Background
Governments are always
starved of funds. To mitigate this problem, they enter into contracts
with private parties; particularly in the area of public service for the
development, financing, operation and maintenance of infrastructural
facilities such as, roads, bridges, ports, etc. An arrangement typically
involves a private sector entity (an operator) constructing the
infra-structural facilities used to provide the public service and
operating and maintaining those infrastructural facilities for a
specified period of time. The operator is paid for its services over the
period of the arrangement through user fees or the grantor pays
annuity. Such an arrangement is often described as a
‘build-operate-transfer’ (BOT) or a ‘public-to-private service
concession arrangement’. A feature of these service arrangements is:
1.
The grantor (generally the Government or a public sector company)
controls or regulates what services the operator must provide with the
infrastructural facilities, to whom it must provide them, and at what
price; and
2. The grantor controls through ownership, beneficial
entitlement or otherwise any significant residual interest in the
infrastructural facilities if remaining at the end of the term of the
arrangement.
Typically under current Indian GAAP, practice is
that the grantor records the cost of constructing the infra-structure as
fixed assets or in some cases as intangible assets. No profit is
recognised on the construction, since it is not appropriate to recognise
any profit on constructing fixed assets/intangible assets for own use.
However,
if one were to look more deeply into the current Indian GAAP, a more
appropriate accounting interpretation of the arrangement would be as
follows:
1. The infrastructure facilities should not be
recog-nised as property, plant and equipment of the operator, because
the contractual service arrangement does not convey the right to control
the use of the public service infrastructure facilities to the
operator. The operator has access to operate the infrastructure
facilities to provide the public service on behalf of the grantor in
accordance with the terms specified in the contract.
2. Under
the terms of contractual arrangements, the operator acts as a service
provider. The operator constructs infrastructure facilities used to
provide a public service and operates and maintains those infrastructure
facilities (operation services) for a specified period of time.
3.
The operator should recognise and measure revenue in accordance with
Accounting Standard (AS) 7, Construction Contracts and Accounting
Standard (AS) 9, Revenue Recognition for the construction and operating
the services it performs.
If the operator performs more than one
service under a single contract or arrangement, consideration received
or receivable should be allocated by reference to the relative fair
values of the services delivered, when the amounts are separately
identifiable.
4. Paragraph 34 of AS 26 Intangible Assets
states that “An intangible asset may be acquired in exchange or part
exchange for another asset. In such a case, the cost of the asset
acquired is determined in accordance with the principles laid down in
this regard in AS 10, Accounting for Fixed Assets.” Paragraph 11.1 of AS
10 states that “When a fixed asset is acquired in exchange for another
asset, its cost is usually determined by reference to the fair market
value of the consideration given. It may also be appropriate to consider
the fair market value of the asset acquired, if this is more clearly
evident.”
5. If the operator provides construction services,
the consideration received or receivable by the operator should be
recognised at its fair value. The consideration may be, rights to a
financial asset (annuities are received from the government), or an
intangible asset (toll charges are collected from public).
6. The operator should recognise a financial asset when it receives annuities from the grantor.
7.
The operator should recognise an intangible asset to the extent that
it receives a right (a licence) to charge users of the public service.
Let’s consider a simple example of how the intangible asset model would work.
Example
The
terms of the arrangement requires an operator to construct a road
within two years and maintain and operate the road to a specified
standard for eight years (i.e. years 3–10). At the end of year 10, the
arrangement will end and the road ownership will continue with the
government. The operator estimates that the costs it will incur to
fulfill its obligations will be as shown in Table 1.
Table 1 — Estimate of Costs
Assume
the operator collects Rs. 200 per year in years 3–10 from users of the
road. The user rates are fixed by the government. Fair value of
construction services is forecast cost plus 5%.
