How Dual Model Accounting For Infrastructure Projects Affects Investor Analysis In Latin America

Primary Credit Analyst: Shripad J Joshi, CPA, CA, New York (1) 212-438-4069; shripad.joshi@standardandpoors.com Secondary Contacts: Veronica Yanez, Mexico City (52) 55-5081-4485; veronica.yanez@standardandpoors.com Candela Macchi, Buenos Aires 0054-114891-2110; candela.macchi@standardandpoors.com Maria del Sol Gonzalez, CFA, New York (1) 212-438-4443; maria.gonzalezcosio@standardandpoors.com Research Contributors: Rohina Verdes, Mumbai +91 22 40405829; rohina.verdes@standardandpoors.com Vivek Velandy, Mumbai; vivek_velandy@standardandpoors.com

Table Of Contents
Accounting Choices For Service Concession Arrangements In Latin America Assessing Profitability Of Service Concession Infrastructure Companies Cash Flow Adequacy Under The Two Models May Achieve Inconsistent Metrics Unless Adjusted, Particularly For Investments In Financial Assets Diversity In Practice On Service Concession Cash Flows--Operating Or Investing? Analytical Adjustments Required For Capitalized Borrowing Costs To Iron Out Differences Co-existing Accounting Regimes In Latin America Can Potentially Create Differences

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Table Of Contents (cont.)

A Need For Accounting Change Appendix Related Criteria Related Research

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Infrastructure for public services such as roads, bridges, tunnels, hospitals, and airports traditionally is constructed, operated, and maintained by the private sector (operator) and financed by the public sector (grantor) through public budget appropriation. Such transactions (public-to-private service concession arrangements) generally are called public-private-partnerships (PPPs). International Financial Reporting Interpretations Committee (IFRIC) 12 "Service Concession Arrangements" is the first specific guidance for operators on how to account for this important transaction class under International Financial Reporting Standards (IFRS). Standard & Poor's Ratings Services believes there is a need to reduce, if not eliminate, the multiple accounting models under IFRIC 12 that can produce different results for similar economic transactions and beckon further analytical scrutiny. IFRIC 12 applies to accounting by operators that construct infrastructure or acquire it from third parties, or to existing infrastructure, for which the grantor gives the operator access to the infrastructure for the purposes of the service arrangement. Moreover, operators in some countries, such as the U.S., account for service concession arrangements as leases, applying a risk and rewards accounting approach; others may treat them as property, plant, and equipment (PP&E), applying a controls accounting approach. The primary objective of IFRIC 12 is to decrease diversity in accounting practice for service concession arrangements; however, it permits three accounting models (see Appendix). In accordance with its principles, an operator can account for its rights in a service concession as: an intangible asset; a financial asset; or both (i.e., a bifurcated model approach). Overview Operators account for concession arrangements using different accounting models based on the nature of activities, although the underlying economics may not be different. We found operators in our sample used a split between the intangible asset and bifurcated models, while the "pure" financial asset model was not applied. The distinct accounting models produce different EBITDA and cash flow adequacy measures that affect financial analysis of companies. The statement of cash flows' classification for service concessions may be investing, financing, or operating activities causing incomparable presentation. We make analytical adjustments to amounts reported to improve comparability and representation of the underlying economics of the transaction. The analytical impact depends on the accounting model applied and how sensitive the issuer's credit is to the service concession transaction.

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Accounting Choices For Service Concession Arrangements In Latin America

Although IFRIC 12 was effective for annual periods beginning on or after Jan. 1, 2008, in Latin America, the transition is much more recent, as countries there made the transition to IFRS e.g., in Brazil, Argentina, and Mexico the transition was between 2010 and 2012 (see "Credit FAQ: Latin America Gets On The IFRS Highway--Cruise Control, Or Speed Bumps Ahead?", published March 22, 2012, on RatingsDirect). Standard and Poor's Ratings Services reviewed the accounting model for a sample of companies in Latin America as they changed from local country GAAP to IFRS, and found a split between the use of the intangible asset and bifurcated models (see tables 1 and 2).
Table 1

