With more investment planned for public-private partnerships, PFI is not going to go away. In this article, KPMG’s Greg McIntosh presents an outline of the basic accounting processes and principles involved in these long-term projects.
The Private Finance Initiative (PFI) has always been controversial and the recent Treasury Select Committee report made some strong criticisms of the value for money offered by this form of procurement. Despite the criticisms existing schemes are here to stay and new schemes are in the pipeline.
Public sector bodies with PFI schemes need to be aware of how they are accounted for and the pitfalls that can be avoided by having a sound understanding of the basic principles that underpin the accounting approach.
This is not the place to explore IFRIC 12 ‘Service Concession Arrangements’. Suffice to say that standard PFI schemes are service concessions within the scope of IFRIC 12 and public sector accounting rules state that public bodies must recognise the infrastructure (together with the related liability to pay for it) on their balance sheets from the date the services commence in accordance with the finance leasing rules of IAS 17.
Under UK GAAP PFI accounting was relatively easy. Keep the land on your balance sheet, impair existing assets prior to transfer to the operator, recognise any transfers of surplus assets, take the unitary charge to your revenue account and set up a deferred asset for your residual interest in the new assets. Under IFRS things get a bit more complicated, but there are a number of key areas to focus on; if you get those areas right them you should be fine.
First you need to have access to the operator’s final financial model. You should have access through the “open-book” provisions of the contract, which should provide much of what you need to account for PFI. Don’t worry of much of the model is incomprehensible! You only really need to refer to the breakdown of capital costs and information from the P&L account on the unitary charge and the operating costs incurred by the operator in delivering the services.
Payments during the construction phase
Payments are likely to be made to the operator during the construction phase of the contract. Examine these closely to determine what they relate to. They may be for services delivered on retained parts of the estate, or capital contributions made in advance of service commencement. If they relate to services they should be expensed, but capital contributions should be taken to prepayments if paid in advance of service commencement and then released to write down the long-term liability when the asset comes into use.
Initial asset and liability
The initial asset and liability should be recognised using the finance lease accounting rules of IAS 17. IAS 17 ‘Leases’ states that “at the commencement of the lease term, lessees shall recognise finance leases as assets and liabilities in their balance sheets at amounts equal to the fair value of the leased property or, if lower, the present value of the minimum lease payments, each determined at the inception of the lease”. The standard goes on to state that “the discount rate to be used in calculating the present value of the minimum lease payments is the interest rate implicit in the lease, if this is practicable to determine; if not, the lessee's incremental borrowing rate shall be used”.
In general the net present value of the minimum lease payments under a standard PFI scheme will be the same as the capital cost of the asset because the asset passes to the grantor at the end of the arrangement for nil consideration and the operator will therefore recover the whole of his investment in the asset over the life of the concession. (NB - this is not the case with NHS LIFT, which has provisions within the contract for sharing gains above an assumed residual value).
When bodies were transferring to IFRS there were long discussions as to whether the capital cost of the asset in the operator’s financial model could be used as a measure of the fair value of the initial asset and liability, or whether it was appropriate to use a valuation basis for initial recognition.
We don’t believe it is appropriate to use a valuation basis as this is likely to result in a material mis-statement of the fair value of the liability, particularly in cases where the valuation is based on depreciated replacement cost (DRC). In arriving at DRC valuations, valuers will not take into account any development costs that the operator will have capitalised and building costs can also vary significantly over the period of construction. We had examples where the valuers were providing DRC valuations that were 50% lower than the capital cost set out in the operator’s financial model.
The capital cost of the infrastructure assets shown in the financial model is the amount that the operator will recover over the life of the concession and we believe this is the amount that should be recognised as the initial fair value of the asset and liability.
Be careful when you are determining the capital cost of the asset from the financial model. Operators will capitalise development costs, including interest, during the construction phase and take these to the balance sheet as a fixed asset or a long-term receivable. It is the total capital cost recognised in the operator’s balance sheet that you are looking for and you can usually tell if you have got it right if the calculated interest rate implicit in the arrangement is not a million miles away from the model’s calculated pre tax internal rate of return (IRR).
Accounting for the asset
Once you recognise the initial asset you should account for it in exactly the same way as any other asset of the same class. You have to do an initial valuation after recognition and this can result in a large impairment if you go for DRC and the valuer tells you that your £100m asset has a DRC of £50m! DRC is only appropriate for specialised assets where there is no ready market value, so think about whether this is actually the case with your infrastructure. For example small hospitals and health centres may have a market value and particularly in the case of smaller assets with ready alternative uses it is not automatically the case that DRC is the appropriate valuation base.