The operator
recognises contract revenue and costs in accordance with AS 7,
Construction Contracts and AS 9, Revenue Recognition. In year 1, for
example, construction costs of Rs. 500, construction revenue of Rs. 525
(cost plus 5 per cent), and hence construc-tion profit of Rs. 25 is
recognised in the statement of profit and loss. The operator provides
construction services to the grantor in exchange for an intangible
asset, i.e. a right to collect tolls from road users in years 3–10. In
accordance with AS 26, Intangible As-sets, the operator recognises the
intangible asset at cost, i.e. the fair value of consideration
transferred to acquire the asset, which is the fair value of the
consideration received or receivable for the construc-tion services
delivered. In accordance with AS 26, the intangible asset is amortised
over the period in which it is expected to be available for use by the
operator, i.e. years 3–10. The depreciable amount of the intangible
asset (Rs. 1,050) is allocated using a straight-line method. The annual
amortisation charge is therefore Rs. 1,050 divided by eight years, i.e.
Rs. 131 per year. The road users pay for the public services at the same
time as they receive them, i.e. when they use the road. The operator
therefore recognises toll revenue when it collects the tolls. The
statement of P&L for years 1-10 will appear as shown in Table 2.
The
above example has been kept simple and numerous other complications
have not been considered such as capitalisation of borrowing costs,
resurfacing obligation, negative grants, revenue sharing arrangements,
etc.
To sum up, it could be said that the current Indian GAAP is
not explicit as to how BOT contracts should be accounted for.
Therefore, there appears to be two methods in which BOT contracts can be
accounted.
Method 1
A classic and conventional
method has been to recognise the construction cost of the infrastructure
as fixed asset and depreciate it over a period of time. The
corresponding revenue on user fees is recognised when user fees are
collected.
Challenges in applying method 2
Scope
Since
the accounting model involved in method 2 is so different from the
traditional ”fixed asset” model, it is critical to determine whether an
arrangement falls within its scope. This is not always straightforward
due to the complexity of the contracts setting out the key terms of the
concession arrangements. One challenge that may arise, is in
deter-mining whether the government body controls any significant
residual interest in the infrastructure asset at the end of the
concession arrangement. Another challenge that may arise in some
circumstances, is to determine whether the government in substance
controls the user price.
Intangible asset, financial asset, or both
The
next step is to determine which of the two ac-counting models
(intangible asset or financial asset) to apply. This decision will have a
significant impact on the revenues recognised from the contract. For
example, it is not uncommon for a contract accounted for by applying the
intangible model to give rise to double the revenues, compared to a
contract with nearly identical cash flows that is accounted for using
the financial asset model. Fortunately, the selection of the model to
apply is not an option. Rather, the model flows from whether the
operator has the right to charge for services (intangible model) or the
right to receive cash flows from the grantor (financial asset). This may
require careful analysis, since a contract that initially appears to
fall within the intangible model may have an element of guaranteed cash
flows. For example, if in the early years of the contract, the
government body guarantees a minimum level of revenues from the
operation of a new expressway to encourage private investment, there may
be both a financial asset and an intangible asset. Accounting for these
“combined model” concessions can become very complex, since costs and
revenues must be divided between the two components of the contract.
Dividing the total consideration into the two components may involve the
use of significant management judgment and estimation.
Estimates and fair values
Accounting
for concession arrangements typically involves an extensive use of
estimates and valuations, which are expected to have a significant
impact on the company’s financial statements. For example, revenues and
costs need to be recognised for the construction of the infrastructure
asset in accordance with AS-7. Since the contract is unlikely to specify
separately the revenue from construction, it is typically necessary to
impute construction revenues by applying an appropriate margin to the
construction costs, and to assign the balance of revenue to operations,
maintenance, etc. Companies may need to use either internal or external
benchmarking for similar construction contracts, since an assessment of
profitability on a service concession arrangement is normally made on an
overall IRR basis and not separately for the construction and operation
phases of the project.
Accounting for negative grants
Certain
arrangements include the provision for negative grants, wherein the
operator is required to make the payment to the grantor during the
duration of the arrangement. The negative grant may be either in the
form of fixed payment (upfront or annual throughout the service
concession arrangement) or in the form of a percentage of revenue earned
during the arrangement. The upfront fixed payment should be treated as
an intangible asset. In the case of annual fixed payment, intangible
assets should be recognised at the present value of the annual amounts.
However, there are mixed practices under Indian GAAP in these matters.
Where the negative grant is in the form of share in the percentage of
revenue earned during concession arrangement, the company should assess
whether the revenue is to be shown on a net or gross basis.
