The 'risks and rewards' approach is embodied in the United Kingdom standard FRS5. It is also currently the preferred approach recommended by the Department of Treasury and Finance where a PPP arrangement does not fall within the scope of the current Australian leasing standard.
The IFRIC decided against using a 'risk and rewards' approach as applied under the leasing standard, because it considered that such an approach leads to complexities and inconsistencies in lease classification. It also considered that the approach could be difficult to apply to service concession arrangements, particularly where users paid for the services provided and recovery of the cost of the asset was contingent on use.390
The 'risks and rewards' approach involves a detailed analysis of all the risk factors to be borne by the government and the operator. The party bearing the majority of the risks will record the asset in its financial reports.
Risks to be evaluated include:
• demand risk - demand for the asset may be less or more than predicted due to factors such as demographic changes or a downturn in economic conditions;
• design risk - property may not meet contractual requirements due to design faults;
• third party revenues - patronage may be less than expected, resulting in a shortfall in revenue to meet construction costs;
• nature of property - includes design faults and operational problems;
• penalties for non-availability - facility may become temporarily unavailable for a range of reasons, resulting in a reduction in payments to an operator by the government;
• potential changes in relevant costs - operating costs escalating beyond projections;
• obsolescence - technology becomes obsolete, requiring expensive upgrades; and
• residual value risk - asset value at expiration of concession agreement could be either less or more than depreciated value.
Once the risks to a particular project are identified, a qualitative assessment of the possible timing of risks, the likelihood of risks occurring, and the consequences of risks eventuating is undertaken. This exercise results in an allocation of risks between government and the private operator, and cash flow modelling for each risk. Other potential risks not capable of meaningful measurement are also recognised. The FRS5 method does not take into account certain other major risks such as construction risks, planning risks and/or site risks because they are not considered to have a direct effect on the economic benefits to be derived from the property, and because they are the responsibility of the construction company.
The Committee has reservations about this approach. Experience has shown that although planning, site risk and construction risks are assigned to the contractor, the state invariably assumes responsibility for the completion and operation of such projects in the event of default by the contractor, because of its duty of care to provide such facilities and services to the public. This scenario occurred, for example, in the case of the Latrobe Regional Hospital.
There is no doubt that a 'risk and rewards' approach is very complex, and because judgements about the identification and allocation of risks are often subjective, inappropriate accounting treatment may occur. Conversely, because the 'control' approach proposed by the IFRIC is very simplistic, it may not necessarily identify the substance of commercially negotiated arrangements and may lead to inappropriate recognition of assets and liabilities.391
Despite its complexities, the accounting profession and other interested parties in their submissions to the IFRIC overwhelmingly preferred a 'risk and rewards' approach because it is more likely to identify the economic substance of the PPP arrangements and the appropriate accounting treatment. Further, a comprehensive assessment of risks must be undertaken to identify the entity that assumes the majority of the risks, thus identifying the controlling entity. In other words, the concepts of 'control' and 'risks and rewards' are not mutually exclusive as the draft document suggests; they are complementary, and control cannot exist without risk exposure.
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390 International Financial Reporting Interpretations Committee Draft Interpretation, D12 - Service Concession Arrangements, p.16
391 Department of Treasury and Finance, Financial Reporting, Update, edn 8, July 2005, p.5