Pelham in the next 12 months—or possibly ever.

As for taking out a loan in 2019 to pay off internal borrowing done in 2017 and earlier, that’s like getting a cash advance on one credit card to pay off the balance on another credit card. It does not reduce the Town’s debt. It just shifts it from one category to another.

Council is now debating the 2018 capital budget.

The proposed budget drastically cuts back expenses compared to what the Town projected it would spend this year.

At the same time, capital projects (buying and repairing stuff) have been delayed to 2019 and beyond, and these projected expenses are much higher than were first proposed for this year.

This raises an obvious question: How will these projects be paid for? The options are three: More internal borrowing, more loans taken out, or more property tax increases.

Unusually, in her draft 2018 budget, Treasurer Quinlin has not included any five-year projections of reserves.

In past years, these projections have been included. They take into account funding sources, use of development charges, parkland dedication fees and projected capital spending.

When asked why these projections were omitted, Quinlin did not answer, replying instead to a question that wasn’t asked.

Did CAO Darren Ottaway, former Treasurer Cari Pupo, Mayor Augustyn, and Council know that “Internal Borrowing” was happening?

When KPMG told Council that the Town’s reserve funds were largely depleted, neither the Mayor nor CAO Darren Ottaway seemed surprised. This is according to former Councillor Marvin Junkin’s recollection of the closed-door, September 5 meeting at which Council received the news.

It is next to impossible that former Treasurer Pupo and CAO Ottaway were unaware that internal borrowing was occurring.

Junkin said that he and his fellow councillors were taken by surprise. Another witness described a shocked silence greeting the news.

Why would the Town use “Internal Borrowing” to pay for things rather than getting a loan to do so?

As we’ve seen, internal borrowing isn’t technically (legally) considered long-term debt.

By borrowing internally, rather than getting loans, the Town appeared to outsiders to have less debt than it did.

Had this long-term debt been shown on its balance sheet, the Town’s borrowing limit would have been lower.

In 2016, the Region approved a $36 million loan for the new Community Centre.

This may explain former Councillor Junkin’s account of the closed-door meeting on September 5. Junkin says that the Treasurer told Council that if Infrastructure Ontario had known about the internal borrowing, the $36 million loan would likely not have been approved, not without special Ontario Municipal Board action.

So why does all this matter?

The bottom line is that the Town spent nearly all of its reserve funds, when, in most cases, it should have used loans to pay for projects. Loans were what Council initially approved.

Internal borrowing made the Town’s debt look lower than its actual liabilities.

This misrepresentation likely allowed the Town to qualify for a $36 million dollar loan that it would not otherwise have received.

The decision to empty its reserve funds, rather than seek loans, has already put the Town in a risky position. The Town now has little flexibility to adapt to unforeseen circumstances. This is seen in Poth Street and Sulphur Springs Drive, two public roads that are likely to be closed for years because the Town has no money to repair them.

Finally, the financial strain on the Town likely means that there will be little money for capital projects (buying and repairing stuff) in the coming years. Expensive leasing of equipment, vs. purchasing, will be the new normal.

Concludes one of our accountancy team members:

“By borrowing so extensively from the reserves, the Town has positioned all projects at likely the same risk level as the Community Centre. I would rate the risk level of the Community Centre in the high to extreme range. This risk is based on expected shortfalls, in my estimation, in real estate proceeds, donations, and operating losses. I would expect a combined shortfall of $10 million over five years and $15 million over 10 years. The closure of roads tells us that we cannot fund repairs to the infrastructure we already have.  More taxes and reduced real estate values are on the horizon.”

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