PERFORMANCE EXAMINATION

Transcription

1 AUDITOR GENERAL f or Western Austr alia PERFORMANCE EXAMINATION Balancing Act: The Leasing of Government Assets Report No 6 September 2003

2 AUDITOR GENERAL f or Western Australia THE SPEAKER LEGISLATIVE ASSEMBLY THE PRESIDENT LEGISLATIVE COUNCIL PERFORMANCE EXAMINATION Balancing Act: The Leasing of Government Assets This report has been prepared consequent to an examination conducted under section 80 of the Financial Administration and Audit Act 1985 for submission to Parliament under the provisions of section 95 of the Act. Performance examinations are an integral part of the overall Performance Auditing program and seek to provide Parliament with assessments of the effectiveness and efficiency of public sector programs and activities thereby identifying opportunities for improved performance. The information provided through this approach will, I am sure, assist Parliament in better evaluating agency performance and enhance Parliamentary decision-making to the benefit of all Western Australians. D D R PEARSON AUDITOR GENERAL September 17, AUDITOR GENERAL FOR WESTERN AUSTRALIA

3 Contents AUDITOR GENERAL S OVERVIEW EXECUTIVE SUMMARY Key Findings What this Examination is About What We Did What We Found Recommendations INTRODUCTION Background The Pros and Cons of Leasing Types of Leases Leasing in Other Jurisdictions Examination Focus and Approach ASSET MANAGEMENT Key Finding Introduction Asset Management Policies Expiry of Leases Recommendations LEASE VERSUS BUY Key Findings Introduction The Lease Versus Buy Analysis Estimating Residual Value Alternative Options Recommendation LEASE CONTRACTING Key Findings Introduction Competitive Quotes Lease Quotation Procedures Standard Lease Agreements Recommendation ACCOUNTING CLASSIFICATION Key Finding Introduction Agency Classification of Leases Recommendation APPENDICES Appendix 1 Advantages and Disadvantages of Buying and Leasing Appendix 2 Finance and Operating Leases Appendix 3 Leasing in Other Jurisdictions Appendix 4 Discount Rates Appendix 5 Risks and Benefits of Ownership and Accounting Classification Appendix 6 Status of Auditor General s 1999 Recommendations PREVIOUS REPORTS OF THE AUDITOR GENERAL AUDITOR GENERAL FOR WESTERN AUSTRALIA 3

4 BALANCING ACT: THE LEASING OF GOVERNMENT ASSETS Auditor General s Overview An increasing trend to leasing more expensive and specialised assets is evident in the Western Australian public sector. Assets being leased include medical equipment, research vessels, special purpose buildings and IT systems. The financial consequences of lease versus buy decisions are therefore far greater so a closer look at the financing of asset acquisitions has been taken, in addition to following up my 1999 Report, Lease Now Pay Later? The Leasing of Office and Other Equipment. This examination has confirmed that significant improvements have been made to address the concerns raised in the 1999 Report. However, it is evident that a long-term view of the costs, risks and benefits of leasing is still not being taken. With leasing, public sector agencies can avoid the risks of asset ownership. If the right assets are leased for the right reasons, then it may also offer a cheaper method of acquisition. However, the lack of comprehensive lease versus buy analyses means that some leases will cost more over the life of the asset than had the asset been bought. Of greater concern is that many lease versus buy analyses appear contrived to justify decisions to lease, an inappropriate response to ongoing budget and debt restraint. A further adverse effect of inadequately informed leasing decisions is that, without strong asset management practices, agencies do not know whether they are surrendering assets before the end of their useful life. In periods of budget and debt restraint, this also does not make economic sense. Inadequately informed decisions to lease will cost millions of dollars more in the end and ultimately further constrain funds available for the delivery of services to the public. There is clear scope for a more rigorous approach to deliver, at least over a few years, the dual benefits of cheaper asset acquisition and some funds for re-allocation to other priorities. With the current push towards procurement reform, it is appropriate to also improve the rigour and transparency of lease versus buy decision-making. It is also important that public sector managers understand the long-term costs, benefits, and implications of their decisions to lease or buy. 4 AUDITOR GENERAL FOR WESTERN AUSTRALIA

