Memorandum by Professor David Heald
1. I am pleased to accept the Committee's
invitation to give evidence and I will restrict that evidence
to my own area of specialist expertise.
I have aligned the structure of the memorandum to the questions
set out in the Committee's call for evidence (House of Lords Select
Committee on Economic Affairs, 2009). A much fuller exposition
of my views is available in an academic paper (Heald and Georgiou,
2009), a copy of which I have supplied to the Clerk.
Question 6: How should future payments by
the Government under existing Private Finance contracts be recorded
in public sector accounts? Is risk transfer an appropriate test?
Should all such liabilities be included in the national debt?
Should they be accounted for separately from government debt?
How much does the public sector accounting treatment of capital
and revenue aspects of projects matter?
2. Self-evidently, this is not one question,
but a batch of questions which I will address, though not in the
How much does the public sector accounting treatment
of capital and revenue aspects of projects matter?
3. The accounting treatment of PFI projects
is of utmost importance for the following principal reasons:
Fiscal transparency (Heald, 2003a) will
be damaged if the accounting treatment adopted by the public sector
client does not reflect the economic substance of the transaction.
If weaknesses in accounting regulation and/or enforcement allow
capital assets to be excluded inappropriately, there will be an
understatement of government borrowing and net debt. These have
implications for, inter alia, fiscal sustainability and intergenerational
In circumstances where accounting arbitrage
takes place (ie the choice of which standards/guidance to follow
is made on the basis of securing the desired "result"),
there are severe threats to Value-for-Money (VFM):
projects may be structured in ways that
are solely designed to qualify for particular accounting treatments,
those preparing the project appraisals
are incentivised to manipulate the appraisal (eg exaggerate the
quantified extent of risk transfer), with likely knock-on effects
to other aspects of appraisal quality (Heald, 2003b).
4. It is important to emphasise that there
are two different systems of accounting that are relevant to PFI:
government financial reporting (since 2001-02 on modified UK GAAP
but from 2009-10 on modified IFRS); and national accounts (European
System of Accounts (ESA) 1995 (Eurostat 1995), supplemented by
Eurostat (2004) guidance). The implications of these separate
systems are discussed below.
How should future payments by the Government under
existing Private Finance contracts be recorded in public sector
accounts? Is risk transfer an appropriate test?
5. These two questions fit together, but
require an explanation of the background to the present position.
In terms of government financial reporting, the issue of balance
sheet treatment arises because of the switch to accruals accounting
(called Resource Accounting and Budgeting in the United Kingdom)
from 2001-02. If cash accounting had been maintained, there would
have been no asset or debt scoring. From its first annual report
in 1997, the Financial Reporting Advisory Board (FRAB) has repeatedly
expressed its dissatisfaction with PFI accounting. Evidence grew
of strong incentives towards Off-Off: ie the capital asset being
neither on the balance sheet of the public sector client, nor
on that of the private sector operator.
6. The former incentive was driven by the
control system exercised by central government: it became common
knowledge in local authorities and NHS Trusts that the PFI was
the "only show in town". Neither public sector funding
nor approval for On-balance sheet PFI would be forthcoming. Of
particular importance became the availability of arbitrage between
the Accounting Standards Board's FRS5A (ASB, 1998) and the Treasury's
Technical Note 1 (Revised) (Treasury Taskforce, 1999), supposedly
an interpretation of FRS5A but which in effect became a competitor
standard (Hodges and Mellett, 2002). The arbitrage worked through
allowing the consideration of a wider range of risks that might
be transferred (FRS5A emphasised demand risk and residual value
risk) and through TTN1R's encouragement of quantitative analysis.