Diverse Accounting Models For Service Concession Arrangements In Latin America

Pre-IFRS accounting Argentine GAAP U.S. GAAP Brazilian GAAP U.S. GAAP Chilean GAAP Chilean GAAP Argentine GAAP Mexican GAAP Chilean GAAP Brazilian GAAP Brazilian GAAP Brazilian GAAP Brazilian GAAP Brazilian GAAP Brazilian GAAP Brazilian GAAP Chilean GAAP Pre-IFRS accounting Year of model for service adoption concessions 2012 PP&E 2010 PP&E Post-IFRS accounting model for service concessions Intangible Assets Bifurcated

Company Empresa Distribuidora y Comercializadora Norte S.A. Eletrobras-Centrais Eletricas Brasileiras S.A. Companhia de Saneamento Bsico do Estado de So Paulo Companhia Energtica De Minas Gerais Cemig Enersis S.A. Empresa Nacional de Electricidad S.A. Chile Autopistas Del Sol S.A. Grupo Aeroportuario del Centro Norte S.A.B. de C.V. Compania Sud Americana de Vapores CCR S.A. Transmissora Aliana de Energia Eltrica SA Ampla Energia e Servicos S.A Centrais Eletricas do Para S.A. Elektro Eletricidade e Servicos S.A. Eletropaulo Metropolitana Eletricidade de Sao Paulo S.A. Companhia Energetica do Ceara - Coelce E-CL S.A.

Country Argentina Brazil Brazil Brazil Chile Chile Argentina Mexico Chile Brazil Brazil Brazil Brazil Brazil Brazil Brazil Chile

2009 PP&E and Intangible Assets Intangible Assets 2010 PP&E 2009 PP&E 2009 PP&E 2012 Investment in Concession 2011 Investment in Concession 2010 Intangible Assets 2010 PP&E 2010 PP&E 2010 PP&E 2010 PP&E 2010 PP&E 2010 PP&E 2010 PP&E 2010 PP&E Bifurcated Bifurcated Intangible Assets Intangible Assets Intangible Assets Intangible Assets Intangible Assets Bifurcated Bifurcated Bifurcated Bifurcated Bifurcated Bifurcated Intangible Assets

The operator recognizes a financial asset if it has the unconditional contractual right to receive cash or another financial asset from, or at the direction of, the grantor for the construction services. Conversely, if the end customers pay for the services provided (e.g., tolls) by the operator, and the operator recovers its investment in the infrastructure from these payments, the infrastructure should be recognized as an intangible asset. In the simplest terms, if the

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operator bears the risk of the cash flows, the infrastructure should be classified as an intangible asset, because the operator has a right (a license) to charge users of the public service. On the other hand, if the grantor bears the risk of the cash flows, the infrastructure should be classified as a financial asset (the operator has a right to be paid by the grantor for providing construction services). As a result, these accounting models produce inconsistent financial results, statement of condition, cash flows and analytical measures.
Table 2

Breakdown Of Accounting Models For Service Concessions In Latin America Under IFRS
Accounting models Intangible asset model Financial asset model Bifurcated model Total No. of companies 8 9 17 Percentage 47 0 53 100

Assessing Profitability Of Service Concession Infrastructure Companies

We typically assess the profitability and levels of volatility of infrastructure companies using Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA). There generally will be a difference in EBITDA under the two models from year to year over the life of the arrangement (see chart 1). This difference between the two models normally arises because under the financial asset model the income is front-loaded in the early years due to the use of the effective interest rate method and no amortization of the asset. The intangible asset model likely will have the opposite consequences and will give rise to lower income in the first few years of the concession term and higher income in later years. The EBITDA under the bifurcated model is likely to be between those of the two "pure" models (the financial asset model and the intangible asset model).

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Chart 1

Under IFRIC 12, certain companies report revenue from works/improvements to concession assets as part of total revenues. They also report a corresponding operating cost in the operations section of the income statement. As a result, revenue from works/improvements to concession assets does not affect reported EBITDA or operating profit, but does affect reported profitability margins. As a part of our adjustments, we exclude the revenue and cost from reported revenue and reported cost of goods sold. Our rationale is: To not understate profitability margins, both historically and in our projections; To not create volatility in profitability (if assessed through the EBITDA margin) that would not be reflective of the underlying business; and To ensure comparability with other infrastructure companies.

