A review of the differing views of HM Treasury and the Accounting Standards Board as to the correct accounting treatment of PFI transactions

Paul Smith and Peter Long review the differing views of HM Treasury and the Accounting Standards Board as to the correct accounting treatment of PFI transactions

Since the PFI was first introduced in 1992 the accounting treatment of PFI transactions has been debated at length. The issue for the accountants is which party to the contract should account for the transaction, or more particularly, on whose balance sheet should the asset and liability appear, the public sector's or project company's? The answer to this question depends upon the application to the transaction of the Financial Reporting Standard 5: Reporting the Substance of Transactions ("FRS 5"). The results have so far, at best, been inconsistent. This issue was recognised in the Bates Review which recommended that the Treasury ("HMT") should prepare interim accounting guidance on PFI transactions pending more definitive guidance from the Accounting Standards Board (ASB).

On 29th September 1997, the "Interim Guidance on the Application of FRS 5 to Accounting for PFI Transactions in the Public Sector" was duly published by the Treasury Taskforce. However, in December 1997, the ASB published for consultation its own draft "Amendment to FRS 5 Reporting the Substance of Transactions: the Private Finance Initiative". This proposed a different approach from that recommended by HMT.

What is the principal difference in the approach of HMT and the ASB?

Two differing approaches may be taken in determining which party has an asset in the property:

• The PFI transaction is considered as a whole, unless: -components are treated independently under the contract and -the cost of the asset or the service is separately identifiable in the contract in which case the accounting tests are applied separately to each component. (This view is endorsed by HMT).
• The components of the PFI transaction relating solely to the provision of services are ignored leaving the remainder to be subject to testing. (This view is endorsed by the ASB).

This may sound like a fine distinction, but it can have radical consequences in accounting terms.

The HMT view
HMT's view is that in deciding how the PFI transaction should be treated for accounting purposes, the transaction should be tested as a whole, UNLESS elements of the PFI payment can be separately identified and operate independently of each other AND the contract is separable, for example: separate elements of the contract run for different periods or can be terminated without affecting other parts of the contract.

As an example, a transaction may include the provision of a building together with maintenance, catering, cleaning and security services. The contract may provide that catering, cleaning and security services are each subject to periodic market testing. If this is the case, then those services may have to be tested as separate components of the PFI transaction. The remaining components will be treated as a single transaction for the purposes of the test.

The ASB view
The ASB also considers that it is necessary to decide whether the contract is separable into elements, but their approach to this is much broader than HMT's.

For example, ASB would look at whether:

• different parts of the contract run for different periods;
• payments can be separated into two or more streams (regardless of whether they are described as "unitary"); or
• variations in payment relate purely to the provision of a particular service (e.g. due to poor catering or cleaning etc.).

The difference in the approach is that the HMT guidance would test the transaction as a whole and only remove the service elements if the payments can be separately identified AND the services are contractually separable. However, the draft ASB guidance would remove the service elements purely on the basis that a separate payment for them could be identified.

Analysis of the remaining components of the transaction - HMT and ASB approaches compared

Once it has been determined which parts of the PFI transaction should be tested, the approach taken by HMT and the ASB is very similar in deciding whether the transaction will be accounted for by the public sector or the project company.

For example, HMT and ASB both consider the level of equity (or risk capital) to be a key criterion in determining which party has an asset in the property and therefore should account for the transaction. HMT's view is that the actual level of equity in the project - this can include mezzanine debt, subordinated debt as well as pure equity - should be between 10% - 20% of the total project funding. The ASB's view is that if the project company is funded to a large extent by purely bank debt, then this would indicate that there is little risk within the project company and that the contract may be purely a financing arrangement.

HMT has set out a broad quantitative test as a guide to whether there is sufficient risk transferred to the project company. The test considers whether the project company's equity holders are subjected to real commercial risk by determining the spread of potential returns on "risk capital" - from worst case to best case - over the life of the concession. To demonstrate real commercial risk the returns must show potential for significant variability and must fall below the level of the lenders' returns in a worst case scenario.

Both HMT and the ASB set out general evidential matters that must be considered in determining which party has an asset in the property, such as:

• Demand risk Can payments made by the public sector vary with the extent to which the asset is actually used?

• Third party revenues Does the project company rely on revenue derived from third parties to cover its costs?

• Non-performance and non-availability Does the contract provide for reductions in payments to the project company on account of poor performance or non availability of the property and is the likelihood of such deductions "real" (e.g. no prolonged "cure" periods)?

• Operating costs Which party is at risk for increases in operating costs (other than variations requested by the public sector)?

• The design of the property Which party has the ability to materially influence the design of the property?

• Obsolescence and changes in technology Which party bears the cost of the asset's obsolescence or the benefit of changes in technology?

• The residual value risk Does the project company or the public sector take the risk (if any) of what the residual value of the property might be at the end of the concession?

• Compensation Is the project company paid any compensation (e.g. outstanding bank debt and termination fees, equity, third party liabilities etc.) on termination even as a result of a project company event of default?

Under both the HMT and ASB guidelines, if it is concluded that the public sector has an asset in the property and the liability to pay for it, this fact should be recorded in its accounts as the fair value of the property depreciated over its useful economic life. In addition, an imputed finance charge on the liability should be included in subsequent years. The recurring payments to the project company should be recorded as an operating cost.

Conclusion
The government's response to the concerns of the public sector and PFI practitioners has been to confirm that projects that have been signed or achieved "best and final offer" stage prior to the date of publication of the final ASB rules and have achieved audit pre-clearance on the basis of the HMT interim guidance rules will not be penalised if the accounting treatment is changed.

Notwithstanding this, the government does not support the methodology set out in the ASB's draft recommendations and, although the ASB has no jurisdiction over public accounting, the government, together with organisations such as the CBI, is presently advising the ASB on amendments to the guidelines such that they comply with the principles of the PFI.

The government has always made it clear that the principal factor in the success of a PFI project is whether it represents value for money, and not whether the asset is on the public sector's balance sheet. However, the accounting treatment of these deals can have a direct impact on whether a particular project is affordable. At a general level, it may also affect the volume of projects in the future, unless the general accounting rules which apply to individual government departments are changed.

The accounting position needs to be resolved - whether by amending general public sector accounting rules or the accounting rules applicable to PFI transactions - if the momentum that has been gathered in the PFI is to continue.

Peter Long is a partner and Paul Smith a chartered quantity surveyor and trainee solicitor in the Energy Projects and Construction group of Cameron McKenna.