5 Executive Summary Key Findings! Significant improvements have been made to address the concerns raised in the June 1999 report Lease Now Pay Later? The Leasing of Office and Other Equipment.! With leasing, public sector agencies can avoid the risks of asset ownership. If the right assets are leased for the right reasons, then it may also offer a cheaper method of asset acquisition. However: " two of the five sampled agencies did not conduct lease versus buy analyses to determine whether leasing was cost effective; " it was not always possible to conclude whether value for money had been achieved from leasing due to unsound estimates used by those agencies conducting lease versus buy analyses; " leasing decisions which did not take into account the nature of the assets and their importance to agencies resulted in additional costs; and " actions taken by some agencies upon expiry of lease agreements have negated the intended benefits from leasing and resulted in additional costs. What this Examination is About The financing of asset acquisitions in periods of budgetary restraints, with many competing demands for available funding, is an ongoing challenge. Many agencies are looking at alternatives to asset ownership and the different methods by which assets may be financed and acquired such as leasing. With leasing 1 :! Agencies can avoid the risks of asset ownership. These risks include less than expected proceeds from disposal of assets (ie residual value risk). Leasing can be particularly beneficial in those situations where there is a high risk of obsolescence.! Leasing may offer a cheaper method of acquisition. Some lessors have developed specialised distribution channels for disposing of assets and therefore, may obtain higher resale prices for second-hand assets than the agency could. In these situations, the benefits of higher disposal values are passed onto the agency in the form of reduced lease payments. As such, the total payments over the term of the lease can be less than an outright purchase (in net present value terms) 2. 1 There are two main types of leases: operating leases and finance leases. Finance leases are those leases where the risks and benefits of ownership of assets are transferred to the lessee. With operating leases, substantially all risks and benefits of ownership are retained by the lessor. 2 Net Present Value means the present value of annual net cash flows less the initial outlay. Present value represents the value in today s dollars of a future payment discounted back to the present at the required rate of return. AUDITOR GENERAL FOR WESTERN AUSTRALIA 5

6 BALANCING ACT: THE LEASING OF GOVERNMENT ASSETS EXECUTIVE SUMMARY (continued) What We Did! By spreading costs over several financial years, leasing can make immediate asset acquisition possible for many agencies. However, these immediate benefits can be negated by the additional costs that can result in the long-term if the wrong type of assets are leased or leasing is undertaken for the wrong reasons. Since first examining the area of leasing in 1999, there has been a trend towards leasing more expensive assets such as medical equipment, research vessels, building construction, and assets associated with systems development. As such, the financial consequences of the lease versus buy decision are now more significant. It was therefore decided to have a closer look at the financing of asset acquisitions. This report identifies how a sample of public sector agencies evaluate the strategic and financial impacts of assets financed by leasing and how they manage these assets to ensure that the public sector is not unduly disadvantaged by leasing arrangements or exposed to unnecessary risks. A sample of five agencies 3 with a combined portfolio of leased assets totalling over $100 million at December 31, 2002, was selected for the examination. The examination looked at 85 lease contracts valued at $97.2 million entered into or expiring between July 2001 and December Lease versus buy analyses (where conducted) were reviewed and recalculated (where necessary). What We Found Asset Management Agencies need to determine whether the benefits, such as transfer of residual value risk, being provided by leasing represent value for money. Leasing will not offer any significant financial benefits if the (residual) value of an asset to an agency is greater than the value placed on the asset by the lessor at the end of the lease term. In most cases, for example, if an agency can effectively use a computer for four years, then leasing will be less attractive. This examination has shown that an agency can obtain, for around the same amount of money (in net present value terms), four years of use if it buys compared with only three years from leasing. 3 Department of Education, Department of Justice, Department for Planning and Infrastructure, Police Service, and Central TAFE. 4 With the exception of the leases of the Police Service s CADCOM and the Department of Justice s Fremantle Justice Centre, which were entered into prior to July 2001 but were current at December 31, AUDITOR GENERAL FOR WESTERN AUSTRALIA

7 Other factors such as possible increases in maintenance would need to be considered. However, without having first identified the useful life and the optimal replacement time for an asset, then it is more likely that these agencies will make poor lease versus buy decisions. The examination identified that four of the five agencies sampled did not apply asset management policies dealing with the use and replacement of assets when making lease versus buy decisions. Actions taken by agencies at the end of leases, including extensions to lease terms and purchasing leased assets, have often negated the intended benefits of leasing and have led to additional costs. For example:! A review of 26 expired leases involving information technology assets valued at $2.2 million at one agency identified that 60 per cent of the items had been bought out at the end of the lease for amounts representing between 19 and 33 per cent of the items original value. In many cases, these amounts meant that the agency had paid twice for the same assets by paying an amount equivalent to the cost of buying the new assets plus the cost of buying the assets second-hand (used).! One agency had extended the leases of 23 per cent of the sampled information technology assets for additional periods of up to 24 months at between 40 and 75 per cent of the original lease payments. Another agency decided in 2002 to extend leases for over items (originally valued at around $15 million) for a further 12 months at 50 per cent of the original lease payments. In net present value terms, this means that agencies are paying up to 30 per cent more than if the assets had been purchased from the outset. Lease versus Buy This examination has confirmed that significant improvements have been made to address concerns raised in the 1999 examination of leasing. Tools and guidelines have been issued by central agencies to assist with the lease versus buy decision. The availability of these resources means that agencies are now able to conduct lease versus buy analyses which they may not have in the past. A non-mandatory whole-of-government leasing facility has also been established. The examination has highlighted that two of the five sampled agencies still do not routinely conduct lease versus buy analyses to support decisions to lease. In these agencies, the decision to lease has been driven by financial constraints (ie insufficient funds were available to purchase assets outright). In the absence of lease versus buy analyses, these agencies do not know whether a premium is being paid for leasing and whether it represents value for money. AUDITOR GENERAL FOR WESTERN AUSTRALIA 7