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Additionally, where some companies report revenue excluding financial income (from financial assets) guaranteed by the grantor, we increase revenue and EBITDA for this income, if it is not included in operating income (rather included as finance income). Our rationale for this is: To not understate EBITDA, both historically and in our projections; and To recognize the benefit of the guaranteed revenue stream that, in our view, supports profitability compared to other transportation infrastructure companies not receiving any such income or not applying IFRIC 12 (see "Key Credit Factors For The Transportation Infrastructure Industry", published Nov. 19, 2013).

Cash Flow Adequacy Under The Two Models May Achieve Inconsistent Metrics Unless Adjusted, Particularly For Investments In Financial Assets
A key metric that focuses on cash flow adequacy--free operating cash flow (FOCF)/Debt--is derived by deducting capital expenditures from operating cash flow (OCF). This metric frequently may be used as a proxy of a company's cash generated from core operations. Prior to the adoption of IFRIC 12, most companies followed the PP&E model, under which all investments made by a company on service concessions were a part of capital expenditures. Similarly, for companies using the intangible asset model, our approach is to include investments in intangible assets (for concessions) as capital expenditures in our analysis. However, the outlier is investments in financial assets, the inclusion or exclusion of which can potentially skew analytical metrics. We believe investments in financial assets should be included as capital expenditures to appropriately depict the cash flow adequacy, as in the case of Companhia Energetica de Minas Gerais S.A. (see table 3).
Table 3

Impact Of Including/Excluding Investments In Financial Assets On Cash Flow Adequacy

Currency--millions of Brazilian Reais (BR$) --Companhia Energtica De Minas Gerais S.A.-2009 Capital expenditures: Property, plant, and equipment Intangible assets Additions to Financial Assets Debt, reported Debt, adjusted Cash flow from operations, reported Cash flow from operations, adjusted [A] [B] [C] [D1] [D2 = D1 (+/-) S&P Adjustments] [E1] [E2 = E1 (+/-) S&P adjustments] 702 1,607 1,390 11,293 14,325 2,570 2,361 347 2,298 1,477 13,227 15,973 3,457 3,194 924 1,852 1,026 15,779 17,011 3,898 3,700 598 1,670 160 10,416 13,152 3,115 2,867 2010 2011 2012

Capital expenditures and key metrics excluding additions to financial assets: Capital expenditures, reported Capital expenditures, adjusted FOCF, reported FOCF, adjusted [F1 = A+B] [F2 = F1 (+/-) S&P Adjustments] [G1 = E1 - F1] [G2 = E2 - F2] 2,309 2,299 261 62 2,645 2,724 812 470 2,776 2,770 1,122 930 2,268 2,263 847 604

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Table 3

Impact Of Including/Excluding Investments In Financial Assets On Cash Flow Adequacy (cont.)

FOCF/debt: Based on reported data (%) Based on Standard & Poor's-adjusted data (%) [H1 = G1/D1] [H2 = G2/D2] 2.3 0.4 6.1 2.9 7.1 5.5 8.1 4.6

Capital expenditures and key metrics including additions to financial assets: Capital expenditures, reported Capital expenditures, adjusted FOCF, reported FOCF, Adjusted FOCF/Debt: Based on reported data (%) Based on Standard & Poor's-adjusted data (%) Variance in FOCF/Debt (%) Based on reported data (%) Based on Standard & Poor's-adjusted data (%) [H1 - H3] [H2 - H4] (12.3) (9.7) (11.2) (9.2) (6.5) (6.0) (1.5) (1.2) [H3 = G3/D1] [H4 = G4/D2] (10.0) (9.3) (5.0) (6.3) 0.6 (0.6) 6.6 3.4 [F3 = F1 + C] [F4 = F2 + C] [G3 = E1 - F3] [G4 = E2 - F4] 3,699 3,689 (1,129) (1,328) 4,122 4,201 (665) (1,007) 3,802 3,796 96 (96) 2,428 2,423 687 445

Diversity In Practice On Service Concession Cash Flows--Operating Or Investing?