There has been considerable comment, including by the National
Audit Office, on how the quantified value of risk transfer frequently
made PFI superior to the Public Sector Comparator (PSC) by a small
7. The incentive for the private operator
came from effects on the level of distributable profits of Special
Purpose Vehicles (SPV) and from taxation treatment that became
associated with contract debtor accounting (Austin, 2009; Heald
and Georgiou, 2009). The combined effect was that many PFIs were
believed to be recorded as fixed assets on the balance sheet of
neither client nor operator. Whereas there might well be differences
on marginal cases between the independently taken judgements of
finance directors and their respective auditors, the overall pattern
8. In February 2007 it appeared as if the
Treasury would withdraw TTN1R and let FRS5A determine accounting
treatment for the client. However, in the March 2007 Budget, the
Chancellor of the Exchequer announced that central government
would adopt IFRS from 2008-09 (later changed to 2009-10). Although
IFRS contains no guidance for the public sector client, IFRIC
12 (IASB, 2006), an interpretation not a standard, prescribes
the treatment for the operator. The Treasury and FRAB then developed
the "mirror-image treatment" of IFRIC 12 for application
by the public sector client. The International Public Sector Accounting
Standards Board (IPSASB) has adopted broadly the same approach
in a consultation paper (IPSASB, 2008), though an Exposure Draft
has not yet been published.
Importantly, the criterion is control, not risks and rewards.
In this context, what is meant by control focuses on control over
access to, and pricing of, "infrastructure" (an expansively
understood term) and on control over residual value (many PFIs
will revert to the public sector client about half way through
their notional economic life). The move away from risks and rewards
to control appears to derive from the problems that have been
encountered on private sector leasing standards, with the International
Accounting Standards Board (IASB) moving towards a "right-of-use"
approach. It is far from clear how much difference there would
be between a properly implemented risks and rewards approach and
a properly implemented control approach. However, the progression
has been from a very problematic history with risks and rewards,
and there seems to be an element of wanting a fresh start. What
the Treasury has implemented for PFI under IFRS adoption aligns
with both what IASB is proposing on leases for the private sector
and what IPSASB intends to propose for the public sector client
of service concessions.
9. I support the mirror-image of IFRIC 12
treatment, based on control, which has been implemented for central
government financial reporting in 2009-10. It is widely expected
that most PFI projects will henceforth be on the balance sheet
of the public sector client and remain off the balance sheet of
the private sector operator. The PFI asset is thus accounted for
in the same way as if it belonged to the client. Contrary to what
the question wording implies, future payments under PFI contracts
are not accounted for. However, good disclosure practice requires
information on these to be available, as is done in aggregate
in Budget Report documentation.
10. National accounts treatment depends
not on UK GAAP/IFRS but on ESA 95 and additional Eurostat (2004)
guidance. The criterion is risks and rewards, but the Eurostat
(2004) guidance interprets this in a particular way. If both (a)
construction risk, and (b) either availability risk or (c) demand
risk is transferred, this is sufficient to allow Off-balance sheet
treatment for the client. This is a lax version of risks and rewards,
which most UK PFIs by number seem likely to pass.
Construction risk is transferred and the normal expectation would
be that availability risk is much lower than demand risk.
11. The national accounts are not affected
by the 2009-10 changeover of Estimates and Resource Accounts to
IFRS, with PFI accounting moving to the control criterion of IFRIC
12. National accounts remaining on a risks and rewards basis creates
a problem for ONS. Under UK GAAP, the financial accounting treatment,
also on risks and rewards, was accepted by ONS, in part on the
basis that it did not have sufficient resources to examine the
huge number of UK schemes. Realisation of the flaws in financial
accounting treatment was one factor behind the work reported in
Chesson and Maitland-Smith (2006), which led to more finance leases
being scored as debt. When pressured by Eurostat for not literally
following the Eurostat guidance, ONS could always reply that its
current practices include more assets on the public sector balance
sheet (and therefore more public debt) than full implementation
would report. The criteria (control for financial reporting, risks
and rewards for national accounts) are now more visibly different
than when the issue was variants of risks and rewards. Moreover,
the weakening effect of Eurostat (2004), in relation to ESA 95,
mirrors the weakening effect of TTNIR relative to FRS5A. It is
not easy to establish the extent to which these effects were intentional,
but they have certainly occurred.
Should all such liabilities be included in the
national debt? Should they be accounted for separately from government
12. The United Kingdom has international
obligations, as well as EU commitments, to compile the UK national
accounts and debt in accordance with international guidance, however
defective that may be on particular issues. Accordingly, the numbers
should be produced on required methodologies and in required formats.
