INTOSAI Privatisation Working Group PWG

1
INTOSAI Privatisation Working Group (PWG)

• Technical case study
• Series 2 PPP

1. Accounting for PFI/PPP Projects
2
Table of Contents

• SUMMARY
• 1. Defining Characteristics of PFI/PPP Deals 5
• 2. Some Potential Benefits/Dangers of
  PFI/PPP 6
• 3. The Accounting Issue for the Public
  Sector 7
• 4. Application of FRS5 8-9
• 5. Whose Balance Sheet? 10-11
• 6. Risk Factors 12-15
• 7. Public or Private? 16-17
• 8. International Accounting Standards 18
• 9. Statistically Based National Accounts
  19-20
• 10. Case Studies 21-24
• CONCLUSION 25
• REFERENCES 26

3
Summary
PFI/PPP is being used internationally to deliver
investment in new public sector projects PFI/PPP
has been used to fund major new public
investment, including schools, hospitals, prisons
and roads. Introduced back in the early 1990s,
the scheme has become a major element of private
sector involvement in the UKs public
services. Under PFI/PPP, a capital project such
as a school is designed, built, financed and
managed by a private sector consortium, under a
long term contract to provide services. In
return, once the development is operational, the
contractor is paid a single unitary payment in
each period, usually relating to availability and
performance. There are advantages and
disadvantages of PFI/PPP. This technical case
study primarily focuses on the accounting
treatment of PFI/PPP projects rather than the
merits of PFI/PPP itself. Accounting for
PFI/PPP contracts is often not straightforward in
practice The accounting issue is whether the
fixed asset and the associated finance should be
counted as on or off the public sector balance
sheet. Under current UK accounting standards,
analysis of who bears the risks is relevant. The
key risks are usually demand risk and residual
value risk. There can be incentives on the
public sector to seek off balance treatment even
when this is not appropriate. In the UK this has
sometimes resulted in inappropriate and
inconsistent treatment. There are examples of an
asset and the associated finance being on
no-ones balance sheet. This may change as the UK
public sector moves towards adopting
International Financial Reporting Standards
principles, which are based more on who controls
or regulates the services the asset provides.
The UK governments 2007 Budget Statement has
said that it will adopt International Financial
Reporting Standards, interpreted as appropriate,
for the public sector from 2008/09 and a revised
draft of the UK Treasury guidance is due in
December 2007.
4
Summary (cont.)

• Is there any guidance for auditors that show how
  PFI/PPP contracts should be correctly accounted
  for by the public sector? (cont)
• Within the UK, the public sector accounting
  treatment of PFI projects is currently governed
  by an Application Note Private Finance
  Initiative and Similar Contracts to the
  Financial Reporting Standard No. 5 Reporting
  the substance of Transactions. The objective of
  FRS 5 is to ensure that the substance of an
  entitys transaction is reported in its financial
  statements rather than the strict legal form.
• The Treasury has produced its own guidance on PFI
  in the form of the Treasury Technical Note 1
  (TN1) How to account for PFI Transactions.
  Whilst it was based upon FRS 5 and provides
  practical guidance on how the standard should be
  applied, some advisors and auditors have taken
  the view that it represents an alternative source
  of guidance to FRS 5 that allows more off balance
  sheet outcomes. In light of the plan to adopt
  International Financial Reporting Standards
  (IFRS) based accounting for the UK public sector
  from 1 April 2008 it is likely that the Technical
  Note will be withdrawn.
• A number of EU states have favoured the use of
  statistically based information to produce
  national accounts. Statistically based National
  Accounts in the European Union states follow the
  European System of National and Regional Accounts
  (ESA). This is an internationally compatible
  accounting framework for systematic and detailed
  description of a total economy (that is a region,
  country or group of countries), its components
  and its relations with other total economies. It
  was most recently updated in 1995. ESA95 uses
  the concept of control to decide if an entity
  belongs to the public or private sector to some
  extent this requires judgement and can lead to
  different auditors reaching different
  conclusions.
• There is no IFRS for the public sectors
  treatment of PFI, although the relevant standard
  for the private sector operators, the
  International Financial Reporting Interpretations
  Committees Interpretation no 12 (IFRIC 12)
  Service Concession Arrangements, sets out some
  relevant principles. Hence this case example for
  accounting for PFI transactions will be largely
  UK focussed, though many issues that arise will
  certainly be applicable to other nations.