In November 2011, the IFRS Interpretations Committee (IC) considered whether all of the cash flows relating to construction services under a service concession arrangement should be presented as operating or investing. The IFRS IC noted that the principle in International Accounting Standard (IAS) 7 "Statement of Cash Flows" is to classify cash flows in a manner that is consistent with the activity that generated them. However, eligibility under the different accounting models for infrastructure construction services does not change the underlying activity to which the construction services relate, i.e., regardless of whether the cash inflows will be obtained contractually from the government (financial asset model) or through services to the public (intangible asset model), satisfying a service concession arrangement (construction service) is expected to be a principal revenue producing activity of an entity which undertakes such arrangements--an operating cash flow. We believe this argument is sound, because construction of PP&E does not lead to revenue, whereas construction of infrastructure under the intangible asset or financial asset model under IFRIC 12 does. Hence, it is more appropriate to classify the service-concession cash flows as operating activities. In practice, however, we have seen the classification of cash flows related to service concessions in company financial statements as investing activities, financing activities, and/or operating activities, implying a potential impact on cash flow from operations (CFO, see table 4).

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Table 4

Impact On Key Metrics For Classification Of Cash Flows Of Service Concession Arrangements
--If cash flows for service concessions are classified as operating activities---Impact-CFO/debt (%) 17.5

--Statement of cash flows-Accounting Currency Investing Financing Operating model Year (mil.) activities activities activities 2012 Brazilian Reais 2012 Brazilian Reais (4,918.1) --

--Adjusted metrics-CFO/debt (%)

Company

CFO

Debt

CFO

% (8.6)

Eletrobras-Centrais Bifurcated Eletricas model Brasileiras S.A. Companhia de Saneamento Bsico do Estado de So Paulo Grupo Aeroportuario del Centro Norte S.A.B. de C.V. Intangible asset model

(434.3) 14,887 56,970

26.1 9,969

--

(40.3)

(50.8)

2,204 11,056

19.9 2,164

19.6

(0.4)

Intangible asset model

2012 US$

(28.2)

--

--

1,192

2,088

57.1 1,164

55.7

(1.3)

Classifying service concession cash flows as operating activities (rather than investing activities) correspondingly reduces cash flow from operations and capital expenditures, thereby fully neutralizing any impact on the FOCF/Debt metric, so the impact on FOCF is not included in the table above.

Analytical Adjustments Required For Capitalized Borrowing Costs To Iron Out Differences
Operator recognizes a financial asset:
When an operator recognizes a financial asset as consideration receivable from the grantor for the construction service provided, the operator generally does not capitalize borrowings costs, but expenses them as incurred.

Operator recognizes an intangible asset:

Operators that recognize an intangible asset will generally capitalize borrowing costs as part of the intangible asset. IAS 23 "Borrowing Costs" provides guidance on the definition of borrowing costs, the determination of borrowing costs to be capitalized and the capitalization period of borrowing costs. In general, the operator will capitalize borrowing costs as they are incurred, as expenditures on the asset's construction are incurred and contract activity progresses. Capitalization should cease when the infrastructure and, therefore, the intangible asset is ready for use. When borrowing costs are capitalized as part of the intangible asset's cost, an operator will report a different EBITDA from another that recognizes a financial asset and expenses borrowing costs during the construction phase, even if both undertake the same construction activity on the same terms. This is a normal consequence of capitalizing instead of expensing borrowing costs. As a result, we address these differences by reversing interest capitalization under the intangible asset model and including the amount as an interest expense to derive our financial metrics. In the cash flow statement, we reclassify capitalized interest from investing to operating cash flow, if reported as investing. This reduces CFO and capital

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expenditures while free cash flow remains unchanged.

