The Treatment of BOOT Schemes in System of National Accounts 1993

John S. Pitzer[1]

Canberra II Group: On the Measurement of Non-Financial Assets

Second Meeting, 13-15October 2003, Paris, France

I.Introduction

II.What is a BOOT scheme?

A.Definition

B.Part of a Larger Set of Public-Private Relationships

C.Incentives to Engage in BOOT Schemes

III.Determining the Risks and Rewards of the BOOT Asset

IV.Accounting for BOOT Schemes

A.Government Financial Interest in the BOOT Asset

B.Imputed Ownership by the Government

V.Summary

The Treatment of BOOT Schemes in System of National Accounts 1993

John S. Pitzer

I.Introduction

  1. A BOOT scheme (Build-Own-Operate-Transfer) is a scheme in which a private unit agrees to build a public facility at its own expense in return for the right to operate it and earn a net operating surplus for an agreed length of time. At the end of this period, ownership of the facility is transferred to the government without compensation.
  2. BOOT schemes present two statistical problems. First, it is not always clear which unit possesses the risks and rewards of the public facility during the contract period because of its reversion to government, because governments often insist on specific designs and methods of operation, and because governments often provide financial support that suggests they have ultimate control. Second, the transfer of ownership at the end of the contract period appears to be a capital transfer, but a private enterprise has no incentive to make such a transfer. It can be assumed that the government is providing compensation in some other manner. Simply recording the transactions of a BOOT scheme as they appear to occur would be misleading.

II.What is a BOOT scheme?

A.Definition

  1. Governments have a responsibility to provide services to the public, many on a nonmarket basis, but others on something approaching a market basis. The traditional method is for the government to produce the services itself. The government’s responsibility, however, is only to provide the services, and this provision can be accomplished by arranging with private producers to supply the desired services.
  2. In recent years, governments have devised and entered into a variety of agreements with private producers to supply public services. In addition to the direct procurement of services from a private producer, governments may arrange for private units to finance the fixed assets necessary to produce the services or have the private units provide the public services directly to the public on a market basis without intervention by the government.
  3. A BOOT scheme is one such method of private involvement. By contractual agreement, a private unit (the BOOT enterprise) agrees to construct or purchase one or more fixed assets (the BOOT asset) that will be used to provide the public services and to finance the capital formation itself, either using its own funds or borrowing on its own account. The BOOT enterprise then retains legal ownership of the asset and is given the right to operate the facilities to produce the public services, usually with some advance agreement about the prices or other fees the BOOT enterprise can charge for those services. There can be a wide variety of additional contract conditions that affect the relative amounts of risk and reward borne by the BOOT enterprise and the government, such as guaranteeing a minimum rate of return for the BOOT enterprise. At the end of the contractual period, legal ownership of the facility is transferred to the government with either no compensation or an amount clearly less than the expected market value of the BOOT asset. Thus, when the contract is signed, the government gains a legal claim to the BOOT asset when the contract terminates. The estimated value at that time is referred to as the residual value of the BOOT asset.
  4. There are two broad categories of public services: (1) services that are delivered to the public for a fee (toll bridges and highways, railroad passenger services, and electricity generation), and (2) services either consumed by the government itself in the production of other services (prisons, facilities maintenance, information technology) or delivered directly to the public without a fee (schools). For services sold to the public, the BOOT contract usually will specify a limit on the fees that can be charged the public or some formula for determining permissible fees. For services paid for by the government, the contract may specify the amount the government will pay for these services and/or a minimum volume of services that will be purchased each period.
  5. BOOT schemes are most commonly arranged between governments (including public corporations) and a private enterprise. They can apply, however, to sectors other than the public sector, most likely nonprofit institutions serving households.This paper will refer to BOOT schemes as if they apply onlyto governments.
  6. A BOOT scheme is similar to a long-term service contract, but with a higher capital component. The capital component implies a larger and longer commitment by both parties and a need for risk sharing agreements.