8 BALANCING ACT: THE LEASING OF GOVERNMENT ASSETS EXECUTIVE SUMMARY (continued) The decision to lease will also be affected by the type of asset. Some specialised assets including custom-built fisheries vessels or purpose-built facilities such as courthouses often do not have a well-developed second-hand market. Therefore, the potential for the lessor to obtain an appropriate level of proceeds on disposal and to assume residual value risk is reduced. In these instances, leasing will be less attractive, as demonstrated by the 25-year lease of the purpose-built Fremantle Justice Centre. The Department of Justice will be paying around $3.6 million (or 25 per cent) more than a government-funded buy option. The Department of Justice advised that the procurement of the Fremantle Justice Centre achieved a transfer of other risks associated with site availability, site location, design and construction, planning and zoning, and maintenance; though, these were not quantified and therefore, the extent to which value for money was achieved is not clear. It is also possible that some or all of these risks could have been transferred via other contractual arrangements without the need for private finance. If an agency also could not operate effectively without an asset and the costs of replacing the asset or dismantling the asset and returning it to the lessor were significant, then leasing the asset would also be less attractive. This was the case with the Police Service s CADCOM 5 system, which will form an integral part of the Police Service s communication system. The lease of CADCOM was terminated on June 27, 2003 to save up to $8.2 million and avoid the serious cost risk of having to purchase CADCOM from the lessor at the end of the six-year lease term. Lease Contracting The sampled agencies were seeking lease finance quotes on a competitive basis and have established or have access to standard lease agreements. Most of the terms and conditions that were identified in 1999 as unduly favouring the lessor and/or exposing agencies to unnecessary risk have been dealt with. However, the lease agreement used by one agency contained several other unfavourable conditions such as inertia clauses and unfavourable indemnity clauses. Accounting Classification The manner in which some agencies had applied the Department of Treasury and Finance s lease versus buy analysis tool (Lease Calculator) resulted in incorrect accounting classifications of leases. In some cases, the Lease Calculator had been adjusted to achieve an operating lease classification. 5 Call Taking, Computer Aided Dispatch and related Communications (CADCOM) System. 8 AUDITOR GENERAL FOR WESTERN AUSTRALIA

9 Recommendations Agencies should:! document their rationale for asset acquisition and replacement;! ensure that comprehensive analyses of risks, benefits and costs are conducted prior to entering into leasing arrangements to determine whether leasing is preferred to buying and represents value for money - all alternative options should be considered;! conduct a financial evaluation of all options available at the end of a lease term and negotiate, as appropriate, with lessors at the expiry of the lease; and! ensure that lease terms and conditions do not unduly favour the lessor or expose agencies to avoidable risks. The Department of Treasury and Finance should increase its focus on the regular review and response to changes in accounting, financial and operational aspects of leasing. AUDITOR GENERAL FOR WESTERN AUSTRALIA 9

10 BALANCING ACT: THE LEASING OF GOVERNMENT ASSETS Introduction Background Public sector investment in assets such as roads, schools, and equipment is essential in assisting in the delivery of services to the community and promoting economic development. Government assets are typically financed by contributions from the Consolidated Fund, borrowings, Commonwealth funds, asset sales, and other funds generated by agencies. In recent years, the Government has implemented a number of policies, tools and guidelines designed to improve the allocation of the State s financial resources towards the acquisition of assets. These include amongst others:! Project Evaluation Guidelines (Department of Treasury and Finance, January 2002) providing a technical and procedural framework for the evaluation of new and existing projects, including capital works and other expenditures requiring Cabinet approval.! Capital User Charge (effective from July 1, 2001) levied on the net assets of agencies to provide an incentive for agencies to reduce their use of capital by disposing of surplus assets or replacing them with more efficient assets. The capital user charge is currently set at eight per cent of net assets. The government asset acquisition or procurement process is also augmented by the buying wisely strategy which is about making sound purchasing decisions that achieve the best overall result and value for money. Whilst assets may be needed to deliver services, it is not essential that an agency own these assets. Alternatives to asset ownership include both non-asset solutions and the various methods by which assets may be financed and acquired ie:! using the private sector for service delivery (eg outsourcing);! redesigning the delivery strategy to eliminate or reduce the need for assets (eg use of telephone or web-based services);! moderating the demand for services (eg introduction of user charge regimes); and! choosing between buying and leasing. Deciding which financing option to use to acquire assets can be a complex decision which requires strategic asset planning and a thorough financial evaluation. In a report tabled in Parliament in June 1999 titled Lease Now Pay Later? The Leasing of Office and Other Equipment, it was concluded that:! public sector managers were often unsure or unaware of the costs and risks involved with leasing; and! very few of the leases examined were subjected to a thorough financial evaluation prior to execution. 10 AUDITOR GENERAL FOR WESTERN AUSTRALIA