5
1. Defining characteristics of PFI/PPP deals

• Contract for private sector participation in the
  development, financing and operation of public
  projects.
• Public sector purchases services from a private
  sector contactor who Designs, Builds, Finances
  and Operates the relevant infrastructure.
• Long-term contract to provide a specified level
  of services.
• Single (unitary) payment made in each period,
  linked to factors such as availability and
  performance. Payment is only made once the
  service is operational, i.e. after construction
  of the associated asset.
• The contract specifies arrangements for the
  property at the end of the contract term.
• Various operational risks transferred are to the
  contractor.

6
2. Some potential benefits/dangers of PFI/PPP

• Benefits
• Allocation of those risks to the private sector
  that it is better at dealing with.
• Better integration of design, construction and
  operation.
• Less prescriptive specifications more
  innovation.
• Dangers
• Contractors margin and financing costs outweigh
  efficiency savings.
• Inflexible, long-term contracts.
• Inappropriate risk transfer.
• Off balance sheet accounting.

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3. The accounting issue for the public sector

• Should the fixed asset and the associated finance
  be On or Off Balance Sheet?
• Why is the accounting an issue?
• Macro considerations
• Public expenditure and borrowing statistics.
• (e.g. in the UK Maastricht criteria and the
  Sustainable Investment rule)
• Micro considerations
• Departmental cash and capital budgets
  (affordability)
• The danger of deals being constructed to count
  as off balance sheet when this is not
  appropriate eg the State retains too little
  control compared to responsibilities.

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4. Application of FRS 5

• Introduction to FRS 5 Substance over Form
• In the UK the accounting treatment of PFI
  projects is governed by an Application Note
  Private Finance Initiative and Similar
  Contracts to the Financial Reporting Standard
  No. 5 Reporting the substance of
  Transactions. FRS 5 sets out to ensure all
  assets and liabilities are fully disclosed and
  that the financial statements provide a true and
  fair view. Only assets that are deemed
  off-balance sheet items should be excluded.
• The underlying principle of FRS 5 is known as
  substance over form and its aim is to reflect
  the true commercial effect of a transaction that
  may not be adequately expressed by its legal
  form.
• A example to illustrate this is when a company
  issues redeemable preference shares to investors.
  These shares will pay out a fixed amount of
  dividend per year up until the preference shares
  are redeemed by the investor. A share issue
  transaction has taken place in legal terms, but
  in substance, the redeemable preference shares
  are like a loan the dividend payments act as
  interest payments. Hence the share issue will be
  reflected in the accounts as a liability rather
  than share capital.
• A central principle of FRS 5 is that the risks
  inherent in the benefits provided by an asset
  determine which entity has the asset. A party
  will have an asset of the property where that
  party has access to the benefits of the property
  and exposure to the risks inherent in those
  benefits.
• As an addendum to FRS 5 there are application
  notes showing how to apply FRS 5 to particular
  transactions. Following debate about the
  accounting treatment of PFI, the Accounting
  Standards Board (ASB) published Application note
  F to aid in the accounting of PFI and similar
  contracts.

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4. Application of FRS 5 (cont.)

• Application note F Private Finance Initiative
  and similar contracts
• Application note F clarifies the question of
  separability within contracts and which potential
  variations in profits (and losses) should be
  taken into account when determining whose balance
  sheet the asset should be disclosed on.
• A contract is separable if payments can be
  separated into elements covering the payment for
  the asset itself and other services provided
  (e.g. services such as laundry and catering etc).
  These separable service elements are excluded
  from the decision of where the asset should be
  disclosed.
• Once any separable service elements have been
  excluded, PFI contracts can be classed into
• (a) those where the only remaining elements are
  payments for the property. These will be akin to
  a lease and SSAP 21 Accounting for leases and
  hire purchase contracts should be applied.
• (b) other contracts where the remaining
  elements include some services. These contracts
  will fall directly within FRS 5 rather than
  SSAP 21.
• At this point it is important to understand and
  decide on whose balance sheet (private or public
  sector) the fixed asset is to be shown on. This
  is decided by the extent to which each party
  bears the potential variations in profits (or
  losses). Only those variations that relate to
  the asset can be included for the purpose of this
  analysis.
• It will therefore be necessary to assess all
  factors that can affect the variation in profits
  relating to the asset.