B.Part of a Larger Set of Public-Private Relationships

  1. BOOT schemes are one group of a larger set of public-private relationships, referred to as private finance initiatives, public-private partnerships, and probably other terms. Some of these other types of relationships include:
  • Build-Own-Operate. The private enterprise builds a public facility at its own expense in return for the right to operate it in perpetuity and charge users a government-regulated fee.
  • Buy-Build-Operate. A public facility is transferred to a private enterprise, which renovates or expands it and operates it in perpetuity.
  • Build-Transfer-Operate. A private enterprise builds a public facility at its own expense and transfers legal ownership of the facility to the government. The government then leases the facility to the private enterprise under a long-term lease.
  • Lease-Develop-Operate. A private enterprise is provided with a long-term lease that permits it to both operate and expand the facility.
  • Long-term service contracts. A private enterprise agrees to provide specified services at a specified rate for an extended period.
  • Joint venture. An agreement between a private enterprise and a government to construct and/or operate a public facility jointly for an agreed period.
  1. There undoubtedly are other public-private relationships than the types listed here. BOOT schemes involve the most complicated accounting problems and will be the focus of this paper. Once a treatment for BOOT schemes is agreed, parallel treatments for other types of relationships most likely can be derived by inference.

C.Incentives to Engage in BOOT Schemes

  1. BOOT contracts are complex and require substantial expenses for legal, financial, accounting, and other services to negotiate an agreement acceptable to both parties. Often equivalent results can be obtained more easily through simpler arrangements. The most commonly cited reason for engaging in BOOT schemes is to gain the expertise and superior productivity of market-oriented producers. Some possible attributes are higher quality of services, higher productivity, better management, the general benefits of competition, and access to innovation. BOOT schemes can also be a way for governments to share the risk involved in owning the facility and producing the services.
  2. BOOT schemes also can be a way for governments to obtain financing more easily for long-term projects. Governments may face market limitations on the amount or duration of borrowing on the market, but a private enterprise may be able to borrow more easily. The schemes can also, however, be a way to evade borrowing limits by having the private enterprise incur the debt, while other conditions of the contract make it clear the government is effectively responsible for the debt. Such evasive arrangements obviously severely harm fiscal transparency.

III.Determining the Risks and Rewards of the BOOT Asset

  1. A venture to provide public services contains most types of risk that would be found in any commercial venture. A BOOT scheme allows these risks to be shared between the BOOT enterprise and the government. Depending on how these risks are shared, economic ownership of the BOOT asset could be attributed to the government or the BOOT enterprise. There is no formula to determine which unit is the economic owner; all of the relevant facts and circumstances in each arrangement need to be considered.
  2. There are numerous types of risk in a business venture. Some that apply to BOOT schemes include:
  3. Demand for the services. The length of the contract and the nature of the services to be provided are the primary determinants of the risk that the demand for the services will be greater or less than expected. A toll road in an undeveloped area will have a high demand risk; a short-term contract for routine office services will have a low risk. Either party could bear the risk depending on the terms of the contract. The government might guarantee a minimum level of demand, or the BOOT enterprise could bear the entire risk.
  4. Design of the asset may not meet the requirements. The government may require only that a certain capacity be provided and let the BOOT enterprise design the asset as it wishes. If the design chosen by the BOOT enterprise is inadequate or cannot be expanded to meet greater than expected demand, the BOOT enterprise suffers the consequences. On the other hand, the government may specify the size and layout of a building and the quality of materials to be used in its construction. It is likely in this case that the government will bear the risk that the design is inappropriate for the task.
  5. The cost and time of construction may exceed expectations, which may lead to financial penalties, an inability to meet demand, or an inability to produce the services at the cost expected. Depending on the causes, either party might bear the risk.
  6. Underperformance or nonavailability of the asset refers to the possibility that the asset may not be maintained well enough to provide the quantity or quality of services expected. Normally, one would expect the BOOT enterprise to bear this risk, but the contract may specify how the asset is to be maintained or how free the BOOT enterprise is to adopt alternative production methods.
  7. Cost changes, positive or negative, obviously affect the price a producer might wish to charge the customer. The contract can assign this risk to either party.
  8. Obsolescence can affect the demand for the services and the assets needed to provide the services.
  9. The government will receive the residual value of the BOOT asset at the end of the contract. Usually the change of ownership is without payment or for a payment that is clearly less than the expected market value of the asset. In these cases, the government will usually bear the risk that the residual value of the asset will be more or less than the value expected at the initiation of the contract. It is possible to shift some of the risk to the BOOT enterprise with conditions specifying the condition of the assets, a variable settlement price, or an option for the government to purchase the asset for a stated price or to refuse to accept the asset.
  10. If the BOOT enterprise borrows money on its own account to finance the BOOT asset, it normally is responsible for the debt service payments. If the government cancels the contract, however, the contract may obligate the government to be responsible for the debt service payments. Such a clause may be an indication that the debt is really a government debt.
  11. The amount of debt taken on by the BOOT enterprise may be so high that it is not likely any lender would have agreed to the loan based only on the BOOT enterprise’s credit rating. If so, the lender may have reason to assume the government has guaranteed the debt.
  12. The prices or other fees guaranteed by the government in the contract may be set so that the BOOT enterprise can amortize an implicit debt equal to the value of the BOOT asset.Such a contract provision implies the government has guaranteed the debt.