11 Leasing in the Western Australian public sector is now guided by the Department of Treasury and Finance s Project Evaluation Guidelines, which were issued in January 2002 but previously existed in an exposure draft form since May At June 30, 2002, public sector leasing commitments totalled $626 million. Although the break-up of these figures by class of assets is not known, most of the commitments relate to the leasing of office accommodation. However, the growth in value of new leases of office and information technology equipment at the Departments of Education, Justice, and Planning and Infrastructure, Central TAFE and the Police Service has been significant, as shown in Figure 1. Value ($m) Value of New Leases # # Cumulative Lease Value Year # # Figure 1: Growth of Equipment Leasing in Selected Agencies The leasing of equipment has been growing since 1999, with the value of new leases jumping in 2000 due to the Department of Education s Learning Technologies program and decisions by Central TAFE and the Police Service to lease all information technology equipment. New leases totalling $22.9 million in 2002 involved the Department of Education s Notebooks for Teachers Program. Source: Selected agencies and OAG The Pros and Cons of Leasing Deciding whether to lease assets is not always easy and in each situation, the agency must weigh the advantages and disadvantages. Whilst a leasing arrangement can be used to overcome shortfalls in funding, it has the potential to cost an agency more in the long run and constrain future budget flexibility by creating expenditure commitments in future years. A lease is a rental agreement by which the legal owner of goods (lessor) allows another party (the lessee) to use those goods for a stated period of time in return for a series of payments. Leases are generally more expensive than borrowing or purchasing outright (in net present AUDITOR GENERAL FOR WESTERN AUSTRALIA 11

12 BALANCING ACT: THE LEASING OF GOVERNMENT ASSETS INTRODUCTION (continued) value terms) 6 because they include a premium to compensate the lessor for assuming the risks of ownership. The most significant risks of ownership 7 are obsolescence and a less than expected resale price when the owner disposes of the assets ( residual value risk ). An agency may determine that it would be highly exposed to these risks if it were to own the assets and therefore, it may be prepared to pay a premium to transfer these risks to a lessor. In these cases, leasing could be shown to be more cost effective. In other cases, leasing can be cheaper than purchasing. Lessors make profits through a combination of interest charges, tax benefits, and proceeds of asset sales or re-leases. Some lessors have developed specialised distribution channels for disposing of assets and therefore, can expect to obtain higher resale prices for second-hand assets than the lessee (agency) could. In these situations, the benefits of higher disposal values are passed onto the lessee in the form of reduced lease payments. As such, the total payments over the term of the lease can be less than an outright purchase (in net present value terms). Appendix 1 provides a summary of the advantages and disadvantages of buying and leasing. Types of Leases The two main categories of leases are finance and operating leases. The difference between these leases is established in Australian Accounting Standard AAS17 Leases and relates to whether there has been a transfer of substantially all risks and benefits of ownership. Finance leases are those leases where risks and benefits of ownership are transferred to the lessee 8. With operating leases, substantially all risks and benefits of ownership are retained by the lessor. Finance leases are akin to borrowing and are generally not supported by the Department of Treasury and Finance (as per the Department s Project Evaluation Guidelines). Without retention of ownership risk by the lessor, agencies could be paying an unnecessary premium over the Government s borrowing rate because private sector financiers generally cannot borrow at rates as favourable as the Government. AAS17 requires leases to be classified as either operating leases or finance leases and specifies certain accounting treatments and disclosures for each type. Appendix 2 details the typical features and accounting treatments of operating and finance leases. 6 Net Present Value means the present value of annual net cash flows less the initial outlay. Present value represents the value in today s dollars of the future payment discounted back to the present at the required rate of return. 7 Other risks of ownership include unsatisfactory performance, idle capacity, uninsured damage, and condemnation of the asset. See Appendix 5. 8 Under a finance lease, legal ownership may or may not eventually be transferred to the lessee. 12 AUDITOR GENERAL FOR WESTERN AUSTRALIA

13 Leasing in Other Jurisdictions Leasing in the Western Australian public sector remains the responsibility of individual agencies, subject to guidelines issued by the Department of Treasury and Finance. A whole - of-government leasing facility has been established but its use is not mandatory. The Western Australian position contrasts with other jurisdictions, which have taken more centralised approaches to leasing, in particular the Queensland Government. Refer to Appendix 3. Examination Focus and Approach At the time of the June 1999 report Lease Now Pay Later? The Leasing of Office and Other Equipment, agencies were generally leasing only personal computers and photocopiers. However, since June 1999, there has been an increasing trend towards leasing expensive assets such as medical equipment, research vessels, building construction, and assets associated with systems development. Therefore, the financial consequences of the lease versus buy decision are now more significant. Additionally, in 2002, Audit reported to Parliament a number of instances where agencies had not pursued the most cost effective financing option:! metropolitan teaching hospitals - medical equipment valued at $3.1 million 9 ; and! Department of Fisheries research vessel valued at $2.12 million 10. Against this background, a performance examination was conducted to assess:! how agencies evaluated the strategic and financial impacts of assets financed by leasing;! whether the method of asset acquisition achieved better value for money and complied with State Supply Commission supply policies; and! how well agencies managed leased assets to ensure that the government was not unduly disadvantaged by leasing arrangements or exposed to unnecessary risks. The following agencies with large portfolios of leased assets (primarily information technology equipment) were selected:! Department of Education! Police Service! Department for Planning and Infrastructure! Central TAFE 9 Report No. 4 of 2002 Public Sector Performance Report 2002 tabled in September Report No. 9 of 2002 Report on Ministerial Portfolios at November 29, 2002 tabled in December AUDITOR GENERAL FOR WESTERN AUSTRALIA 13

