Feature / Accounting for PPP/PFI projects under IFRS

Peter Dymoke, senior manager, government and public sector (technical accounting) at PricewaterhouseCoopers, explains how international financial reporting standards will impact on the way private finance initiative projects are reported in public sector accounts including a detailed look at the different entries on the income and expenditure account. ARTICLE ONLY AVAILABLE ON-LINE

What’s the issue?

Following confirmation in the 2008 budget, all NHS bodies will be required to account under international financial reporting standards (IFRS) from 2009/10. This will result in numerous changes in the way NHS bodies account for their activity. Due to their scale and complexity, public-private partnership (PPP) projects (a subcategory of which is the private finance initiative (PFI)) will probably have a greater impact on NHS body accounts than any other type of NHS activity. 

HM Treasury has announced that the principles of International Financial Reporting Council Interpretations Committee Interpretation 12 (IFRIC 12) will be adopted for accounting for PFI and PPP projects. This means that instead of looking at risk and reward in schemes, the assessment will be based solely on the control of the asset.  

While the original intention of IFRIC 12 is not to apply for accounting by public sector purchasers of PPP/PFI projects, the Treasury believes, supported by thinking by international public sector accounting standards setting bodies, that the principles in IFRIC 12 may be applied ‘in reverse’ to public sector bodies. Applying these principles will mean that schemes whose assets were previously accounted for off-balance sheet will be accounted for on the balance sheet in almost all cases. 

In addition to ‘vanilla’ hospital accommodation projects, NHS LIFT and managed equipment projects may also fall under IFRIC 12, although some features of some of these projects may result in them instead being accounted for as leasing arrangements or other transaction forms.  All contractual forms caught within the scope of IFRIC 12 are referred to in this article and in IFRIC 12 as service concession arrangements.

Affordability of PFI/PPP projects            

The recent Treasury guidance requires that all service concession arrangements be accounted for as follows:

•  Where the public sector purchaser (‘grantor’) determines how the asset is used throughout the service concession term, and determines what happens to the asset at the end of the service concession term, the grantor will show the property in the arrangement as a tangible fixed asset.
• The grantor will also have a long term liability to pay the operator for this asset, along with a long term contract for the operator to operate and maintain the asset. This service contract is usually embedded within the service concession arrangement, such that it cannot be legally or financially separated from the rest of the arrangement. The liability is accounted for as a finance lease creditor, while the service contract is accounted for such that the fair value of services received in each year is matched to that year.

This means that unlike current accounting treatment for off balance sheet arrangements, each year’s unitary charge payment is split into:

• Services charged to operating expenses in the income and expenditure account;
• Finance lease interest charged to finance costs in the income and expenditure account; and
• The remaining amount amends the carrying value of the finance lease creditor.

To illustrate the financial impact on the affordability of PPP/PFI projects, we have modelled the financial implications of bringing a PFI project on-balance sheet and compared this to the off-balance sheet position. The project is a new build hospital of capital cost £200 million with a concession term of 30 years. We assume that the first year’s unitary charge payment is £20 million, inflated by RPI-x, while annual revenue costs are approximately £10 million per annum, also inflated at RPI-x.

It should be noted that in the first half of the project, the on balance sheet treatment is more expensive while the off balance sheet treatment is more expensive in the second half of the project, as shown below.

It should also be noted that the model ignores asset revaluations, whose effect would be as follows:

• In off balance sheet accounting, an increase in the residual interest credit; and
• In on balance sheet accounting, an increase in asset carrying value; this in turn will increase depreciation charged and PDC dividend.

In consequence, asset revaluations would further increase the adverse impact of on balance sheet accounting. In addition, this change in accounting will cause the following impacts on a NHS body’s income and expenditure account to arise (the figures in brackets are estimates for the first few years of the modelled hypothetical project):

• Depreciation charges will increase because the asset will now require to be depreciated (approx £3 million per annum);
• There will be an additional expense item comprising the finance lease interest (approx 10 million per annum);
• The direct cost of services will reduce and will reflect the long term service contract built into the service concession (a reduction of approx 10 million per annum); and
• Residual interest credits will be lost (approx £3 million per annum).