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5. Whose Balance Sheet?

• The factors or risks that might affect balance
  sheet treatment.
• The FRS 5 risk analysis looks to establish who
  will bear the risks (potential variations in
  profits/losses) associated with the asset.
• The principal factors that, depending on the
  particular circumstances, may be relevant are
• Demand risk the risk that demand for the asset
  will be greater or less than expected
• The presence, if any, of third-party revenues
• Who determines the nature of the property (design
  risk)
• Penalties for underperformance or
  non-availability
• Potential changes in relevant costs
• Obsolescence, including the effects of changes in
  technology
• The arrangements at the end of the contract and
  residual value risk the risk that the actual
  residual value of the asset at the end of the
  contract will be different from that expected.
• It should be noted that construction risk who
  bears the financial implications of cost and time
  overruns during the
• construction period (and related warranty repairs
  caused by poor building work after the asset has
  been completed) is not
• generally relevant to determining which party has
  an asset of the property once construction is
  completed, because such
• risk normally has no impact during the propertys
  operational life.
• The following pages elaborate on the above
  factors.

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5. Whose Balance Sheet (Cont.)?

• Application of FRS 5
• Assuming that FRS 5 is applicable the Application
  Note sets out a number of factors or risks that
  could affect the property related profits/losses.
  Two other indicators based on the financing of
  the contract and arrangements if the contract is
  terminated early are

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6. Risk Factors

• Demand Risk
• This is the risk that demand for the asset will
  be greater or less than predicted/expected.
  Where demand risk is significant, it will
  normally give the clearest evidence of who should
  record an asset on their balance sheet. For
  example, the demand for hospital beds by patients
  may be less or more than what was predicted.
• The length of the contract may influence the
  significance of demand risk, since it is
  difficult to forecast for later periods.
• Once it is established that demand risk is
  significant, it is necessary to determine who
  will bear it.
• Third Party Revenues
• A feature of some PFI contracts is that the asset
  in question may be used by third parties. Where
  the private sector partner relies on revenues
  from third parties to cover its property costs,
  this is evidence that the asset should be on
  their balance sheet.
• Conversely if third party usage is minimal or is
  restricted by the public sector then this is
  evidence that the asset should be on the public
  sectors balance sheet.

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6. Risk Factors (cont.)

• Who determines the nature of the property/Design
  Risk
• If the public sector determines the key features
  of the asset and how it will be operated, this is
  evidence that the asset should be on their
  balance sheet. Conversely if the private sector
  has significant ongoing discretion over what
  property is to be built and how it will be
  operated, that indicates that the asset belongs
  on their balance sheet. In this case the private
  sector is bearing design risk.
• This is defined as the risk that the design of
  the asset is such that, even if it is constructed
  satisfactorily, it will not fully meet the
  requirements of the contract.
• One of the key features of a PFI transaction is
  that the Private sector partner can make
  investment decisions concerning the design and
  build of the asset (before, during and after
  construction) that affect operational efficiency
  during the life of the contract.
• For example, the private sector partner may
  choose to use more expensive insulating materials
  and triple glazing to improve the energy
  efficiency of a building during the operating
  phase. If the design solution is not as energy
  efficient as expected the private sector may need
  to spend more on heating costs to maintain the
  asset at the required temperature range.
• Penalties for underperformance or
  non-availability
• Many PFI contracts provide for penalties if the
  asset is below a specified standard or is
  unavailable because of private sector default (It
  should be noted that penalties relating purely to
  services, such as catering and laundry, however,
  are not relevant and should not be brought into
  the assessment). For example, in a PFI contract
  involving a catering service, penalties caused by
  a leaking kitchen roof are relevant but penalties
  due to meals being too small are not.
• Where potential penalties are not significant
  i.e. they will not affect the private sectors
  profits (e.g. the contract itself gives the
  private sector ample time to rectify a fault),
  this provides evidence that the asset belongs to
  the public sector.
• Conversely if potential penalties are significant
  in that they can affect the private sectors
  profits then this would provide evidence that the
  asset belongs on their balance sheet . For
  example, a PFI contract for a road may contain
  penalty clauses if lanes are closed for
  maintenance for more than a specified period.

