Appendix 5D Ernst & Young Accounting Treatment

Transcription

1 Appendix 5D Accounting Treatment (Ernst & Young)

2 Appendix 5D Ernst & Young Accounting Treatment Introduction An off balance sheet treatment from the position of the Authorities is a fundamental requirement of the Treasury in supporting the project. This requirement is based on the presumption that the project will be off the public sector balance sheet only when sufficient project risk has been transferred to the private sector. No formal accounting opinion has been performed for this project to date. However, in assisting the Authorities in developing their OBC, Ernst & Young has considered the issues that will impact upon the final accounting opinion, which will be required from the Authorities Accounting Officers and reviewed by the Authorities Auditors as part of the Final Business Case. In September 1998 the Accounting Standards Board ( ASB ) produced an Application Note ( AN ) for use in applying FRS 5 to PFI Transactions. Following this, the Treasury Taskforce on 24th June 1999 issued a revised Technical Note PFI Technical Note Number 1 (Revised) ( the Technical Note ) to provide additional practical guidance on the following areas of the AN to ensure the overarching principles of the AN are consistently applied. In accordance with Ernst & Young LLP s policy of applying Government guidance in accounting for PFI transactions, the Technical Note has been used to review the accounting treatment for this project. Whilst the ASB has reviewed the Technical Note, and does not consider it to be inconsistent with FRS 5, it is possible that the use of other technical guidance, including the ASB Application Note and the FRS 5, may result in a differing view to that given using TN 1. The initial view at the OBC stage, after reviewing the qualitative indicators and the allocation of the key risks of the project under TN 1, is that the majority of significant risks will lie with the Contractor, indicating that the transaction is likely to be accounted for as off balance sheet from the view of the Authorities. This appendix is in regard to the accounting and disclosure aspects of the project only, and does not cover other aspects such as legality or value for money. It is also important to note that our indicative conclusion on the accounting treatment is based on the Reference Project included within this OBC. Any change in these underlying inputs may change the nature of the conclusion reached. Moreover, a final analysis will involve a quantitative analysis which we have not yet been able to perform and this may result in a change in our indicative views. The UK Government announced in March 2007 that government departments and other entities in the public sector will be required to prepare their financial statements using International Financial Reporting Standards ( IFRS ), as adapted as necessary for the public sector. This requirement is currently expected to be effective for local authorities from 1 April In December 2007 HMT Treasury published a consultation paper relating to accounting for PPP arrangements, including PFI, under IFRS. As this consultation is still in progress, it is not possible at present to clearly set out the accounting required for the transaction under IFRS by the Authorities. The analysis set out in this appendix has therefore been performed on the existing guidance as set out above and does not discuss the potential accounting for the transaction under IFRS. The final decision on the accounting treatment is the responsibility of the relevant Accounting Officer in conjunction with the Authorities Auditors. We therefore recommend that, in accordance with the TN, you discuss this accounting assessment with your Auditors as soon as possible.

3 General overview of balance sheet treatment methodology TN 1 has been used to provide an initial view on the accounting treatment for this project at pre-isds stage. The assessment of the balance sheet treatment is divided into two stages: separation of contract, and assessment of the risk allocation in respect of the property-related services. Basic principle Under FRS 5, assets of an enterprise are defined as rights or other access to future economic benefits controlled by an entity as a result of past transactions or events. The general principle of FRS 5 is that a party will have an asset of a property where that party has access to the majority of the benefits of the property and exposure to the risks inherent in those benefits. The terminology used in FRS 5 has been adopted here. The public sector body entering into the Contract is referred to as the purchaser, whilst the private sector body is the Contractor. The property used for the purposes of the Contract, in this case the waste management assets, is referred to as the property with the term asset reserved for items recognised on the balance sheet. In the case of this scheme the Authorities are the purchaser under the contract. The property will not be deemed to be an asset of the Authorities if the analysis under TN 1 demonstrates the balance of risks and rewards lie predominately with the Contractor. Under TN 1, it should be noted that it is solely the payment stream related to the property that will be reviewed for accounting treatment. Other nonproperty-related services are not relevant for this analysis. Separation of contract The first stage of the balance sheet analysis is to consider whether individual elements of the contract operate independently from each other, so as to be able to identify whether there is a payment stream that relates solely to the asset of the property. Any such separable elements that relate solely to services should be excluded when determining which party has an asset of the property. Paragraph F10 of the ASB s Application Note F for FRS 5, which is elaborated upon in TN 1, provides that a contract may be separable in a variety of circumstances, including, but not limited to, the following three situations: Situation 1 The contract identifies an element of a payment stream that varies according to the availability of the property itself and another element that varies according to usage or performance of certain services. Situation 2 Different parts of the contract run for different periods or can be terminated separately. For example, an individual service element can be terminated without affecting the continuation of the rest of the contract. Situation 3 Different parts of the contract can be renegotiated separately. For example, a service element is market tested and some or all of the cost increases or reductions are passed onto the purchaser in such a way that the part of the payment by the purchaser that relates specifically to that service can be identified. This OBC is for the procurement of a residual waste treatment facility and the 4Ps Payment Mechanism, which the Authorities intend to utilise, is based on a unitary charge for the delivery of the whole service

