The Canadian Institute of Chartered Accountants' Handbook (CICA Handbook), which codifies generally accepted accounting principles in Canada, contains provisions for classification of leases. Section 3065.03 defines a capital lease as "a lease that, from the point of view of the lessee, transfers substantially all of the benefits and risks incident to ownership of property to the lessee". The same section defines an operating lease as "a lease in which the lessor does not transfer substantially all the benefits and risks incident to ownership of property".
Section 3065.05 of the CICA Handbook also states "... a lease that transfers substantially all of the benefits and risks of ownership to the lessee is in substance an acquisition of an asset and an incurrence of an obligation by the lessee...".
Section 3065.06 sets out three conditions, the presence of one or more of which, at the inception of the lease, would reasonably constitute the transfer of substantially all of the benefits and risks of ownership to the lessee.
The three conditions are:
We had discussions with representatives from the Department of Finance and the Department of Supply and Services. We obtained a copy of each of the five leases above. We also obtained a copy of a letter from KPMG related to the Fredericton-Moncton Highway transaction, which provides an opinion on the accounting implications of the Province having entered into an arrangement with a not-for-profit corporation that will provide highway services.
We reviewed the above documentation and applied the provisions of Section 3065 of the CICA Handbook as outlined below to determine whether each lease should be classified as an operating lease or a capital lease.
To determine the expected economic life of each of the assets, we conducted discussions with personnel in the Department of Supply and Services and reviewed the historical experience with similar assets.
To assess the satisfaction or otherwise, of the third condition (recovery of investment and earning a return), we obtained the appropriate incremental borrowing rates of the Province from the Treasury & Debt Management Division of the Department of Finance. Using these rates, we calculated the present value of the minimum lease payments and compared the present value with the fair market value of the property at the inception of the lease to determine whether or not the 90% condition (see condition 3 in the subsequent analysis) is satisfied.
The estimated economic life of all the properties in question was determined in consultation with the representatives of the Department of Supply and Services to be over forty years. Since the leased term for the Highway is thirty years and the term for each of the others is twenty-five years, none of the leases satisfies the second condition for classification as a capital lease.
We computed or reviewed the calculation of the present value of the minimum lease payments for each of the leases, using the appropriate Provincial incremental borrowing rate, and compared the result to the fair value of the leased property at the inception of the lease. We determined that the present value of the minimum lease payments of the Highway, Centracare and Fredericton North School leases were each close to, but less than 90% of the fair market value of each of the respective properties at the inception of the lease. Therefore these leases are properly classified by the Province as operating leases. Similar calculations for the Moncton North School and Miramichi Youth Centre leases exceeded 90% and as a result these leases should be classified as capital leases. The fair market values of the Moncton North School and the Miramichi Youth Centre total approximately $30 million which is the approximate amount of the asset and related debt not recorded by the Province.
Our analysis is summarized in the table below:
Conditions (section 3065.06)
Section II(e)
Terms of Reference
"To evaluate the accounting classification of leases included in Public Private Partnership arrangements".Background
The Province of New Brunswick has, in recent years, been attempting to involve the private sector in the delivery of public services. In some instances, this involvement is such that the government contracts with a single private sector provider for the design, construction, operation and financing of a particular project and then enters into a lease arrangement with the provider. These arrangements have become known as Public Private Partnerships and the accounting for such arrangements is often an important feature of the arrangement. Lease terms are often specifically crafted to ensure the lease qualifies as an operating lease and not a capital lease so there is no requirement for the lessee to record an asset and an associated debt.
The Province of New Brunswick has classified all of its leases arising from Public Private Partnership arrangements as operating leases. Accordingly, no assets and no capital lease obligations are recorded in the accounts of the Province and the lease payments are recorded as expenditures in the year they become payable.Scope of Review Procedures
We obtained from senior personnel in the Department of Finance a list of the leases included in Public Private Partnership arrangements. These leases are as follows:
A number of other arrangements were also discussed but not reviewed because the Province's commitment to make payments is contingent on savings being achieved and accordingly, payments are expensed when the liability is confirmed.
To determine whether there is reasonable assurance the Province will obtain ownership of the leased property, we examined the purchase/renewal provisions of each lease to determine if they would result in a direct transfer of title to the Province, constitute a bargain purchase option or, in some other manner, provide reasonable assurance the Province would obtain ownership of the leased property.
Analysis
In applying the first condition to the leases, we concluded none of the leases contained a bargain purchase option. The Moncton North School lease and the Miramichi Youth Centre lease each contained purchase and renewal clauses that could possibly be interpreted as providing reasonable assurance the lessee (the Province) will obtain ownership of the leased property. However, since these leases meet the third condition and are therefore evaluated by us as capital leases in any event, no further analysis was warranted.
From the point of view of a lessee, a lease would normally transfer substantially all of the benefits and risks of ownership to the lessee when, at the inception of the lease, one or more of the following conditions are present:
(1) There is reasonable assurance that the lessee will obtain ownership of the leased property by the end of the lease term. Reasonable assurance that the lessee will obtain ownership of the leased property would be present when the terms of the lease would result in ownership being transferred to the lessee by the end of the lease term or when the lease provides for a bargain purchase option.
(2) The lease term is of such a duration that the lessee will receive substantially all of the economic benefits expected to be derived from the use of the leased property over its life span. Although the lease term may not be equal to the economic life of the leased property in terms of years, the lessee would normally be expected to receive substantially all of the economic benefits to be derived from the leased property when the lease term is equal to a major portion (usually 75% or more) of the economic life of the leased property. This is due to the fact that new equipment, reflecting later technology and in prime condition, may be assumed to be more efficient than old equipment which has been subject to obsolescence and wear.
(3) The lessor would be assured of recovering the investment in the leased property and of earning a return on the investment as a result of the lease agreement. This condition would exist if the present value, at the beginning of the lease term, of the minimum lease payments, excluding any portion thereof relating to executory costs, is equal to substantially all (usually 90% or more) of the fair value of the leased property, at the inception of the lease.Conclusion
Based on the foregoing analysis, we would consider the Fredericton-Moncton Highway, Centracare and Fredericton North School leases to be correctly classified by the Province as operating leases. It is also our opinion that the Moncton North (Evergreen Park) School lease and the Miramichi Youth Centre lease should be accounted for as capital leases, not as operating leases which is the present classification in the accounts of the Province.