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6. Risk Factors (cont.)

• Potential changes in relevant costs
• These relate only to property costs and not
  changes in service costs. PFI contracts may deal
  with potential relevant costs in different ways.
  Relevant costs includes any planned expenditure
  on the property itself, such as
• replacement of parts of the fabric of the
  building (e.g. windows)
• replacement of certain items of plant, machinery
  and equipment
• property maintenance
• The contract may have the effect that any
  significant future cost increases can be passed
  on to the public sector, which would be evidence
  that the property is an asset of the public
  sector. For example, this would be the case
  where the PFI payments will vary with specific
  indices so as to reflect the private sectors
  costs.
• Conversely, where the private sectors costs are
  both significant and highly uncertain, and there
  is no provision for cost variations to be passed
  on to the public sector, then this is evidence
  that the property is an asset of the private
  sector. For example, this would be the case
  where the payments are fixed or vary in relation
  to a general inflation index such as the Retail
  Prices Index in the UK.
• Obsolescence, including the effects of changing
  in technology
• This may be relevant depending on the nature of
  the contract. For PFI deals involving
  information technology systems this will be of
  great significance as to who bears the future
  costs associated with obsolescence or changes in
  technology. In other cases like roads contracts,
  the issue of obsolescence will not be so
  relevant.
• Where the potential for obsolescence or changes
  in technology are significant, the party that
  bears the cost and any associated benefits will
  be the one that should be most likely to have the
  asset on their balance sheet.

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6. Risk Factors (cont.)

• Arrangements at the end of the contract and
  Residual Value Risk
• Residual risk is the risk that the actual
  residual value of the asset at the end of the
  contract will be different from that expected.
  The risk is more significant the shorter the PFI
  contract is in relation to the useful economic
  life of the asset.
• Where this risk is significant, who bears it will
  depend on the arrangements at the end of the
  contract. For example, the public sector will
  bear the residual value risk where
• - it will purchase the asset for a
  substantially fixed or nominal amount at the end
  of the contract
• - the property will be transferred to a new
  private sector partner, selected by the public
  sector, for a substantially fixed or
  nominal amount or
• - payments over the term of the PFI contract
  are sufficiently large for the private sector not
  to rely on an uncertain residual value for
  its return.
• Conversely, the private sector will bear residual
  value risk where
• - it will retain the asset at the end of the PFI
  contract or
• - the asset will be transferred to the public
  sector or another private sector partner at the
  prevailing market price.

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7. Public or Private?
In determining whether each party has as asset,
it will not be appropriate to focus on one
feature in isolation. Rather, the combined
effect of all relevant factors should be
considered for a range of reasonably possible
scenarios, with greater weight being given to
more likelier outcomes.
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7. Public or Private - Flow Chart

• This flow chart summarises the
• decision route that should be taken
• in order to assess the balance sheet
• treatment between the public sector
• and the private sector under the UK
• accounting standard FRS 5

Can the contract be separated into asset and
service elements?
Yes
After excluding separable service elements, is
the remaining element only for the asset itself?
No
Yes
No
Apply accounting treatment for leases
Apply FRS 5 assess who has the benefits and
risks of the property.
Private Sector
Public Sector
Public sector recognises asset and liability to
pay for it. Private sector recognises a debtor.
Public sector does not recognise asset.
Private sector recognises asset.
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8. International Accounting Standards

