balancing act: the leasing of government assets...management policies dealing with the use and...

AUDITOR GENERAL f o r We s t e r n A u s t r a l i a

Report No 6 September 2003

PERFORMANCE EXAMINATION

Balancing Act: The Leasing of Government Assets

AUDITOR GENERAL f o r We s t e r n A u s t r a l i a

THE SPEAKER THE PRESIDENT LEGISLATIVE ASSEMBLY LEGISLATIVE COUNCIL

PERFORMANCE EXAMINATION – Balancing Act: The Leasing of Government Assets

This report has been prepared consequent to an examination conducted under section 80 of the Financial

Administration and Audit Act 1985 for submission to Parliament under the provisions of section 95 of the

Act.

Performance examinations are an integral part of the overall Performance Auditing program and seek to

provide Parliament with assessments of the effectiveness and efficiency of public sector programs and

activities thereby identifying opportunities for improved performance.

The information provided through this approach will, I am sure, assist Parliament in better evaluating

agency performance and enhance Parliamentary decision-making to the benefit of all Western Australians.

D D R PEARSON AUDITOR GENERAL September 17, 2003

2 AUDITOR GENERAL FOR WESTERN AUSTRALIA

Contents

AUDITOR GENERAL’S OVERVIEW

EXECUTIVE SUMMARYKey FindingsWhat this Examination is AboutWhat We DidWhat We FoundRecommendations

INTRODUCTIONBackgroundThe Pros and Cons of LeasingTypes of LeasesLeasing in Other JurisdictionsExamination Focus and Approach

ASSET MANAGEMENTKey FindingIntroductionAsset Management PoliciesExpiry of LeasesRecommendations

LEASE VERSUS BUYKey FindingsIntroductionThe Lease Versus Buy AnalysisEstimating Residual ValueAlternative OptionsRecommendation

LEASE CONTRACTINGKey FindingsIntroductionCompetitive QuotesLease Quotation ProceduresStandard Lease AgreementsRecommendation

ACCOUNTING CLASSIFICATIONKey FindingIntroductionAgency Classification of LeasesRecommendation

APPENDICESAppendix 1 – Advantages and Disadvantages of Buying and LeasingAppendix 2 – Finance and Operating LeasesAppendix 3 – Leasing in Other JurisdictionsAppendix 4 – Discount Rates

4

5 5 5 6 6 9

10 10 11 12 13 13

16 16 16 16 18 19

20 20 20 21 22 28 29

30 30 30 30 31 31 33

34 34 34 34 36

37-45 37 38 39 40

Appendix 5 – Risks and Benefits of Ownership and Accounting Classification 42Appendix 6 – Status of Auditor General’s 1999 Recommendations 45

PREVIOUS REPORTS OF THE AUDITOR GENERAL 46

AUDITOR GENERAL FOR WESTERN AUSTRALIA 3

BALANCING ACT:THE LEASING OF GOVERNMENT ASSETS

Auditor General’s Overview

An increasing trend to leasing more expensive and specialised assets is evident in the

Western Australian public sector. Assets being leased include medical equipment, research

vessels, special purpose buildings and IT systems. The financial consequences of lease versus

buy decisions are therefore far greater so a closer look at the financing of asset acquisitions

has been taken, in addition to following up my 1999 Report, Lease Now – Pay Later? The

Leasing of Office and Other Equipment.

This examination has confirmed that significant improvements have been made to address

the concerns raised in the 1999 Report. However, it is evident that a long-term view of the

costs, risks and benefits of leasing is still not being taken.

With leasing, public sector agencies can avoid the risks of asset ownership. If the right assets

are leased for the right reasons, then it may also offer a cheaper method of acquisition.

However, the lack of comprehensive lease versus buy analyses means that some leases will

cost more over the life of the asset than had the asset been bought. Of greater concern is that

many lease versus buy analyses appear contrived to justify decisions to lease, an

inappropriate response to ongoing budget and debt restraint.

