Public Private Partnerships Private Finance Initiative Accounting UK Experience

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Public Private Partnerships Private Finance
Initiative Accounting UK Experience

• 28 November 2007

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Overview of Privative Finance Initiative What is
PFIHistory and statisticsAccounting for PFI -
UK GAAPAccounting for PFI - The future under
IFRS
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What is PFI?

• Arrangement for the public sector to contract to
  purchase services from the private sector on a
  long term basis
• Often 15 to 30 years
• Private sector will construct and maintain
  infrastructure to deliver the required services
• Development phase followed by operational phase
• Private sector will contract through a special
  purpose company
• The SPV will use private finance, mix of equity
  and limited recourse debt

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What is PFI?

• The SPV is paid a fee referred to as the
  unitary charge or payment
• Unitary charge covers principal and interest on
  the debt, the services delivered and a return to
  the private sector shareholders
• Unitary charge normally commences after
  completion of the infrastructure assets and then
  paid over the rest of the contract life
• Unitary charge is at risk if the contractors
  performance falls below required standard or if
  the asset is unavailable
• Private sector bears cost overruns, delay and
  service standard risks

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What is PFI?

• Only certain projects are suitable for PFI
• Projects are required to show that they are value
  for money (VfM)
• Projects should have a major capital investment
• The value of the project should be large to
  ensure that procurement costs are not
  disproportionate
• The technology should be stable and not
  susceptible to fast paced change
• Need confidence that assets and services will be
  used over the entire contract term

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History and statistics

• Total capital value of UK PFI projects from 1987
  to date is 56.9 bn (US 116.6 bn) 11 of UK net
  debt
• UK public sector net debt 2006/2007 500 bn (US
  1025 bn)
• 1987 value completed 369 m
• 1987 1996 value completed 4.4 bn
• 1997 - 2007 value completed 112.2 bn
• Highest level of completion was 2003 33 bn but
  this has fallen to 14.6 bn for 2006

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History and statistics by sector

• Transport 46.6 bn (roads and rail)
• Health 20.5 bn (includes 34 new hospitals)
• Defence 11.8 bn
• Education 9.8 bn (includes 200 new and
  refurbished schools)
• These sectors represent 76 of PFI capital value
  in the UK and 86 in England (Scotland/Wales and
  Northern Ireland 13.4 bn)

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Typical PFI contract

• The private sector contractor is engaged to
  design and build a school and to provide
  maintenance services as well as cleaning and
  catering
• The property will take two years to build and
  then the contract runs for another 28 years
• At the end of the 30 year term the school passes
  to the public sector for nil consideration
• Payment is by way of a unitary charge for all
  works and services from the local government (
  the purchaser) to the contractor payable monthly
  over 28 years once the school is built
• Unitary payments are fixed subject to deductions
  for failure to perform services of the property
  not being available

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Accounting for PFI contracts

• Current UK GAAP accounting
• Proposed change to IFRS from April 2008

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Accounting for PFI UK GAAP

• Relevant pronouncements are
• a) Financial Reporting Standard 5 Reporting the
  substance of transactions Application Note F
  Private finance initiative and similar contracts
  (FRS 5 ANF), and
• b) Treasury Taskforce Technical Note 1 How to
  account for PFI transactions (TN1)
• TN1 should be used by public sector purchasers to
  determine the accounting treatment of a PFI
  transaction
• FRS 5 ANF applies to both purchasers and
  contractors
• TN1 should be read in conjunction with FRS 5 ANF
  and uses the same terminology for consistency

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Accounting for PFI UK GAAP

• Debate as to whether TN1 is an interpretation of
  FRS 5 ANF or is in effect a separate statement of
  guidance
• TN1 uses the same terminology and closely refers
  to the paragraphs in FRS 5 ANF and states that it
  provides guidance on how to apply FRS 5 ANF
• However, there are clear differences which will
  in many cases lead to different accounting
  treatments for the same transaction

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Accounting for PFI FRS 5 ANF

• Contracts for services are not capitalised
• Where a property is needed to fulfil the service
  it is necessary to determine which party
  (purchaser or operator) should record the
  property
• General principal, a party will have a property
  asset where it has access to the benefits of the
  property and exposure to the risks
• If the contract is separable any separable
  service elements are treated independently
• If the remaining elements of the arrangement are
  akin to a lease for property SSAP 21 for lease
  accounting is used
• Other contracts ( most PFI arrangements) fall
  within FRS 5

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Accounting for PFI Separation of contract

• Separation is required where
• a) payment streams vary according to availability
  of property and a separate element varies
  according to usage or performance of services
• b) different parts of the contract run for
  different periods or can be terminated separately
• c) different parts of the contract can be
  renegotiated separately eg market testing on
  service elements such as repairs and maintenance
• Most contracts are not separated (other that
  utility payments), therefore most fall within FRS
  5 ANF

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Accounting for PFI How to apply FRS 5

• Establish which party bears the majority of
  potential variations in property related profits
  and losses
• Include repairs, maintenance and other property
  related services but exclude cleaning, catering
  etc
• Greater weight to factors more likely to have
  commercial effect in practice
• Consider both probability of future profit
  variation and its likely financial effect

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Accounting for PFI Key factors

• Factors to consider are
• a ) demand risk
• b) third party revenues
• c) design risk
• d) penalties for non availability or
  underperformance
• e) potential changes in relevant costs
• f) obsolescence, including changes in technology
• g) residual value risk

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Accounting for PFI Demand risk