Co-existing Accounting Regimes In Latin America Can Potentially Create Differences

Prior to the IFRS changeover, infrastructure assets were classified in varied ways by companies in Latin America. As it relates to concession arrangements generally, infrastructure assets were included in the operator's PP&E in pre-changeover Brazilian GAAP. Similarly, there was no specific guidance on concession arrangements under pre-changeover Argentine GAAP and generally, infrastructure assets were included in the operator's PP&E. With the transition to IFRS, some of these reporting differences for service concession arrangements have been reduced--but not eliminated. Companies that report in accordance with local country GAAP, e.g., Colombian GAAP, may continue to report service concessions as PP&E or other assets and amortize these assets over the term of the service concession arrangement (see chart 2). It is therefore critical to understand the accounting and determine whether to make analytical adjustments accordingly, at least until all countries in Latin America have made the transition to IFRS. Transition to IFRS--pursuant to Law 1314 of July 13, 2009 in Colombia which introduced changes in accounting, audit and information disclosures with the aim of converging with IFRS--adoption of IFRS will begin in a phased manner starting with public companies or companies that derive at least 50% or more of their revenue from exports or imports. The effective date for such companies is Jan. 1, 2014 (i.e., date of transition) and consequently, IFRS will be adopted fully for annual periods ending Dec. 31, 2015. Small and medium-sized companies' may adopt IFRS for SMEs in 2016.

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Additionally, under U.S. GAAP, there is no specific accounting guidance that addresses accounting for service concessions. In the absence of U.S. GAAP, depending on the terms of the service concession contract, in our view, some operating entities may apply by analogy the principles of IFRIC 12 while other entities may account for their rights over the infrastructure in a service concession as a lease. This is fundamentally another key difference in analyzing service concession operators in Latin America and across the globe.

A Need For Accounting Change

Today, when numerous countries in Europe, Asia, Australia and Latin America continue to build or enhance their infrastructure, it's time that accounting for service concessions reflects the real economics of the underlying transaction in a manner that is comparable across companies, industries and borders to meet investor demands.

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Generally, accounting policy choices, if consistently applied from one period to another may be effective, assuming they reflect the purpose of the underlying transaction; however, multiple accounting models in one standard or interpretation such as IFRIC 12 create differences in analysis and don't achieve the objectives of the overall accounting framework, in our view. The matters discussed herein are only a handful of the accounting issues that may have analytical consequences. Certain other issues that warrant additional in-depth analysis include whether particular types of arrangements are in the scope of IFRIC 12 such as the definition of public service--what is deemed to be a public service in a developed country, or vice versa, may not be viewed as a public service in a developing country for social or political reasons; to more complex topics such as the accounting for the various rights and obligations of operators. Further, the nature and provisions of the contract may vary by industry and/or sector. The legal frameworks under which such arrangements are carried out also vary from country to country. Until there are more economically representative changes on this key accounting interpretation, or at least reconsidered and concluded, it remains a good strategy for companies to keep their investors and analysts well informed, by communicating information about service concessions through clear, consistent, transparent disclosures and timely dialogue.

Appendix
Summary of IFRIC Interpretation 12: Service Concession Arrangements
An arrangement is only within the scope of IFRIC 12 if the public entity (grantor) controls and/or regulates the services provided with the infrastructure and their price, and controls any significant residual interest in the infrastructure. IFRIC 12 applies to: Infrastructure that the operator constructs or acquires from a third party for the purpose of the service arrangement; and Existing infrastructure to which the grantor gives the operator access for the purpose of the service arrangement. Under IFRIC 12, in these circumstances, the operator does not recognize the infrastructure as PP&E. Therefore, the key question addressed by IFRIC 12 is what category of asset the operator should recognize. For all arrangements falling within the scope of IFRIC 12 (essentially those where the infrastructure assets are not controlled by the operator), the infrastructure assets are not recognized as PP&E of the operator. Rather, depending on the terms of the arrangement, the operator recognizes: A financial asset--where the operator has an unconditional right to receive a specified amount of cash or other financial asset over the life of the arrangement; or An intangible asset--where the operator's future cash flows are not specified (e.g. where they will vary according to usage of the infrastructure asset); or Both a financial asset and an intangible asset where the operator's return is provided partially by a financial asset and partially by an intangible asset.

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Related Criteria
Key Credit Factors For The Transportation Infrastructure Industry, Nov. 19, 2013

Related Research
Credit FAQ: Latin America Gets On The IFRS Highway--Cruise Control, Or Speed Bumps Ahead?, March 22, 2012 Credit FAQ: Peeling Back The Accounting Layers Of IFRS Changeover In Latin America, March 22, 2012

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