A further adverse effect of inadequately informed leasing decisions is that, without strong

asset management practices, agencies do not know whether they are surrendering assets

before the end of their useful life. In periods of budget and debt restraint, this also does not

make economic sense.

Inadequately informed decisions to lease will cost millions of dollars more in the end and

ultimately further constrain funds available for the delivery of services to the public. There is

clear scope for a more rigorous approach to deliver, at least over a few years, the dual benefits

of cheaper asset acquisition and some funds for re-allocation to other priorities.

With the current push towards procurement reform, it is appropriate to also improve the

rigour and transparency of lease versus buy decision-making. It is also important that public

sector managers understand the long-term costs, benefits, and implications of their decisions

to lease or buy.


Executive Summary

Key Findings ! Significant improvements have been made to address the concerns raised in the June

1999 report Lease Now – Pay Later? The Leasing of Office and Other Equipment.

! With leasing, public sector agencies can avoid the risks of asset ownership. If the right

assets are leased for the right reasons, then it may also offer a cheaper method of asset

acquisition. However:

" two of the five sampled agencies did not conduct lease versus buy analyses to

determine whether leasing was cost effective;

" it was not always possible to conclude whether value for money had been achieved

from leasing due to unsound estimates used by those agencies conducting lease

versus buy analyses;

" leasing decisions which did not take into account the nature of the assets and their

importance to agencies resulted in additional costs; and

" actions taken by some agencies upon expiry of lease agreements have negated the

intended benefits from leasing and resulted in additional costs.

What this Examination is About The financing of asset acquisitions in periods of budgetary restraints, with many competing

demands for available funding, is an ongoing challenge. Many agencies are looking at

alternatives to asset ownership and the different methods by which assets may be financed

and acquired such as leasing. With leasing1:

! Agencies can avoid the risks of asset ownership. These risks include less than expected

proceeds from disposal of assets (ie residual value risk). Leasing can be particularly

beneficial in those situations where there is a high risk of obsolescence.

! Leasing may offer a cheaper method of acquisition. Some lessors have developed

specialised distribution channels for disposing of assets and therefore, may obtain higher

resale prices for second-hand assets than the agency could. In these situations, the

benefits of higher disposal values are passed onto the agency in the form of reduced lease

payments. As such, the total payments over the term of the lease can be less than an

outright purchase (in net present value terms)2.

1 There are two main types of leases: operating leases and finance leases. Finance leases are those leases where the risks and benefits of ownership of assets are transferred to the lessee. With operating leases, substantially all risks and benefits of ownership are retained by the lessor.

2 Net Present Value means the present value of annual net cash flows less the initial outlay. Present value represents the value in today’s dollars of a future payment discounted back to the present at the required rate of return.



EXECUTIVE SUMMARY (continued)

! By spreading costs over several financial years, leasing can make immediate asset

acquisition possible for many agencies.

However, these immediate benefits can be negated by the additional costs that can result in

the long-term if the wrong type of assets are leased or leasing is undertaken for the wrong

reasons.

Since first examining the area of leasing in 1999, there has been a trend towards leasing

more expensive assets such as medical equipment, research vessels, building construction,

and assets associated with systems development. As such, the financial consequences of the

lease versus buy decision are now more significant. It was therefore decided to have a closer

look at the financing of asset acquisitions.

This report identifies how a sample of public sector agencies evaluate the strategic and

financial impacts of assets financed by leasing and how they manage these assets to ensure

that the public sector is not unduly disadvantaged by leasing arrangements or exposed to

unnecessary risks.

What We Did A sample of five agencies3 with a combined portfolio of leased assets totalling over

$100 million at December 31, 2002, was selected for the examination.

The examination looked at 85 lease contracts valued at $97.2 million entered into or expiring

between July 2001 and December 20024. Lease versus buy analyses (where conducted) were

reviewed and recalculated (where necessary).

What We Found

Asset Management Agencies need to determine whether the benefits, such as transfer of residual value risk,

being provided by leasing represent value for money. Leasing will not offer any significant

financial benefits if the (residual) value of an asset to an agency is greater than the value

placed on the asset by the lessor at the end of the lease term.