• Demand risk is risk that demand for the property
  will be greater or less than expected
• Where demand risk is significant it normally
  gives the clearest evidence of which party should
  record a property asset
• Length of contract may influence demand risk
• Where demand risk is significant, need to
  understand if payments depend on usage and who
  will gain if usage is greater than expected
• If purchaser has to pay regardless of usage this
  is clear evidence that the property is
  purchasers asset
• If payments vary proportionately over all
  reasonably likely levels of demand ie purchaser
  does not pay if property not needed this is
  evidence that the property is operators asset
• a ) demand risk
• b) third party revenues
• c) design risk
• d) penalties for non availability or
  underperformance
• e) potential changes in relevant costs
• f) obsolescence, including changes in technology
• g) residual value risk

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Accounting for PFI Third party revenues

• Some properties are used by third parties
• If operator relies on third party revenues to
  earn return this is evidence that the asset is
  the operators (eg toll road)
• If third party use is minimal this is evidence
  that the asset is the purchasers

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Accounting for PFI Design risk

• Where operator has significant discretion over
  how to fulfil the contract and makes key
  decisions on what property is built
• Balance between quality of build and maintenance
  costs
• Risk that the property will not meet the
  requirements of the contract
• Not construction risk

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Accounting for PFI Penalties

• Penalties if asset is unavailable
• Assess likelihood and whether payments are
  significant
• Penalty may have little impact if operator has
  time to rectify the fault

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Accounting for PFI Changes in costs

• If cost changes are passed to the purchaser this
  is evidence that the asset is the purchasers
• If cost changes fall to the operator this is
  evidence that the asset is the operators.
• Even if the unitary charge is inflation indexed
  linked the operator has the risk that actual
  costs may vary in excess of infaltion

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Accounting for PFI Obsolescence

• Relevance depends on nature of the contract
• Technology assets more likely to be obsolete than
  buildings
• Which party bears the costs?
• Often change in law rests with public sector and
  other changes with the operator

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Accounting for PFI Residual value

• Risk is that the actual residual value will be
  different from that expected
• More significant where life of property is in
  excess of contract term
• Where significant normally gives clear evidence
  as to which party should record the asset
• Consider effect of options and transfer prices at
  the end of the contract
• Operator has residual risk where it retains the
  property or has market value option

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Accounting for PFI Assessment

• Look at all relevant factors and not focus on one
  factor
• Greater weight given to outcomes likely to occur
  in practice
• Also asses operators financing, if debt funding
  is too high then suggests that the contract is a
  financing
• Real in substance equity is required for
  purchaser to get off balance sheet accounting

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Accounting for PFI Required accounting

• If off balance sheet record unitary charge as a
  cost each period
• If on balance sheet record the assets and record
  a liability, treat unitary charge as paying for
  services, capital repayment of liability and
  finance costs

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Accounting for PFI TN1

• TN1 allows demand risk and residual value risk to
  be looked at in a different way
• If it can be mitigated then demand risk can be
  considered not significant
• For specialised properties (eg schools, hospitals
  and prisons) residual value risk can be regarded
  as of low significance if the property will
  continue to be used by the purchaser
• TN1 also requires quantitative analysis using
  Monte Carlo simulation
• In summary an asset is more likely to be off
  balance sheet under TN1
• May result in asset on no balance sheet

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Accounting for PFI The future and IFRS

• UK Government will adopt IFRS for the UK public
  sector from April 2008
• FRS 5 ANF and TN1 will not be relevant under
  IFRS, but IFRS has no specific guidance for the
  public sector
• IFRIC 12 is the relevant guidance for service
  concession arrangements under IFRS
• But IFRIC 12 is only applicable to the operator
• HM Treasury recognise the need for further
  guidance for the public sector and are expected
  to publish draft guidance in December 2007

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Accounting for PFI - IFRS

• Assuming the accounting treatment in the public
  sector mirrors that by the private sector under
  IFRIC 12, assets should appear on either the
  public or the private partys balance sheet, not
  or both or on neither.
• However, not just an accounting issue. Funding
  and other regulatory aspects need to be
  considered and so it is possible that assets will
  still be off balance sheet
• Will any change be retrospective or prospective
  only?

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PFI arrangements Accounting treatment under
IFRIC 12

• If the grantor
• controls or regulates the services the operator
  provides and
• retains the residual interest in the asset
• The operator
• does not recognise the P,PE
• recognises the consideration received/receivable
  in exchange for the construction of services as
  either a financial asset or an intangible asset
• Assuming symmetry, the grantor
• recognises the P,PE under IAS 16 as adapted and
  interpreted for the public sector
• service costs are charged to operating expenses
• asset costs are split between 1) financing costs
  and 2) repayment of liability

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PFI arrangements Accounting treatment under
IFRIC 4

• If the grantor
• controls or regulates the services the operator
  provides but
• the residual interest in the asset is controlled
  by the private sector,
• the arrangement is out of scope of IFRIC 12
  however falls within the scope of
• IFRIC 4
• IFRIC 4 requires the grantor to determine whether
  the arrangement contains a lease
• If a lease is identified, the grantor will apply
  IAS 17

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Disclaimer
This presentation does not constitute an
accounting opinion of Ernst Young LLP and only
contains general accounting guidance on certain
issues under UK GAAP and International Financial
Reporting Standards in respect of accounting for
Private Finance Initiative arrangements. The
presentation covers only a summary of the
relevant standards and guidance and accordingly,
may not be applicable to any specific situation.
The presentation should not be relied upon by
any party. The actual accounting treatment in
any particular case needs to be determined by the
relevant entity and agreed with the entitys
auditors in the context of the specific facts and
circumstances.. Ernst Young LLP can give no
assurance that the auditors would agree with our
analysis.