4 and it is anticipated that the draft performance regime will cut across all areas of the contract. Equally, it is anticipated that in all instances each component of the payment mechanism will contain both property and service elements. As such, the payment mechanism is not likely to be separable for the elements of property related services, such as energy recovery. Since it is typically considered that these service elements of the contract are relevant to the accounting analysis of the property, the Technical Note requires that the project be considered under FRS 5 criteria. The contract may be structured so that certain specific service elements of the contract are benchmarked or will be subject to market testing. The expectation, however, is that these will relate to a proportion of the service element of the contract only, and so the separation of these will not indicate that a residual payment stream applies solely to the property. Conclusion regarding separability Based upon this OBC and the analysis detailed above, the contract will combine service and property elements under a single non-separable charge. Therefore, following TN 1 guidance, the application of SSAP 21, Accounting for leases and hire purchase contracts, is not relevant under these circumstances and the project should be considered under FRS 5 criteria. Assessment of property-related assets Given that the FRS 5 route has been identified as the likely accounting treatment application of the contract, TN 1 identifies both qualitative and quantitative drivers for determining the accounting treatment. The initial qualitative and quantitative assessments are evaluated below. In the absence of fully developed contract documentation, we consider that a detailed quantitative analysis is not possible at the OBC stage. Rather, one based on the relative importance of the key risks and their allocation is more appropriate. Qualitative drivers The three qualitative factors are considered in turn below: Termination for Contractor default - A financing arrangement would be indicated where in the event of Operator default the senior debt financier is fully paid out by the Authorities under the terms of the contract. In such circumstances the property would be considered an asset of the purchaser. Nature of Contractor s financing - The Operator s financing arrangements may indicate a level of senior debt funding that would only be possible if a more significant entity were standing behind the arrangement. In practice this means that very high levels of gearing would seem to imply a risk free (ie, insufficient risk transfer has occurred) project, which should therefore be considered an asset of the Purchaser; and Who determines the nature of the property? - Where the Operator has significant and ongoing discretion over how to fulfil the PFI contract and makes key decisions on what property is built and how it is operated, this is an indication that the property is Operator s asset. Conversely when the purchaser determines the key features of the property and how it is operated, this is evidence that the property is their asset. The assignment of design risk (ie the risk of the property not meeting the output specifications or being fit for purpose ) between the two parties is a significant indicator of who determines the nature of the property. Consideration of each of these qualitative drivers is given in relation to this Project below: Termination for Contractor default The draft contract documentation will utilise SOPC 4 drafting and incorporate, where applicable, waste sector specific SOPC 3 derogations. Correspondingly, the contract will use the market value of the project as the basis for the termination sum in the event of Contractor default. This payment is reliant on a further

