Accountancy Interpretation of Public Sector Leasing Arrangements

Published 11 June 2020

Following a two week trial in the Commercial Court, in which DAC Beachcroft acted for the successful Defendant – the Isle of Wight Council, the Court has handed down a significant judgment concerning the application of the ultra vires doctrine in cases concerning public bodies.

Central to the judgment was the appropriate classification of a public sector hire contract / leasing arrangement; more specifically the extent to which the Lease should properly be classified as a Finance Lease (and thereby ‘capital expenditure’) or an Operating Lease (and thereby a ‘revenue expense’). The Judgment will act as an important guide for all accountancy firms on this issue, and has particular significance for those that provide services to public bodies.

The Facts:

The case concerned a voluntary aided maintained school on the Isle of Wight, that had entered into a hire contract (“the Lease”) with the Claimants (a modular building company and their various financiers) for the provision of a sixth form building, which was to be constructed using modular units built off-site, and leased to the College for 15 years from 2013 at an annual rent of nearly £700,000.

The Lease proved to be prohibitively expensive and the College found itself unable to make the payments under the lease and ceased doing so in September 2017. This prompted the Claimants to terminate the Lease and pursue a claim against the College for the remainder of all sums due under the contract for the balance of the hire period (c.£7.5m). The Council was also pursued on the basis that it was alleged the College had entered into the contract as the Council’s agent (by virtue of section 49(5) of the School Standards and Framework Act 1998). The Defendants also faced ancillary claims founded in misrepresentation / negligent misstatement.

The case was defended primarily on the basis that it was contended that the College had had no vires (legal power) to enter into the Lease, and in doing so the Council cited numerous breaches of public law as to why that was the case. In the most part however, the enforceability of the Lease turned upon an accounting question, namely: whether the Lease was: 

i.  A Finance Lease (and therefore void on the basis that it amounted to Capex; and therefore borrowing without consent) or 

ii.  An Operating Lease (and therefore had been legitimately entered into by the College utilising funds from its Revenue budget).

Finance Lease vs. Operating Lease

Having heard expert accountancy and property valuation evidence, Mr Justice Foxton accepted the argument that the contract was a finance lease rather than an operating lease, thereby constituting a form of borrowing*. The College was therefore entitled to a declaration that the Lease was void.

The Lease was interpreted with reference to International Accounting Standard 17 (“IAS17”)(as the applicable accounting standard in force at the time the Lease was entered into), which provided that a Finance Lease “is a lease which transfers substantially all of the risks and rewards of ownership to the lessee.” An Operating Lease on the other hand was merely defined in IAS17, as a Lease which “is not a Finance Lease.” With a finance lease, the substance of the transaction is considered the same as if the school had purchased the building and financed it through a loan.

The judgment makes it clear that simply choosing to call a Lease an Operating Lease in order to suit the commercial aspirations of the parties, is of no consequence. As the Judge explained, “the parties' own descriptions cannot be decisive of an issue which turns on the economic substance of the transaction.” Instead, the firm conclusion was that the issue of Lease classification should involve an assessment of the substance (as opposed to the form) of the Lease; specifically with reference to the so called Primary and Secondary Indicators as prescribed by IAS17. The key tests in this instance were:

1. The extent to which the “present value of minimum lease payments” (PVMLP) amounted to “substantially all” of the fair value of the asset:

The first issue to be determined in this regard was what counts as "substantially all,” given that there is no express threshold percentage ratio stated in IAS 17?

Here, there was a difference of opinion between the accountancy experts. The expert appointed on behalf of the Claimant gave evidence to the effect that “substantially all” is generally taken to be a minimum of 90%, although there was an acknowledgement that practitioners can elect to apply different percentages. In contrast, the Council’s expert explained that although some accountants use a 90% figure, since neither IAS 17, nor the peer guidance on IAS 17 given by KPMG and Deloitte refer to a 90% figure), it should be approached with caution. As the Judge explained, “there is no single bright numerical line, rather an accountant must exercise his judgment by applying the test of "substantially all" according to the ordinary meaning of those words.” In the end, Foxton J found that the valuation evidence pointed very clearly to the fact that the 90% threshold had been exceeded, even after one applied all realistic assumptions in the Claimant’s favour.