However, there is no reason why the Treasury cannot ensure that
the more accurate and relevant figures are also provided for Parliament,
citizens and the media. In my view, the IFRS treatment of PFI
is strongly preferable to the Eurostat treatment and more relevant
to debates about VFM, fiscal sustainability and intergenerational
equity. Therefore, on grounds of fiscal transparency, figures
should be reported prominently on both bases.
13. The Treasury should be commended for
having been one of the international pioneers of the application
of accruals accounting to government. Moreover, a decision was
taken in 1995 to align budgeting with accounting, a process completed
for 2003-04. The logic of these developments favoured the transition
from UK GAAP (which will disappear) to IFRS and that is being
implemented from 2009-10. This transition has also provided "cover"'
beneath which the misleading accounting for PFI could be assigned
to the past. Against this record of achievement, the Treasury
(2009c) has depressingly decided that budgeting for PFI will from
2009-10 be done on a national accounts basis. This decision runs
counter to the Treasury's (2009b) own Alignment Project, designed
to give a clearer line of sight from Spending Reviews (budgets)
to Estimates to Resource Accounts. The justification advanced
for this decision is that the Treasury has no choice because of
obligations to follow the national accounts for purposes of fiscal
rules and other fiscal reporting.
This is threadbare, given that IFRS is more fiscally conservative
on this matter than Eurostat (2004). Moreover, the Treasury has
always insisted on being able to design and operate its public
expenditure framework, without interference even from other UK
departments. The most plausible explanation is that PFI (inside
Estimates, Resource Accounts and Whole of Government Accounts,
but largely outside national accounts and debt) is expected to
compensate for the sharp planned reductions in public sector net
investment that are presaged in the 2009 Budget Report (Treasury,
2009a). Given the impact of the global financial crisis on UK
public finances, the small "gains" that might be achieved
by this subterfuge are simply not worth the damage to trust and
Question 7: Would public sector investment
in the last decade have been lower without Private Finance? If
so, by how much?
14. Both parts of this question are unanswerable
on anything other than a speculative basis. The Spending Review
system, which started in 1998, has operated throughout this period.
The level of public spending, and the amount of PFI, has been
determined by the Treasury. From the perspective of an individual
local authority or NHS Trust, it might feel that there would have
been less investment for them if they had not opted for PFI, but
that conclusion cannot necessarily be taken to the aggregate level.
Over the last decade there has been a remarkable rate of growth
of public expenditure andgiven the emphasis put on the
self-imposed sustainable investment rulethe Treasury might
have considered that Off-balance sheet PFI investment, not scoring
within net debt or Maastricht debt, allowed there to be more "public"
investment than otherwise.
Question 10: Is there an optimal mix between
conventional procurement and Private Finance for public sector
investment? What is the long run role of private finance in the
delivery of infrastructure both in the UK and globally?
15. These are complex policy questions that
are difficult to answer briefly. However, I would stress the following
PFI is one method of public procurement:
its existence may discipline conventional procurement just as
the option of conventional procurement may discipline the PFI
The choice between PFI and conventional
procurement (PSC) should be done on an even-handed basis at project
appraisal stage and samples of chosen projects should be subjected
to thorough post-audit. The criterion should be VFM, undistorted
by considerations of either the accounting or budgeting systems.
The viability of PFI relative to conventional
procurement depends upon generating efficiency gains in operation,
in order to offset higher financing costs, and upon the SPV having
sufficient retained resources to ensure that asset condition at
reversion date meets the contractual expectations of the public
In terms of both future UK and international
reliance on PFI, much depends on the capacity of public authorities
to act as intelligent and effective customers and on the underlying
objective of policy being to ensure that VFM is not subordinated
to presentational devices that damage fiscal transparency and
increase fiscal risks. The laxness of the Eurostat (2004) rules,
which has provoked concern at the International Monetary Fund,
indicates that the difficulties encountered by the United Kingdom
may be replicated internationally.
Amendment to FRS5A: Reporting the Substance of TransactionsPrivate
Finance Initiative and Similar Contracts, London, Accounting
Austin, P (2009) Accounting for PFI Projects,
presented at SMI Conference, "IFRSImpact on UK PFI",
January, London, Mazars, mimeo.
Chesson, A and F Maitland-Smith (2006) Including
finance lease liabilities in public sector net debt: PFI and other,
Economic Trends, No 636, November, London, Office for National
Statistics, pp 27-42.