Other factors
Numerous
other issues need to be considered such as capitalisation of borrowing
costs, provision for maintenance obligation, etc. and the efforts
involved in applying method 2 should not be undermined.
Issue
Parent
Ltd is a listed entity. Parent Ltd has set up a special purpose vehicle
(SPV) which is its 100% subsidiary, for the purposes of entering into
an arrangement with NHAI. SPV has entered into BOT contract with NHAI.
As per the Agreement, NHAI has granted an exclusive right to the SPV to
construct, operate and maintain the road for a period of thirty years.
The SPV has sub-contracted the construction for 60% of the road contract
to Parent. In 2012-13, Parent has executed the work of above road
project and the profit margin is approximately 5%. Parent recognises the
margin earned in its stand-alone financial statements. Whether Parent
should eliminate the profit on revenue received from SPV from
construction services provided to the SPV, in its consolidated financial
statements (CFS)?
Response
The response to the
above question will depend on the method the Parent is following with
respect to the accounting of service concession arrangements.
Method 1
If
method 1 as described above is used, Parent should eliminate the profit
on revenue received from SPV from construction services provided to the
SPV, in its
CFS. This is primarily for two reasons. Firstly,
paragraph 10.1 of AS-10 Accounting for Fixed Assets states as follows
“In arriving at the gross book value of self-constructed fixed
assets…………
Any internal profits are eliminated in arriving at such costs.” Secondly, paragraph 16 of AS-21 Consolidated Financial
Statements
states as follows “Intragroup balances and intragroup transactions and
resulting unrealised profits should be eliminated in full.”
Method 2
If
method 2 is applied, Parent should not eliminate the profit on revenue
received from SPV from construction services provided to the SPV, in its
consolidated financial statements; provided method 2 is applied in its
entirety. Under this method, the company applies the principles of the
Guidance Note/IFRIC 12. The group is not controlling the infrastructure,
which in substance has been sold to the grantor in lieu of a right to
use (intangible asset). As the group has sold the infrastructure, an
appropriate profit should be recognised. In other words, the arrangement
is seen as providing construction services to the government, rather
than a construction service provided by the Parent to the SPV.
The
application of accounting treatment above should not be seen as a means
of applying the Indian GAAP principles (method 2) to selectively
recognise the profits that Parent has made on its billing to the SPV.
Rather, it is a holistic application of Indian GAAP principles to the
entire service concession arrangement. Therefore, in addition to the
cost incurred by the SPV on billings by Parent, there may be other cost
incurred in executing the contract. The Indian GAAP principles
enumerated above should be applied to the total construction cost
including those charged by Parent to the SPV. This would mean that in
addition to not eliminating the profit made by the Parent on its billing
to the SPV, Parent would also have to recognise an additional profit
representing the margin on other cost. Further, all service concession
arrangements that fulfils certain specific criteria (and explained in
this article), will have to be accounted for in this manner. In
ad-dition, other matters may need careful consideration such as
provision for maintenance and resurfacing obligation, negative grant,
sharing of revenue with grantor, capitalisation of borrowing cost, etc.
Thus
under method 2, the entire arrangement is recorded based on Guidance
Note/IFRIC 12 principles. There are numerous challenges in applying
method 2 and it is not a straight forward exercise. This may have the
effect of recognising the profit made on the construction services
including the billings of the Parent to the SPV; however, it has too
many other repercussions and accounting consequences (discussed in this
paper) which would need careful consideration.
Method 2
An
alternative method under current Indian GAAP is to recognise the
construction of the infrastructure as a construction service rendered to
the grantor in exchange of an acquisition of a right to use (an
in-tangible asset) or an unconditional right to annuities (a financial
asset). Those principles of current Indian GAAP are more clearly
articulated in the Exposure Draft Guidance Note on Accounting for
Service Concession Arrangements. International Financial Reporting
Standards IFRIC 12 Service Concession Arrangements also has similar
requirements. The working model with respect to this method has been
explained in this article, using a simple example where the construction
service is exchanged for an intangible asset (right to use). There are
numerous challenges in applying method 2, which are described below.
When method 2 is used, it should be applied to all contracts in the
group that meet the requirements set out in the Guidance Note ED/ IFRIC
12.
