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 early the 1990’s, the scheme has become a major element of private sector involvement in the UK’s 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. 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-one’s balance sheet. Is there any guidance for auditors that show how PFI/PPP contracts should be correctly accounted for by the public sector? Within 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’. The objective of FRS5 is to ensure that the substance of an entity’s transaction is reported in its financial statements rather than the strict legal form.

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) • 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 FRS5 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 FRS5 that allows more off balance sheet outcomes. After pressure from the Financial Reporting Advisory Board and others, 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. • Currently, efforts are being made to develop relevant accounting standards applicable on an international level. Interpretations of the International Financial Reporting Standards (IFRS) are being drafted and are expected to be issued in early 2007. The interpretations are only, strictly speaking, applicable to the private sector. 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 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 • Contractor’s margin and financing costs outweigh efficiency savings. • Inflexible, long-term contracts. • Inappropriate risk transfer. • Off balance sheet accounting.

7. 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.

8. 4. Application of FRS5 Introduction to FRS5 – 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’. FRS5 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 FRS5 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 FRS5 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 FRS5 there are application notes showing how to apply FRS5 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.

9. 4. Application of FRS5 (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 SSAP21 ‘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 FRS5 rather than SSAP21. • 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.

10. 5. Whose Balance Sheet? The factors or risks that might affect balance sheet treatment. The FRS5 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 property’s operational life. The following pages elaborate on the above factors.

11. 5. Whose Balance Sheet (Cont.)? Application of FRS5 • Assuming that FRS5 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 contractis terminated early are:

12. 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 sector’s balance sheet.

13. 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 require 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 sector’s 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 sector’s 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.

14. 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 sector’s costs. • Conversely, where the private sector’s 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.

15. 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.

16. 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.

17. 7. Public or Private - Flow Chart Can the contract be separated into asset and service elements? 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 Yes After excluding separable service elements, is the remaining element only for the asset itself? No Yes No Apply accounting treatment for leases Apply FRS5 – 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.

18. 8. International Accounting Standards International developments • The accounting treatment of PFI deals has been scrutinised. • As at September 2006, this issue is being looked at 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 produced draft interpretations concerning the accounting treatment of “Service Concession Arrangements”. These draft interpretations (numbers 12-14) are, strictly speaking, only applicable to the private sector operators, providing guidance on the balance sheet and profit and loss accounting in the contractor’s accounts. • The draft interpretations are 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 the services the private sector operator provides, and - has the residual interest in the fixed asset, which is significant then the fixed asset is deemed to belong on the public sector’s balance sheet.

19. 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. Eurostat’s main aim is to promote harmonisation of statistical methods across the member states.

20. 9. Statistically Based National Accounts (cont.) Public or Private Entity • ESA95 uses the concept of control rather than ownership to determine if an entity belongs in the public or private sector. This is 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 FRS5 section) 3.Demand risk – (as explained under the FRS5 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.

21. 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 public sector balance sheet 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. • Contractor’s 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 (a treatment that was symmetrical with the private sector operator’s 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 – FRS5 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 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. • In the UK, there are guidelines set out by the Accounting Standards Board and the Treasury which aim to clarify the balance sheet treatment of PFI assets. • As at September 2006 IFRIC, which is part of the International Accounting Standards Board (IASB), is aiming to develop a set of high quality, understandable and enforceable global accounting standards for PFI and similar projects. These standards, strictly, will only have to apply to the private sector. • The major issue relating to the accounting treatment of PFI deals is whether the private or the public sector bears the risks. • 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 http://www.hm-treasury.gov.uk/media/8e294/ppp_ttf_technote1.pdf • Application Note F – Private Finance Initiative and Similar Contracts –Issued 1998 http://www.frc.org.uk/images/uploaded/documents/frs_5_amendment.pdf • Evaluating the operation of PFI on roads and hospitals: Association of Chartered Certified Accountants, Research Report 84,1999 http://image.guardian.co.uk/sys-files/Society/documents/2004/11/24/PFI.pdf • Management Paper - Building for the future – the management of procurement under the private finance initiative: Audit Commission, June 2001. http://www.audit-commission.gov.uk/Products/NATIONAL-REPORT/2DEA4286-58A0-4d5a-A2DA-3DE70F2CEEC3/BuildingfortheFuture.pdf • Accounting treatment of Network Rail Ltd - www.hm-treasury.gov.uk/media/86F/45/rail_accounting062002.pdf http://www.hm-treasury.gov.uk/media/86F/45/rail_accounting062002.pdf • Meeting the investment challenge, HM Treasury, July 2003 http://www.hm-treasury.gov.uk/media/648B2/PFI_604.pdf • Local Government and the Private Finance Initiative - Department of the Environment, Transport and the Regions http://www.local.odpm.gov.uk/pfi/index.htm • Guardian website - http://society.guardian.co.uk/privatefinance http://society.guardian.co.uk/privatefinance • International Federation of Accountants (IFAC) website - www.ifac.org http://www.ifac.org • Public Finance website – www.publicfinance.co.uk http://www.publicfinance.co.uk • International Accounting Standards Board website – www.iasb.org http://www.iasb.org