2. Leased asset of such a specialised nature that only the lessee can use them without major modifications

Whilst the Claimants’ mantra throughout the trial was that the sixth form building comprised 81 modules that could be easily relocated, the Judge found that the reality of the situation was that the building had been constructed on site with the intention that it would never be moved. Even on the Claimants’ own evidence, the relocation cost was likely to exceed £1.2m and therefore relocation was not a commercially viable proposition.

3. Lease term is for major part of economic life of asset

The judge’s findings of fact (with reference to the valuation expert opinion that was presented by the parties), also pointed very firmly to the conclusion that this further primary Finance Lease indicator was satisfied. The conclusion that moving the building was uneconomical, combined with the location of the building and the only viable end-party user being another School or College, all pointed to the further conclusion that the leased asset did not have any residual ‘in situ’ value and therefore a Lease to the College would inevitably exhaust the major part of the economic life of the asset.

In ordering that the Claimants should be responsible for paying 95% of the Council’s costs, Foxton J further rejected the claim that section 49(5) deemed the College to have entered into the contract as the Council’s agent. He found that such a construction was incompatible with the legislative framework as a whole. Equally, the claims for misrepresentation and/or negligent misstatement also failed (on the basis that any representations made by the College and/or the Council prior to the entry of the Lease) did not, as a matter of fact, induce the Claimants to enter into the Lease.

The wider impact: This judgment has the potential to have a significant impact upon contracts between private companies and public entities. Central Government austerity measures and budgetary constraints in the public sector have inevitably meant that funding for capital projects has been reduced. Companies such as the Claimants have stepped in to try and take advantage of this new commercial opportunity.

It of course remains to be seen whether the judgment in this particular case will cause public bodies up and down the country to re-evaluate existing contracts. However, what is clear is that every leasing arrangement and the ultimate lease classification will fall to be considered on a case by case basis, following an assessment of individual merits and the nuances of each transaction. Leasing arrangements that represent a ‘bad deal’ for the public purse may face a challenge.

From an accountancy perspective, particularly regarding the PVMLP test, the Judge also cautioned practitioners that the substance of the Lease may in certain circumstances mean that accountancy practitioners should moderate their approach; as the Judge explained: “this case involves a modular building, installed on site after substantial preparatory and groundwork, designed to meet the lessee's specialised requirements, subject to a 15-year lease term and which it would involve a significant financial and logistical effort to relocate. These are characteristics which might be thought to test the outer limits of the concept of an operating lease, and to make the use of a lower PVMLP threshold more prudent.”

The Future: Accountants in this sector will no doubt already be alive to the impact of International Financial Reporting Standard (“IFRS”) 16 - Leases, which became applicable to public sector institutions for accounting periods commencing on or after 1 April 2020. The overall effect of IFRS 16 is to eliminate the distinction and accounting treatment between operating and finance leases for lessees. Under IFRS 16 all leases (with the exception, as an option, of low value or short-term leases) should be accounted for as a “right of use asset”.

The effect of this would appear to result in a lease, which may have been previously classified as an operating lease, being recorded as a right of use asset and capitalised on the balance sheet, with an associated lease liability also shown on the balance sheet.

The full Judgment can be found here: https://www.bailii.org/ew/cases/EWHC/Comm/2020/1118.html

The Council were represented by DAC Beachcroft LLP (Duncan Greenwood Partner and Mark Cawthorne Senior Associate) whose accountancy expert was Adam Smith of BDO LLP. The team that had conduct of the case on behalf of the Council can be contacted using the details below.

Footnotes

*A maintained school cannot borrow without the Secretary of State’s consent, which had not been obtained: see paragraph 3 of Schedule 1 to the Education Act 2002.