Avoid using your accounting model to account for assets. When public sector bodies were told that they would be moving to IFRS as the basis of accounting for PFI schemes we were engaged by a number of bodies to model the potential impact on balance sheets and revenue accounts over the life of the arrangement. We developed an accounting model which did the job, subject to a number of simplifying assumptions. In parallel, the Department of Health commissioned another major accounting firm to prepare a detailed accounting model which attempted to cover every element of PFI accounting.
In the end the department had to issue an instruction to health bodies that they should not use this model to account for assets and this is just as true today as it was then. Keep your asset accounting separate and recognise that all your accounting model is really doing is showing you how to allocate the property-related rental between principal and interest and you can’t go wrong.
Accounting for service costs
The P&L account in the operator’s financial model identifies the operating costs which can be used as proxy for the service element of the unitary charge. You are trying to identify the fair value of the services provided by the operator so it is useful to determine whether you need to add a margin to these costs to get to the fair value. In some instances operating costs are simply passed through and are identified as such in the financial model. Service costs should be deducted from the unitary charge to arrive at the property-related rental, which is the equivalent of the minimum lease payments under IAS17.
Lifecycle replacement costs should also be stripped out of the unitary charge at the same time. These are normally identified in the P&L and may be direct costs, or relate to contributions to a lifecycle reserve which is utilised at a later date. Complications relating to lifecycle costs are considered below.
Accounting for the property-related rental
Once service costs and lifecycle costs are stripped out of the unitary charge you are left with the property-related rental. Your accounting model should then calculate the effective interest rate and allocate the interest element of the property-related rental over the life of the arrangement. The repayment of the long-term obligation is the balancing figure (total unitary charge less service costs, lifecycle costs and interest). This is effectively an annuity calculation and rather like a repayment mortgage the principal repayments start off low and get higher, whilst the interest payments start high and get lower. If your model comes out with the opposite answer, or the interest rate is twice the pre- tax IRR then take a break – you have probably made an error!
There were long discussions at the time IFRS came in as to whether the property-related rental should be expressed in the accounting model in “real” or “nominal” terms over the life of the concession. Our initial view was that contingent rentals based on an existing index such as RPI should be included in the property-related rental on the basis of the assumed level of the index at the start of the arrangement and that any increases or decreases resulting from subsequent changes in the index should be charged or credited to revenue in the periods in which they were incurred.
This approach was challenged on the grounds that it was not consistent with IAS 17 and led to the liability actually increasing in the early years of the contract. Government guidance eventually recommended that any element of the property-related rental that increases or decreases in future due to uncertain factors (including index linked rentals) should be excluded as a contingent rental when calculating the apportionment of the rental between the finance cost and repayment of the liability.
This means that the property-related rental should be expressed as a constant in the accounting model over the life of the concession and the resulting interest rate is a “real” rather than a “nominal” rate. This should be bone in mind when comparing the calculated interest rate to the pre-tax IRR in the operator’s financial model.
Bodies should identify lifecycle replacement costs incurred by the operator which would normally be capitalised under their own accounting policies and separately account for them as capital expenditure. This assumes that bodies have either adopted component accounting for those material components that are programmed to be replaced over the life of the concession, or are able to write out these assets when they are replaced where component accounting is not adopted. You should also watch out for lifecycle funds because contributions to these funds should strictly be taken to the balance sheet as prepayments until such time as the funds are utilised and the prepayments can be released to non-current assets.
Our accounting model is based on the simplifying assumption that lifecycle costs are not material and are charged to revenue as part of the service costs. We did this because we recognised that it would be overly complicated to try and introduce component accounting into the model when its primary purpose is to identify the property-related rental and then to calculate the principal and interest elements of that rental over the life of the arrangement. Once calculated these remain constant and any differences between the actual unitary charge and the nominal unitary charge per the operator’s financial model should be dealt with through the income statement. These will consist of contingent rentals relating to indexation and any other movements in the actual charge caused by performance or availability deductions.
There are many other areas where complications can arise, particularly where there are significant third party revenues or there are options to purchase at the end of the concession and a significant residual value is built into the financial model as is the case with NHS LIFT. These areas are too complex to consider here, but we are happy to provide support to any public sector entity contemplating entering into a PFI, or even considering whether existing or proposed PPP arrangements or any form of managed service agreement with the private sector could get caught by the service concession rules. As is always the case, rules based on one form of contact can often have unintended consequences and as public bodies look to new ways of delivering services, there is the very real risk that accounting is forgotten in the rush to innovate.
Greg McIntosh is a director of the public sector audit and assurance department at KPMG. He can be reached via greg.mcintosh [at] kpmg.co.uk, or by phone on 07884 476962.