Eurostat (1995) European System of AccountsESA
95, Luxembourg, Eurostat.
Eurostat (2004) Long Term Contracts between Government
Units and Non-government Partners (Public-Private Partnerships),
Heald, D A (2003a) Fiscal transparency: concepts,
measurement and UK practice, Public Administration, Vol 81(4),
Heald, D A (2003b) Value for money tests and accounting
treatment in PFI schemes, Accounting, Auditing and Accountability
Journal, Vol 16(3), pp 342-71.
Heald, D A and G Georgiou (2009) The substance
of accounting for Public-Private Partnerships, paper presented
at the 2009 conferences of Comparative International Governmental
Accounting Research (Modena) and of the International Institute
of Public Finance (Cape Town), revised 31 August, mimeo.
Hodges, R and H Mellett (2002) Investigating accounting
standard setting: accounting for the United Kingdom's Private
Finance Initiative, Accounting Forum, Vol 26(2), pp 126-51.
House of Lords Select Committee on Economic Affairs
(2009) Call for Evidence: Private Finance Projects and Off-balance
Sheet Debt, London, mimeo.
IASB (2006) IFRIC 12: Service Concession Arrangements,
London, International Accounting Standards Board.
IPSASB (2008) Accounting and Financial Reporting
for Service Concession ArrangementsConsultation Paper,
New York, International Federation of Accountants.
Kellaway, M, (2007) Letter of 5 October 2007 to Russell
Coleman, HM Treasury, available at: http://220.127.116.11/about/methodology_by_theme/public_sector_accounts/downloads/2003_04_MK_RC_05Oct07.pdf
(last accessed 25 September 2009).
Treasury (2009a) Budget 2009: The Economy and
Public FinancesSupplementary Material, London, HM Treasury.
Treasury (2009b) Alignment (Clear Line of Sight)
Project, Cm 7567, London, Stationery Office.
Treasury (2009c) Consolidated Budgeting Guidance
from 2009-10 (IFRS updated), London, HM Treasury, available
(last accessed 25 September 2009).
Treasury Taskforce (1999) How to Account for PFI
Transactions: Technical Note 1 (Revised), London, Office of
25 September 2009
36 I am Professor of Accountancy at the University
of Aberdeen Business School and specialist adviser on public expenditure
and government accounting to the Treasury Committee of the House
of Commons. From 1 August 2004 to 31 July 2009, I served a five-year
term as a member of the Financial Reporting Advisory Board, on
the nomination of the Head of the Government Economic Service
as an independent economist. It is important to stress that the
views expressed in this memorandum are my own and must not be
attributed to any organisation. Back
This scepticism was reinforced by marked variations across departmental
groupings in the proportion of PFI assets by value on the client's
balance sheet as at October 2007: Department for Children, Schools
and Families (0% on); Ministry of Defence (39% On); Department
of Health (2% on); Ministry of Justice (93% On); and Department
for Transport (88% On) (Heald and Georgiou, 2009, Table 1). These
differences appear to reflect differences in control environments
and audit arrangements, rather than objective differences relevant
to the criterion of risks and rewards. Back
The United Kingdom has no obligation to follow IPSASB's standards.
The operating philosophy, as in Australia and New Zealand, is
to minimise adaptations and interpretations of private sector
For example, see Table 2.6 of Treasury (2009a, p 35). Back
If the strict logic of Eurostat (2004) were to be followed and
many PFIs treated as off the client's balance sheet in the national
accounts, the issue would arise as to whether they are then included
on private sector balance sheets, contrary to the financial reporting
treatment. The national accounts are an articulated set of accounts,
in which all cases of Off:Off and On:On are unacceptable. Back
The Treasury may rely on a letter sent on 5 October 2007 by the
Office for National Statistics to the Treasury (Kellaway, 2007),
but that would be to attribute the wrong significance to that
letter. The letter referred to the compatibility of IFRIC 12 to
national accounts classification, not to how the Treasury should
run its budgeting system after the adoption of IFRS. Back
In the mid and late 1990s, the amount of actual PFI was reduced
by the effects of the universal testing rule, whereby all public
sector projects had to be assessed for PFI-ability. Back