IV.Accounting for BOOT Schemes

  1. There are two major accounting problems with BOOT schemes. First, the method by which the government gains a financial interest in the BOOT asset must be determined. Second, based on the risk and reward assessment, a decision has to be made about whether the BOOT enterprise or the government is the economic owner of the BOOT asset. If the government is the owner, then some method of financing its ownership must be imputed. The following sections consider these issues.[2]

A.Government Financial Interest in the BOOT Asset

  1. Assume the BOOT enterprise is the economic owner of the BOOT asset. At the same time, the government appears to own the residual interest in the BOOT asset. The residual value of the asset can be estimated and discounted to a present value. At first glance it would appear that this residual value should be included on the government’s balance sheet, which would mean both the BOOT enterprise and the government own the same asset at the same time. Including this value on the government’s balance sheet would be incorrect because it would increase the government’s net worth relative to the instant before the contract is signed without any event occurring to justify the increase. Yet it is also true that at the conclusion of the contract, the government obtains ownership of the BOOT asset, not as a gift but in exchange for something else of equal value. Thus, the question to be resolved is how and when the government gainsits claim to the BOOT asset.
  2. One approach is found in the financial accounting literature. With BOOT schemes, governments often provide the land on which the BOOT asset will be constructed. The BOOT enterprise is given the right to use the land for the duration of the contract. If there is no explicit payment for the use of the land, then a property income transaction should be imputed.
  3. When an enterprise leases a structure, it will frequently make improvements that are inseparable from the structure to improve the effectiveness of the enterprise’s use of the structure during the lease term. These leasehold improvements are fixed assets, but any residual value at the conclusion of the lease—assuming the lease is not renewed—belongs to the owner of the structure. Thus, the entire BOOT asset could be considered a leasehold improvement to the land, and the residual value is then transferred to the government at the conclusion of the lease.
  4. This approach is not satisfactory. First, leasehold improvements are generally selected with a service life roughly equivalent to the expected duration of the lease, perhaps including extensions expected but not yet negotiated. The residual values, therefore, should be negligible. In a BOOT scheme, the residual value is expected to be quite substantial. Second, the lessee, knowing that its rights to the leasehold improvements will expire with the lease, will depreciate the improvements over the term of the lease. If there actually is a large residual value, as with a BOOT scheme, then this depreciation will overstate the rate of decline of the value of the improvements and understate the national wealth.
  5. The mechanism for the government’s purchase of the residual value of the BOOT asset is found in the operating arrangements specified by the BOOT contract.BOOT schemes are not normal commercial transactions, in which an enterprise would evaluate a proposed investment project by estimating the return to its investment over the total service life of the asset or would plan to sell the asset after a certain number of years and recover the residual value. To earn a market rate of return on its total investment over just part of the service life without recovering the residual value means that the government is granting concessions that effectively raise the rate of return.
  6. The enterprise expects to earn a higher rate of return on its investment in the BOOT asset than it could in any alternative investment, usually by charging monopoly prices to the general public or selling services to the government at a price higher than the government would otherwise agree to. The high rate of return results from the government agreeing to forego future revenue that it would otherwise have the right to receive or agreeing to overpay for the purchase of services. Thus the government obtains the right to the residual value of the BOOT asset in exchange for allowing the BOOT enterprise to accumulate monopoly profits. Implicitly, the BOOT enterprise gives the government a financial claim on the monopoly profits at the rate that they are expected to be earned, and at the end of the contract the financial claim is exchanged for the BOOT asset.
  7. As an example, assume the government contracts with an enterprise to build a new prison for a cost of 1000 and then operate it for ten years. Each year, the government will pay 200 to the BOOT enterprise on the first day of the year. After ten years, the prison will be transferred to the government. Its expected value at that time is 600. The appropriate discount rate is ten percent. Instead of recording the annual payments of 200 as purchases of services and a capital transfer of 600 at the end of the contract, the annual payments should be recorded as 165.78 for services and 34.22 for a financial claim of the government against the BOOT enterprise. At the end of each year a property income flow is imputed at the rate of ten percent, which further increases the claim of the government. The growth of the financial claim over the ten years will be as follows: