Accounting for subsequent costs on PPP projects

SUITS THE C-SUITE By Peter John R. Ventura

Business World (04/04/2016 – p.S1/2)

Given the continued efforts of the Public-Private Partnership (PPP) Center to develop bankable PPP projects, more and more local and foreign investors are drawn to invest in these PPP projects. In 2016, the PPP Center registered about 39 projects in its pipeline with an estimated value of $30 billion (P1.4 trillion). The lineup includes roads, railways, airports, water and prison facilities projects and some will be rolled out within 2016.

PPP arrangements commonly involve a public entity or a governmental body with the primary responsibility to provide public service (known as the grantor) and a private entity that finances the construction and manages the operation of the PPP project (known as the operator). The private entity is bound by a set of operational and maintenance standards, as well as pricing mechanisms, set by the grantor. In return for the services being provided, the private entity obtains either a contractual right to collect from the grantor or a license to collect fees from the users of the public service for a specified period of time.

A private entity commonly assesses a PPP agreement based on whether it is within the scope of the Philippine interpretation of International Financial Reporting Interpretations Committee (IFRIC) 12, Service Concession Arrangements. Once assessed to fall under IFRIC 12, further evaluation will have to be made, particularly on whether to apply the so-called Financial Asset model or the Intangible Asset model.

Basically, if the private entity obtains guaranteed cash flows from the PPP agreement, the private entity may recognize a financial asset. On the other hand, if the entity only obtains a right or license to charge users fees, then the entity may recognize an intangible asset. In some cases, both a financial asset and an intangible asset may be recognized in one PPP agreement.

PPP agreements require that the private entity maintain the infrastructure asset in good working condition. Some PPP agreements also require certain upgrades to the project’s infrastructure. The costs of such maintenance and upgrades are commonly called “subsequent costs.” As these maintenance and upgrades are required throughout the life of the PPP agreements, they will require substantial costs or investments which should also be properly accounted for. This gives rise to an accounting challenge as private entities may construe that these significant subsequent costs should be capitalized as assets. However, as discussed in the subsequent paragraphs, capitalizing such costs may not always be the proper accounting treatment.

Generally, a PPP agreement includes the following types of subsequent costs, which are for the account of the private entities:

· Routine Maintenance — refer to small-scale activities associated with regular and general upkeep of the infrastructure.

· Periodic Maintenance — refer to activities undertaken to prolong the structural integrity and avoid degradation of the infrastructure, which are reactive in nature and dependent on use.

· Special/Major/Emergency Works — refer to activities undertaken as a result of natural calamities (such as landslides, washouts and flooding, and earthquakes) and any interventions done to ensure the undisrupted operation of the infrastructure.

· Additional and Improvement Works — refer to the construction of additional and improvement works for the purpose of expanding the infrastructure and/or enhancing its accessibility.

Subsequent costs would usually be considered capitalizable if they increase the capacity/volume or revenue being produced by the infrastructure asset even though the additional revenues provided may not be identifiable on a stand-alone basis. For example, construction of an additional lane of a toll road will potentially allow an increase in the traffic volume and therefore will represent an upgrade even though it is unclear how much traffic volume such an extra lane will produce.

Subsequent costs considered capitalizable may be treated differently depending on the model used. Under the financial asset model, subsequent costs may be considered as a new financial asset, while under the intangible asset model, these costs may be treated as a new intangible asset.

On the other hand, subsequent costs that do not increase the capacity/volume or revenue produced by the infrastructure asset are usually considered part of maintenance and therefore treated as expense. Routine maintenance, periodic maintenance and special or emergency works as described above would fall under maintenance work.

Periodic maintenance works are contractual obligations to restore the infrastructure assets and are commonly expressed in very general terms such as keeping the infrastructure in “good working condition” or “state-of-the-art” working condition. Since these would be considered contractual obligations, a periodic provision may be recognized at the best estimate of the wear-and-tear of the infrastructure after considering the time value of money. Private entities refer to the guidance under Philippine Accounting Standards (PAS) 37 Provisions, Contingent Assets and Contingent Liabilities in recognizing and measuring the costs of these periodic maintenance works.

Routine maintenance and special or emergency works are not specific contractual obligations, but just part of a general obligation to maintain the infrastructure. In this case, the costs will be accounted for as incurred.

Private entities are often uncomfortable with considering maintenance cost as expenses, as this will have an effect on their operations. Given that there are various accounting treatments for subsequent costs, private entities should be mindful of the accounting implications when structuring or implementing upgrades or maintenance in their PPP agreements to avoid surprises when the upgrade or maintenance works are eventually recorded in their books.

With a proper understanding of the relevant accounting treatments, private entities can better plan for the project’s operations and the eventual return of their investment.

This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the authors and do not necessarily represent the views of SGV & Co.

Peter John R. Ventura is a Senior Director of SGV & Co.