14 BALANCING ACT: THE LEASING OF GOVERNMENT ASSETS INTRODUCTION (continued) The number and value of equipment leases held by each agency at December 31, 2002 is shown in Table 1. AGENCY NO OF CURRENT LEASES VALUE Department of Education 827 $46.9 million Police Service 477 $15.1 million Central TAFE 51 $6.4 million Planning and Infrastructure 160 $2.1 million Table 1: Number and Value of Leases Current at December 31, 2002 The Department of Education is by far the largest lessee of the sampled agencies, with most of its leases held by schools. Notes: The figures for the Police Service do not include the lease of CADCOM, which was terminated on June 27, Source: Selected agencies and OAG In addition, the Department of Justice was selected to contrast their decision not to lease information technology equipment with the agencies above and to examine the financing of the construction of the Fremantle Justice Centre (with lease payments commencing in March 2001). The examination looked at 85 lease contracts valued at $97.2 million entered into between July 2001 and December Lease versus buy analyses (where conducted) were reviewed and recalculated (where necessary) in accordance with AAS17. The examination excluded leasing of office accommodation and motor vehicles. The discount rates applied in the audit analysis of leases in this report are based on the Western Australian Treasury Corporation s lending rate to public sector agencies. See Appendix 4 for more information. On July 1, 2001, the Department of Treasury and Finance introduced an eight per cent charge on the net assets held by an agency, known as the capital user charge (CUC). The Project Evaluation Guidelines require the CUC to be used as the agency s benchmark rate (discount rate) when comparing buy and lease options. As the CUC rate of eight per cent is higher than the Western Australian Treasury Corporation s lending rate, agencies may be placed in the position of proceeding with and being held accountable for a lease that is preferred to purchasing from the perspective of the agency, but will not be beneficial for the whole-of-government. The guidelines state that 11 With the exception of the leases of CADCOM and the Fremantle Justice Complex, which were entered into prior to July 2001 but were current at December 31, AUDITOR GENERAL FOR WESTERN AUSTRALIA

15 agencies will have to use their discretion in these situations and that the lease/buy decision is ultimately the agency CEO s prerogative. If an agency decides to proceed with a lease, even though the analysis shows that leasing is preferred using the CUC but not when using the lending rate, then it is required to document the reasons for doing so. Audit observed that using the Western Australian Treasury Corporation s lending rate would lead to a lower figure for the discount rate than the use of the CUC. Agencies need to examine the sensitivity of the lease versus buy analysis to the choice of discount rate. AUDITOR GENERAL FOR WESTERN AUSTRALIA 15

16 BALANCING ACT: THE LEASING OF GOVERNMENT ASSETS Asset Management Key Finding Introduction Only the Department of Justice applied asset management policies to support its lease versus buy decision. The other four sampled agencies did not apply appropriate asset management and replacement policy frameworks when making lease versus buy decisions. Deciding on the most cost effective method of financing an asset acquisition is not always easy. In some circumstances, leasing will be advisable; in others, buying the asset will be the right decision. The decision to buy or lease will be affected by the extent to which an asset is used and replaced, and by the type of asset. Asset Management Policies In the lease versus buy decision, the residual value of the asset is the most significant factor. The estimate of residual value will be affected by the agency s asset management and replacement policies, and the impact of those policies on the useful life 12 of the agency s assets. As demonstrated later in the report, in general terms:! if the useful life of an asset to an agency equates to the economic life 13 of the asset, then leasing will be less attractive; and! if the useful life of an asset to an agency is much less than the asset s economic life then leasing will be more attractive. Table 2 shows a number of conditions that can either increase or decrease the useful life of an asset to an agency. 12 Useful life is the period over which an asset is expected to provide benefits or be of value to an agency. 13 Economic life is the period over which an asset is expected to be economically useable by one or more users. 16 AUDITOR GENERAL FOR WESTERN AUSTRALIA