• International developments
• The accounting treatment of service concession
  arrangements has been scrutinised by the
  International Financial Reporting Interpretations
  Committee (IFRIC) of the International Accounting
  Standards Board (IASB). The IASB is committed
  to developing, in the public interest, a single
  set of high quality, understandable and
  enforceable global accounting standards that
  require transparent and comparable information in
  general purpose financial statements.
• IFRIC have published Interpretation no 12 in
  November 2006 concerning the accounting treatment
  of Service Concession Arrangements. This
  interpretation is, strictly speaking, only
  applicable to the private sector operators,
  providing guidance on the balance sheet and
  profit and loss accounting in the contractors
  accounts.
• The interpretation is based on the concept of
  control rather than risk and rewards. For assets
  used to provide services to the public, If the
  public sector body
• controls or regulates what services the operator
  must provide with the infrastructure, to whom
  it must provide them, and at what price and
• - controls - through ownership, beneficial
  entitlement or otherwise any significant
  residual interest in the infrastructure at the
  end of the term of the arrangement
• then the fixed asset is deemed NOT to belong on
  the operators balance sheet (and by implication
  should be on the public sector bodys balance
  sheet).
• The Interpretation is seen by some in Europe as
  controversial and has yet to achieve EU
  endorsement. The UK public sector is moving
  towards adopting the International Financial
  Reporting Standards principles. The UK
  governments 2007 Budget Statement has said that
  it will adopt International Financial Reporting
  Standards, interpreted as appropriate, for the
  public sector from 2008/09 and a revised draft of
  the UK Treasury guidance is due in December 2007.

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9. Statistically Based National Accounts

• National Accounts
• The national accounts are an internationally
  comparable accounting framework that describes
  the activities in a national economy, including
  the transactions that take place between sectors
  of that economy.
• The Office for National Statistics, ONS produce
  the national accounts for the UK they are
  compiled on a legal basis following a 1996
  regulation from the Council of the European
  Union.
• The relevant international manuals are the
  European System of Accounts 1995 (ESA95) and the
  System of National Accounts 1993 (SNA93), which
  ESA95 is based on.
• ESA95 is designed as an integrated system of
  economic statistics that are broken down into
  broad sectors (e.g. government, households and
  corporations). They record the economic activity
  of those sectors rather than the individual
  entities within them. It is not used to account
  for individual entities.
• National Accounts based on ESA95 are used for
  international comparisons within Europe, and
  because it is based on SNA93, can be used for
  worldwide comparisons.
• The Statistical Office of the European
  Communities, Eurostat is the statistical arm of
  the European Commission. They produce data for
  the European Union by using the data provided
  from the statistical offices of the member
  states. Eurostats main aim is to promote
  harmonisation of statistical methods across the
  member states.

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9. Statistically Based National Accounts (cont.)

• Public or Private sector asset
• ESA95 uses the concept of control rather than
  ownership to determine if an entity or asset
  belongs in the public or private sector. But it
  treats this as effectively similar to analysing
  the risk transfer between the public and private
  sector.
• It recommends that assets involved in PFI deals
  should be off balance sheet for government, if
  both of the following conditions are met
• 1. the private partner bears the construction
  risk, and
• 2. the private partner bears at least one of
  either availability or demand risk.
• If the above criteria is not met then the asset
  is deemed to be a government asset and should be
  present on their balance sheet.
• Analysis of risks in PFI
• Many risks may be observed in practice under a
  PFI contract, hence Eurostat have selected three
  main categories of
• generic risks
• 1. Construction risk covers risk as to who
  bears the financial implications of cost and time
  overruns during the construction
  period
• 2. Availability risk (as explained under the
  FRS 5 section)
• 3. Demand risk (as explained under the FRS 5
  section)
• Eurostat is of the opinion that information on
  such risks can easily be obtained by
  statisticians and that the burden of the
  different risks is generally identifiable in the
  contracts.

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10. Case study 1

• Major Office Refurbishment
• Complete refurbishment of existing,
  architecturally listed, office buildings
• Provision of accommodation services therein over
  30 years for 4,300 staff
• Capital spend 500m
• Services such as management services considered
  not separable, thus application of FRS5 required.
  