5 private sector operator being willing to pay for the assets concerned; if no payment is received, no payment will be made to either the Contractor or senior funders. Under these terms, the balance of risk rests with the Contractor and so will support an off balance sheet treatment from the point of view of the Authorities. Nature of Contractor s financing It is unclear what debt/equity funding will be used for the project by the bidders, and therefore this factor is uncertain. Who determines the nature of the property? TN 1 makes it clear that the property is an asset of the Contractor where the Contractor has significant and ongoing discretion over how to fulfil the contract and makes the key decisions on what property is built and how it is operated, bearing the consequent costs and risk. This OBC assumes that the Contractor will be wholly responsible for all aspects of the design and will take responsibility for fulfilling the requirements of the contract. The Contractor will be required in the ISDS to provide the services to the standard set out in the output specification. It is anticipated therefore, that the Contractor will be provided with the flexibility to determine how the property enables the requirements of the output specification to be achieved. The key risks over the nature of the property, including how it is to be operated and the cost implications and future life cycle expenditure levels will thus be borne by the Contractor. This provides a preliminary indication that the property will be an asset of the Contractor. Overall, there is strong contributory evidence from the qualitative factors at the OBC stage that the project structure will support an off balance sheet treatment. In order to provide further evidence, the quantitative factors below have been reviewed and a view has also been provided. Quantitative drivers TN 1 requires a quantitative risk analysis to be performed that evaluates the potential variations in property profits (costs and revenues that flow from features of the property) for the Authorities and the Contractor. The allocation of property profits will demonstrate the extent to which each party bears the potential variations in these profits, hence providing a quantitative indicator of which party bears the risks and rewards of ownership. As stated previously, it is considered that a detailed quantitative analysis is not possible at the OBC stage. Therefore, outlined below is a review of the quantitative factors associated with the project and the potential treatment this would indicate. Demand risk The Application Note states, Where demand risk is significant, it will normally give the clearest evidence of who should record an asset of the property. It is anticipated that the payment mechanism will seek a unitary payment for the delivery of all services contained in the draft contract specification. The demand for services is a function of both the volume and composition of contract waste. Volume It is anticipated that the ISDS will require the Contractor to recover and divert a given target percentage of waste regardless of volume. It is likely that bidders will be required to specify maximum and minimum tonnage thresholds within which capacity will be provided without recourse to the contract change mechanism. Within these bands the Contractor will bear the balance of the risk that increases in waste volume result in differential cash flow or profit to that projected at financial close. Within these bands the risk that greater waste volumes require further investment to achieve performance targets, or that a decrease in waste volumes results in over-investment in facilities will remain with the Contractor. The application of the contract change mechanism beyond these maximum and minimum tonnage thresholds should transfer demand risk back to the public sector.

6 Given the nature of the 4Ps payment mechanism and the likely variations of waste volumes over the contract period, it is estimated at this stage that within likely tonnage ranges, the balance of volume related demand risk is likely to be with the Contractor. Composition At this stage it is anticipated that the Contractor will be exposed fully to changes in waste composition to the extent that these influence the demand for services, although it is anticipated that various thresholds regarding the composition of the waste received will be established by the Contractor (for example in terms of calorific value). Outside of these thresholds it is likely that the Partnership will bear composition risk. An initial assessment of these demand risk elements indicates that this risk is likely to be shared 1 between the Contractor and the Authorities. Third-party revenue Third party revenue risk is the risk that revenues arising from third party demand for the property will be greater or less than expected. It is expected that the draft ISDS will request a guaranteed annual amount of third party revenue. The total value of guaranteed third party income is unknown at this stage, but it is envisaged that the realisation of the Contractor s required project rate of return will be partly dependent on the generation of this guaranteed revenue and that, therefore, the risk is with the Contractor. Design risk Design risk is the risk that the design of the property is such that, even if it is constructed satisfactorily, it will not fully meet the requirements of the contract. Under the ISDS, the Contractor will bear the risk that the design solution may result in different life cycle, maintenance or operating cost profiles than expected. There is no link between the payment structure and changes to these costs. This gives a preliminary indication that the Contractor will bear the design risk in the project and it is anticipated that the Contractor will bear the balance of this risk. Deductions for under performance or non-availability The project includes a performance regime covering both the non-performance and non-availability of the property and associated services. However, the only deductions that are relevant for this analysis are those that are specific to the property. That is, any deductions that relate to failures that result in the property no longer being available for use (ie, non-availability deductions). The terms of the deduction regime included within the ISDS will transfer a significant degree of risk to the Contractor and therefore it is anticipated that the Contractor will bear the risk of under-performance or non-availability of the property. Potential changes in relevant costs The proposed contract extends for a proposed 25 years and, therefore, the Contractor s cost base will be subject to variations arising from changes in technology, and, for example, inflation of materials and labour rates. For the purposes of this initial analysis, the only relevant cost changes are those that relate specifically to the property. Therefore, changes in the cost of providing non-property-related services are ignored although these will form the majority of the relevant costs. 1 For clarity, the allocation of a designated risk as shared does not imply that the risk is borne by each party equally. Rather, it implies that it has not been possible to accurately determine which party bears the greater exposure to that risk. Alternatively, where a risk has been allocated to a party, this does not imply that it is exposed to 100% of that risk. Instead, it implies that, at this stage, the party is expected to bear the balance of the exposure to that risk.