17 $ USEFUL LIFE % USEFUL LIFE % LEASING ATTRACTIVENESS $ LEASING ATTRACTIVENESS! Systems in use and nature of services! Systems or operations are not subject provided require most up-to-date equipment. to change.! Optimal replacement period (eg after! New assets can be given first to high warranty expires) may be shorter than an need individuals or departments and asset s economic life after which, costs of then rotated through the agency as they maintenance etc outweigh benefits. get older ie cascade policy.! The asset is used more often by a large! The useful life of the asset can be number of users leading to greater physical extended by making minor modifications wear and tear. or upgrades to the asset. Table 2: Conditions that Increase and Decrease the Useful Life of an Asset The useful life of an asset will vary amongst agencies, depending on conditions that exist in each agency. Source: OAG It is therefore important that agencies develop optimal use and replacement strategies for its assets and document those strategies in an asset management and replacement policy. This should then drive the decision to buy or lease assets. For example, with the exception of the Department of Justice, all of the sampled agencies lease their information technology equipment. However, only the Department of Justice applied asset management policies dealing with the use and replacement of information technology equipment to its lease versus buy decisions. The Department of Justice has implemented a strategy of maintaining and replacing personal computers on a three to four year life cycle and leveraging off the standard three-year warranties applicable to personal computers. Cascade policies and memory upgrades are used to extend the useful life of personal computers. This is also enabled by the existence of a standard operating environment throughout the Department. The funds required to replace personal computers can be staggered over a number of years, avoiding the constraints of needing huge capital funding injections once every three to four years. Based on these policies, the Department has decided against leasing information technology equipment. Without the application of appropriate asset management policies, there is a greater risk that agencies will make poor lease versus buy decisions. By leasing, agencies may be unnecessarily surrendering assets well before the end of their useful life. There is also the risk that the acquisition and replacement of assets will be driven by leasing rather than operational need and optimal replacement times, and therefore resulting in additional costs. AUDITOR GENERAL FOR WESTERN AUSTRALIA 17

18 BALANCING ACT: THE LEASING OF GOVERNMENT ASSETS ASSET MANAGEMENT (continued) Expiry of Leases At the end of a lease term, lessees (agencies) normally have up to three options available. Agencies can either: 1. return the assets to the lessor and buy or lease new assets; 2. purchase the leased assets from the lessor at a certain value; or 3. extend the term of the lease and pay reduced lease payments. If an agency has strong asset management policies which have driven or have been instrumental in determining their allocation of operational and capital funds, then the decision to be made at the end of the lease may simply involve Option 1. That is, decide whether the assets are still required and either buy new assets or enter into new leases for new assets because funding has been allocated for that purpose. However, without appropriate asset management policies and/or the availability of necessary funds, then an agency that has chosen to lease (for whatever reason) may be forced into Option 2 or 3. Options 2 and 3 need to be carefully considered because they can negate any financial benefits obtained from leasing. As stated in the Project Evaluation Guidelines, it is the actions of the lessee (or agency) at the end of a lease arrangement that generally determines the overall financial performance of the lease. A sample of leases, which expired between July 2001 and December 2002, were examined to assess the action taken by agencies. Department of Education A sample of 26 leases relating to information technology assets valued at $2.2 million that expired between July 2001 and December 2002 was examined at the Department of Education. Around 60 per cent of the leased items were bought out at the end of the original lease term 627 items were purchased at amounts representing between 19 and 33 per cent of the items original value. Most of these items were three-year old computers leased as part of the Department s Learning Technologies Program in schools. For example, 120 personal computers valued at around $1 200 each in May 1999 were purchased by a school from the lessor in May 2002 for $400 each. This resulted in an additional net present value premium of up to 20 per cent compared with purchasing the computers outright back in May 1999, thereby negating any benefits that may 18 AUDITOR GENERAL FOR WESTERN AUSTRALIA

19 have been obtained from leasing. Essentially, the Department of Education has paid twice for the same assets by paying an amount equivalent to the cost of buying the new assets plus the cost of buying the assets second-hand (used). Only some schools had negotiated with lessors to reduce the purchase amount. A further 23 per cent of the leased items were leased for additional periods of up to 24 months at between 40 and 75 per cent of the original lease payment. For example, in April 2002, one school agreed to pay $ over 15 months for 48 three year old computers (or $601 each). As these computers were valued at $ (around $1 917 each) in April 1999, the school is paying an additional 30 per cent (in net present value terms) to keep the assets for a further 15 months. As stated in the Project Evaluation Guidelines, given that the asset is now worth typically 15 per cent of its original value, this does not provide value. The remaining 172 items were returned to the lessor. Police Service In 2002, due to financial constraints, the Police Service implemented a decision to extend its three-year leases of information technology assets for an additional 12 months at 50 per cent of the original lease payments. By December 31, 2002, leases for over items (originally valued at around $15 million) had been extended. This resulted in an additional net present value premium of up to 15 per cent compared with purchasing outright, thereby negating any benefits that may have been obtained from leasing. Costs were also incurred in upgrading computers prior to the end of the three-year lease terms. The Police Service advised that it was its intention at the beginning of the leasing arrangement to lease the assets for three years and then to undertake a refresh. However, circumstances outside of the leasing arrangement required the Police Service to reassess this strategy. Recommendations Agencies should:! document their rationale for asset acquisition and replacement; and! conduct a financial evaluation of all options available at the end of a lease term and negotiate, as appropriate, with lessors at the expiry of the lease. AUDITOR GENERAL FOR WESTERN AUSTRALIA 19