• This PFI contract was deemed to be on the
  relevant UK public sector departments balance
  sheet, under FRS 5, as the public sector retained
  demand and residual value risk and these were
  considered to outweigh the other risks.

22
10. Case study 2

• PFI contract for custodial facility
• Assumed useful economic life of building more
  than 25 years, Design, Construct, Manage and
  Finance contract. Planned size - 800
  individuals.
• Contractors accounting of capital cost under FRS
  5 - as a finance debtor.
• Contractor provides
• Security
• Staffing
• Maintenance and repair
• Medical and health care assistance
• Drug tests and treatment programme
• Educational programme
• Contract length 30 years, after which asset
  reverts to public sector. Built on public sector
  land.
• Maintenance lifecycle costs 500k per annum
• Contract payment 25m per annum
• This PFI property asset was deemed to
  be on the public sector balance sheet under FRS 5
  (a treatment that was symmetrical with the
  private sector operators decision to account for
  the capital asset as a finance debtor). One
  factor in the decision was the difficulty in
  predicting likely demand.

23
10. Case study 3

• New Build Offices
• New build landmark building, some degree of
  specialisation
• 35 year contract
• Service elements were not all separable FRS 5
  was therefore applicable
• Reversion to purchaser at nil cost, in defined
  condition. Expected depreciated replacement cost
  200m
• No third party revenue, obsolescence risk
  considered small
• 95 debt funded
• This PFI contract is on the public sector
  balance sheet

24
10. Case study 4

• Flight Simulator and associated training services
• Provision of a comprehensive training programme
  for a particular aircraft type
• Major capital equipment requirement is several
  flight simulators, capital spend 50m
• Contract length 30years but with public sector
  option to walk away at year 20.
• This PFI contract would probably be deemed to be
  off balance sheet for the public sector under FRS
  5 as the private sector has taken on a
  substantial element of demand risk and the
  residual value risk.

25
Conclusion

• The accounting treatment of Private Finance
  Initiative contracts can be complex and has
  proved controversial.
• The major determinant of the accounting treatment
  of PFI deals under the UK accounting standard FRS
  5 has been whether the private or the public
  sector bears the majority of the risks associated
  with the PFI fixed asset.
• In the UK, guidelines set out by the Treasury,
  which aimed to clarify the balance sheet
  treatment of PFI assets under the FRS 5
  accounting standard, have not led to consistent
  treatment either between the public and private
  sectors or within different parts of the public
  sector.
• The UK PFI accounting guidance for the public
  sector will need to be revised for 2008/09
  accounts onward as the UK public sector moves to
  produce accounts based on international financial
  reporting standards.
• The relevant international accounting guidance,
  IFRIC Interpretation no 12, is strictly only
  applicable to the private sector operators. But
  if the UKs Treasury decides to apply the
  principles of the Interpretation to the public
  sector, then it is possible that there will be
  some clear guidance under which it would be
  expected that most PFI project fixed assets would
  be on the public sector balance sheet.
• It is important to ensure that the PFI contract
  is value for money rather than whether or not it
  can be excluded from the public sector balance
  sheet.

26
References

• Treasury Technical Note No. 1 How to account
  for PFI Transactions
• ASB FRS 5 Application Note F Private Finance
  Initiative and Similar Contracts Issued 1998
• Evaluating the operation of PFI on roads and
  hospitals Association of Chartered Certified
  Accountants, Research Report 84,1999
• Management Paper - Building for the future the
  management of procurement under the private
  finance initiative Audit Commission, June 2001.
• Accounting treatment of Network Rail Ltd
  -www.hm-treasury.gov.uk/media/86F/45/rail_accounti
  ng062002.pdf
• Meeting the investment challenge, HM Treasury,
  July 2003
• Local Government and the Private Finance
  Initiative - Department of the Environment,
  Transport and the Regions
• Guardian website - http//society.guardian.co.uk/p
  rivatefinance
• International Federation of Accountants (IFAC)
  website - www.ifac.org
• Public Finance website www.publicfinance.co.uk
• International Accounting Standards Board website
  www.iasb.org