In addition to this, in the case of foundation trusts, the imputed finance lease creditor balance will impact upon prudential borrowing limits and related covenants.

Transition steps

The accounting changes required to amend a PPP/PFI transaction from off balance sheet to on balance sheet will depend on the stage the project is at. If the project assets are still under construction, it is unlikely that significant ledger entries in respect of the project will have resulted under either treatment. However, if part or all of the project assets are now operational, the project will need to be ‘wound back’ to its inception then calculations carried out to the extent necessary to generate opening balances for the project as at 1 April 2009. In addition, the requirement for prior year comparatives means that this exercise is needed to generate opening balances as at 1 April 2008.

This exercise may require for the project assets:

• A comprehensive view of construction works value carried out to date;
• An estimate of the opening value of the asset as would have been determined by the District Valuer on completion;
• An estimate of the present value of the asset;
• Assessment of how the asset is made up into different components and the values of each of these;
• Assessment of how each of these components would have been depreciated.

In addition to the above, this exercise will require for the liability and income and expenditure account postings:

• An estimate of the fair value of the lease creditor on completion of construction;
• An estimate of the fair value of services received in each year of the project;
• Determination of actual RPI or RPI-x inflation in each year of the project;
• An estimate of lifecycle additions to the asset that are capital in nature.

Having obtained these amounts or estimates, working papers generating the resulting entries will require preparation and discussion with the external auditor. In addition, NHS bodies will need to ensure that they have or can obtain the version of the operator’s financial model agreed at financial close of the project. NHS bodies will also need to ensure that they can understand the make up of this model since it contains important information on how the project cost and revenue components are made up.

Other issues

Due to the increased net impact on revenue budgets arising from the change in accounting treatment, NHS bodies will need to reconsider the impacts on their strategy for managing their built estate and their procurement plans. The potentially detrimental impact on budgets will also impact on overall strategic aims since these may now be curtailed.

Among other things, NHS bodies will need to consider if:

• They are in current financial difficulties?
• They are saving to invest?
• They are planning new service initiatives?

Finally, NHS bodies should not ignore these issues; reassuringly, our experience is that most NHS bodies are now actively considering them. However, our experience is that the scale of this task should not be underestimated and the timescales are tighter than they first appear – particularly as these changes may need to be applied retrospectively. This means that the accounting treatment at 1 April 2008 needs to be determined, as well as the treatment going forward.

As a minimum we would recommend that NHS bodies undertake the tasks set out below:

• Assess all of their PPP projects against the IFRIC 12 tests as implemented by HM Treasury to determine their accounting treatment. For any project requiring to be accounted for on balance sheet, the following steps also need to be taken;
• Allocate unitary charge payments between finance lease interest, operating cost and finance creditor amortisation. An acceptable means of estimating these elements will require determination.
• Ensure that the fixed asset component elements of these projects are fully understood. This could take the form of a component analysis to support information for the NHS body’s asset register. This exercise is needed to ensure compliance with the requirements of fixed assets accounting under IFRS.
• Agree a policy for determining whether lifecycle maintenance elements should be expensed or capitalised.
• Prepare detailed supporting working papers and transactions schedules to satisfy audit requirements.
• Determine the carrying value of the assets, taking appropriate professional advice.
• Looking to the future, NHS bodies will also need to build the impact of these changes into their strategic financial planning and the resources available to support delivery of these plans.

Conclusions

This article should illustrate the extent of the work required for successful implementation of IFRS based accounting for PPP/PFI projects.  While seemingly daunting, NHS bodies should understand that the new accounting framework will generate incentives for proper monitoring and management of these contracts, due in part to the more detailed supporting information requirements of IFRS. Further incentives for such monitoring will arise from the emphasis within IFRS on the fair value of balance sheet items. NHS bodies should therefore not see the additional requirements of IFRS accounting as a burden but as an opportunity to ensure proper management of these complex transactions.