20 BALANCING ACT: THE LEASING OF GOVERNMENT ASSETS Lease Versus Buy Key Findings Introduction! Two of the sampled agencies do not conduct lease versus buy analyses prior to entering into leasing arrangements. Consequently, these agencies are not able to demonstrate whether value for money has been achieved.! It was not always possible to conclude whether value for money had been achieved from leasing due to unsound estimates used by those agencies conducting lease versus buy analyses.! Leasing decisions that did not adequately take into account the nature of the assets and their importance to agencies resulted in additional costs.! Leasing is often seen as the first and only option for dealing with the risks of asset ownership, without consideration of alternative options for dealing with these risks. The key to establishing whether leasing is more cost effective than purchasing outright is to determine whether the amount being paid to transfer ownership risks represents value for money. This first involves identifying the cash inflows and outflows (and their timing) associated with each financing alternative and discounting the cash flows to calculate their present worth. The Project Evaluation Guidelines requires agencies to assess whether leasing is preferred to buying after quotes for lease finance have been obtained. This is also required by State Supply Commission guidelines which state that agencies should only enter into leasing arrangements after thorough examination of the financial implications, and having obtained independent financial advice. The decision to buy or lease should be well documented. If a decision is made which takes into account reasons beyond the financial outcome of a lease versus buy analysis, then those reasons and how they affected the decision should also be documented. The Project Evaluation Guidelines issued by the Department of Treasury and Finance include a chapter on the Analysis of Leases and the use of a Lease Calculator to assist agencies in conducting a lease versus buy analysis. The Lease Calculator is a spreadsheet application consisting of a number of worksheets. Users are required to enter the terms of the lease (purchase price, number of payments, lease payments per period in advance or arrears, financier s benchmark and lease margin rates, and other lease costs if any) and minimum and maximum residual values. 20 AUDITOR GENERAL FOR WESTERN AUSTRALIA

21 The Lease Versus Buy Analysis From discussions with management and review of leasing transactions, leasing is often seen as the favoured option even before an analysis is performed. The attractiveness of not having to find the money up front creates a strong incentive for agencies to lease. Therefore, there is a risk that procurement choices will be distorted towards leasing, with lease versus buy analyses either not performed or structured to support a decision to lease. This examination identified that two of the sampled agencies do not conduct formal lease versus buy analyses prior to entering into individual lease transactions. In the absence of lease versus buy analyses, these agencies did not know whether a premium was being paid for leasing and whether it represented value for money for the intended benefits being provided. Table 3 provides a summary of leasing policies in place at the sampled agencies. AGENCY Department of Education Police Service Department for Planning and Infrastructure Department of Justice Central TAFE FINDINGS Leasing is at the discretion of management. The examination of a sample of 17 lease transactions (valued at $4.6 million), excluding the Notebooks for Teachers Program, identified that formal lease versus buy analyses were not performed. All orders for IT equipment valued over $300 are leased. No lease versus buy analyses have been conducted since a formal lease versus buy decision was made in October Leasing is at the discretion of management but only after a formal lease versus buy analysis has been performed. Independent advice is sought for lease transactions over $ In accordance with the Department s IT Strategic Plan, IT equipment is not leased. Leasing is only entered into after a formal lease versus buy analysis has been performed by the Department of Treasury and Finance. Table 3: Leasing Policies at Sampled Agencies Lease versus buy analyses are not always performed. Source: OAG The availability of the Lease Calculator means that some agencies are however, now able to conduct lease versus buy analyses which they may not have in the past. The Department for Planning and Infrastructure conducts a lease versus buy analysis prior to entering into a leasing transaction. If the Lease Calculator shows that leasing is not beneficial, then the transaction will not proceed. AUDITOR GENERAL FOR WESTERN AUSTRALIA 21

22 BALANCING ACT: THE LEASING OF GOVERNMENT ASSETS LEASE VERSUS BUY (continued) Central TAFE is the only sampled agency that uses the whole-of-government leasing facility established by the former Department of Industry and Technology. In using the facility, Central TAFE is provided with the results of analyses conducted by the Department of Treasury and Finance using the Lease Calculator. Estimating Residual Value The lack of formal lease versus buy analyses at the Department of Education, for example, has resulted in the Department failing to identify at least three finance leases valued at $2.5 million (from a sample of 17 valued at $4.6 million) which cost up to four per cent more than the purchase option, before taking into account the residual value of the assets. Many other leases at the Department of Education appeared to be cheaper than purchasing but this was before the residual value of the assets was taken into account. It was therefore not possible to conclude whether value for money had been achieved. The estimate of residual value is critical in the lease versus buy analysis. A lower agency estimate of residual value will favour leasing, that is, leasing is financially beneficial if the residual value the agency places on the asset is much lower than the resale value that the lessor can achieve. Therefore, the outcome of the lease versus buy analysis can be heavily influenced by the agency s estimate of residual value. For example, in one of the sampled agencies conducting lease versus buy analyses, the same residual value estimate had been used regardless of the type of asset. Items such as desktop computers, servers, and survey equipment had been analysed using an estimated residual value of five per cent, even though each of these items would be expected to have different useful lives and/or market values. Explanations of the basis for the estimate could not be provided by the agency. Table 4 compares the residual values of five per cent for a sample of leased assets with the residual values at which the agency would have been financially indifferent between buying and leasing, that is, the point at which the costs of buying and leasing are equal (point of financial indifference ) 14. The table illustrates that differences in residual value estimates, as small as 0.4 per cent, could have affected the financial outcome of the agency s lease versus buy analyses. 14 The Lease versus Buy Analysis Model developed by the Queensland Treasury Corporation calculates the residual value estimate at which an agency should be financially indifferent between buying and leasing. 22 AUDITOR GENERAL FOR WESTERN AUSTRALIA