7 To the extent that the Contractor retains these risks against a set payment profile, an off balance sheet treatment would be implied. Whilst not finalised at this stage, it is anticipated that the indexation formulae included within the payment mechanism will allow for an element of the total unitary payment to be inflated based on the Retail Price Index. Because the unitary charge indexation will not be directly linked to variations in the Contractor s actual costs, it is anticipated that the risk of potential changes in relevant costs, other than inflation, will be borne by the Contractor. Obsolescence/technological/environmental change Given the nature of the project (waste handling and processing), the risk of obsolescence or changes in technology being likely to crystallize is relatively significant for this project. Where this does not arise through a change in law, it is anticipated that the risk will be borne by the Contractor as the waste management system designed to meet the output specification is built around the technology solution. Changes in environmental laws or regulations or rules governing PPP/PFI projects, all make it possible that future costs will need to be incurred relating to the property or property-related services. Given the proposed 25 year life of the project, it is likely that such changes will occur at some point over the term of the contract. Under SOPC 4 the balance of costs of complying with changes in law will be borne by the public sector and therefore the public sector bears the element of this risk. Overall, an indicative view on the risk associated with obsolescence / technological change is that the Authorities bear the balance of risk. Residual value Residual value risk is the risk that the actual residual value of the property at the end of the contract will be different to that expected. Under the ASB Application Note, residual value is market value at the end of the contract. Under the Treasury approach, the definition of residual value depends on whether the property is specialised (residual value is the depreciated replacement cost with potential variations for risk) or nonspecialised (estimated open market value at the end of the lease, eg, the present value of what can be obtained by selling or leasing the asset at a market value at the end of the primary lease term). We have taken the view that the property will be specialised. It is anticipated that the draft project agreement will make provision for the Authorities to notify the Contractor whether it wishes the Contractor to transfer all or any of its rights, title and interests in and to the pre-agreed list of assets to the Authorities or whether to re-tender the provision of the service. In practice it is expected that the waste management assets will return to the ownership of the Authorities at the expiry of the contract term. It is not anticipated there will be provision for any remuneration to pass from the Authorities to the Contractor in consideration for the facility hand-over. The Authorities will therefore assume residual value risk over the transferred assets. However, the experience of other schemes suggests that the draft project agreement is likely to make provision for a survey to be carried out on the project assets. To the extent that the survey concludes that the assets have not been adequately maintained, deductions from the unitary payment over the final 18 months of the contract may be made by the Authorities. Therefore, under a regime such as this, it is anticipated that residual value risk will be with the Authorities, but the risk that the value of the assets at the end of the project will be different from that expected is low. Environmental Risk The environmental risk for this project will relate mainly to the occupation and use of land and waste management facilities, whether the land and facilities belong to the Partnership or are supplied by the contractor as part of his solution. In accordance with the 4Ps guidance, the risk from adverse environmental impacts from ground conditions will reside with the Contractor from commencement of services, dependant on the suitability and acceptance of the appropriate surveys.

8 For sites offered by the Authorities for the project, it will retain the risk of dealing with any existing environmental issues. However, the Contractor will be required to accept that the environmental issues have been adequately dealt with as to not affect the contract and hand back the sites to the Authorities at the end of the contract in no worse condition; all additional risk associated with complying with new environmental regulations will be covered by the specific change in law provisions in the project agreement. For other environmental issues, the Contractor will be required to maintain the necessary leases, licences and consents to undertake the services in the contract, effectively ensuring that these risks are borne by the Contractor. Conclusion A summary of the relevant criteria affecting the accounting analysis for the Authorities are shown in table 1.1 below: Table 1: Key risks for accounting analysis Key Risk Partnership Shared Contractor Risk Level Demand High Third-party revenues Medium Design Medium Under-performance or nonavailability Changes in relevant costs (other than general inflation) Medium High Obsolescence/legislative change Medium Residual value Low Environmental Medium The initial view, after reviewing the qualitative indicators and the allocation of the key risks of the project based on the OBC documentation, is that the majority of significant risks are projected to lie with the Contractor, indicating the potential to achieve an off balance sheet view from the point of view of the Authorities. Any significant change to the final documentation may result in a change to the analysis and the result. It may also be the case that a full quantitative analysis based on the final numbers would result in a different outcome.