23 Equipment Purchase Price Estimate of Residual Residual Value Break-Even Desktops x (5%) (5.4%) Desktops x (5%) (8.2%) Survey Equipment (5%) (5.6%) Desktops x (5%) (6.7%) Table 4: Point of Financial Indifference or Residual Break-Even The financial outcome of a lease versus buy analysis is extremely dependent on residual value estimates. In some cases, the residual value estimate at which the agency would be financially indifferent between buying and leasing is not much higher than the actual estimate used by the agency. Source: OAG In practice, estimating residual value can be extremely difficult and it is not unreasonable to expect estimates of residual values for the same class of assets to differ amongst agencies. Although the Department of Treasury and Finance s Lease Calculator takes into account a range of possible residual values and assigns probabilities to those values, it is still necessary for an agency to input an initial estimate into the Lease Calculator. Refining the residual value estimate can take time and money and may not necessarily add to the value of the lease versus buy analysis. Lease versus buy decisions should therefore be based on a comprehensive analysis of benefits and risks as well as costs, taking into consideration:! the type of asset and its importance to the agency; and! the way the asset will be used by the agency (as defined in its asset management policies). Type of Asset Specialised assets such as custom-built fisheries vessels or purpose-built facilities such as courthouses often do not have a well-developed second-hand market. In these cases, the private sector would find it difficult to sell or re-lease the asset at the end of its lease term and assume residual value risk. As such, the value of the asset to the agency will most likely be greater than the value placed on the asset by the lessor. The lessor would therefore seek to run the lease for most of the asset s economic life and/or recoup the whole cost of the asset plus a profit or interest component from the lessee. Leasing these types of assets without the retention of any significant level of risk by the lessor (or private sector) will therefore generally not offer a substantive financial benefit, as demonstrated in the acquisition of the Fremantle Justice Centre by the Department of Justice. Specialised assets and its effects on the leasing decision have now been documented in the Department of Treasury and Finance s Project Evaluation Guidelines. AUDITOR GENERAL FOR WESTERN AUSTRALIA 23

24 BALANCING ACT: THE LEASING OF GOVERNMENT ASSETS LEASE VERSUS BUY (continued) Department of Justice Fremantle Justice Centre Planning for the replacement of the Fremantle Courthouse commenced in July A large number of possible sites were investigated by the Department of Justice in the ensuing years. Finding a suitable site proved difficult because the city of Fremantle is a densely developed area and most sites are privately owned, multitenanted and/or unavailable. Consequently, a decision was taken in early 1997 to consider private sector involvement in the construction of the Fremantle Justice Centre (FJC). The Department of Justice was allocated $15.5 million in capital works funding, if necessary, to acquire the Fremantle Justice Centre. In late 1997, property owners/developers were invited to lodge expressions of interest to develop FJC. A number of options were put to the market for procuring FJC including a once-off purchase by the State or a private sector owned development which is leased to the Department under a build, own, operate, and transfer (BOOT) scheme. Short listed respondents were then issued a Request For Proposal (RFP) in May However, the request for a once-off purchase price did not appear in the RFP. An addendum was issued in July 1998 making such a request. The request was later withdrawn after objections were received from some respondents who were not in a position to sell the land which was to be the subject of its proposals. The Department was therefore locked into leasing FJC. In December 1998, a successful contractor was selected. The successful respondent was also able to offer to transfer the building to the Department at the end of a 25- year lease term. Negotiations commenced in early 1999 to establish a leasing arrangement for the FJC. Various lease finance alternatives were examined by both the Department of Treasury and Finance and the Western Australian Treasury Corporation. The WATC advised that these alternatives would cost between $4.63 and $10.04 million (or 31 and 68 per cent) more than if the government had funded the construction of the FJC and would involve no significant risk retention by the lessor. Further negotiations took place and a final lease agreement was signed in November 1999, with lease payments commencing in March 2001 following the construction of the centre. The lease has been classified as a finance lease in the Department of Justice s Statement of Financial Position (balance sheet). The terms of the agreement mean that the Department will be paying around $3.6 million (or 25 per cent) more than a government funded buy option. The Department of Justice advised that the procurement of the FJC achieved a transfer of other risks associated with site availability, site location, design and construction, planning and zoning, and maintenance; though, these were not quantified and therefore, the extent to which value for money is achieved is not clear. It is possible that some or all of these risks could have been transferred via other contractual arrangements without the need for private finance. The Department of Justice also advised that it has applied the lessons learnt from the procurement of the FJC to the acquisition of Acacia Prison. Formalised structured risk identification and evaluation processes were established early and continually monitored throughout the project delivery period. 24 AUDITOR GENERAL FOR WESTERN AUSTRALIA