In most cases, for example, if an agency can effectively use a computer for four years, then

leasing will be less attractive. This examination has shown that an agency can obtain, for

around the same amount of money (in net present value terms), four years of use if it buys

compared with only three years from leasing.

3 Department of Education, Department of Justice, Department for Planning and Infrastructure, Police Service, and Central TAFE. 4 With the exception of the leases of the Police Service’s CADCOM and the Department of Justice’s Fremantle Justice Centre, which

were entered into prior to July 2001 but were current at December 31, 2002.

AUDITOR GENERAL FOR WESTERN AUSTRALIA6

Other factors such as possible increases in maintenance would need to be considered.

However, without having first identified the useful life and the optimal replacement time for

an asset, then it is more likely that these agencies will make poor lease versus buy decisions.

The examination identified that four of the five agencies sampled did not apply asset

management policies dealing with the use and replacement of assets when making lease

versus buy decisions.

Actions taken by agencies at the end of leases, including extensions to lease terms and

purchasing leased assets, have often negated the intended benefits of leasing and have led

to additional costs. For example:

! A review of 26 expired leases involving 1 048 information technology assets valued at

$2.2 million at one agency identified that 60 per cent of the items had been bought out

at the end of the lease for amounts representing between 19 and 33 per cent of the items’

original value. In many cases, these amounts meant that the agency had paid twice for

the same assets – by paying an amount equivalent to the cost of buying the new assets

plus the cost of buying the assets second-hand (used).

! One agency had extended the leases of 23 per cent of the sampled information

technology assets for additional periods of up to 24 months at between 40 and 75 per cent

of the original lease payments. Another agency decided in 2002 to extend leases for over

7 500 items (originally valued at around $15 million) for a further 12 months at 50 per

cent of the original lease payments. In net present value terms, this means that agencies

are paying up to 30 per cent more than if the assets had been purchased from the outset.

Lease versus Buy This examination has confirmed that significant improvements have been made to address

concerns raised in the 1999 examination of leasing. Tools and guidelines have been issued

by central agencies to assist with the lease versus buy decision. The availability of these

resources means that agencies are now able to conduct lease versus buy analyses which they

may not have in the past. A non-mandatory whole-of-government leasing facility has also

been established.

The examination has highlighted that two of the five sampled agencies still do not routinely

conduct lease versus buy analyses to support decisions to lease. In these agencies, the

decision to lease has been driven by ‘financial constraints’ (ie insufficient funds were

available to purchase assets outright). In the absence of lease versus buy analyses, these

agencies do not know whether a premium is being paid for leasing and whether it represents

value for money.



EXECUTIVE SUMMARY (continued)

The decision to lease will also be affected by the type of asset. Some specialised assets

including custom-built fisheries vessels or purpose-built facilities such as courthouses “often

do not have a well-developed second-hand market”. Therefore, the potential for the lessor to

obtain an appropriate level of proceeds on disposal and to assume residual value risk is

reduced.

In these instances, leasing will be less attractive, as demonstrated by the 25-year lease of the

purpose-built Fremantle Justice Centre. The Department of Justice will be paying around

$3.6 million (or 25 per cent) more than a government-funded buy option. The Department of

Justice advised that the procurement of the Fremantle Justice Centre achieved a transfer of

other risks associated with site availability, site location, design and construction, planning

and zoning, and maintenance; though, these were not quantified and therefore, the extent to

which value for money was achieved is not clear. It is also possible that some or all of these

risks could have been transferred via other contractual arrangements without the need for

private finance.

If an agency also could not operate effectively without an asset and the costs of replacing the

asset or dismantling the asset and returning it to the lessor were significant, then leasing the

asset would also be less attractive. This was the case with the Police Service’s CADCOM5

system, which will form an integral part of the Police Service’s communication system. The

lease of CADCOM was terminated on June 27, 2003 to save up to $8.2 million and avoid the

‘serious cost risk’ of having to purchase CADCOM from the lessor at the end of the six-year

lease term.

Lease Contracting The sampled agencies were seeking lease finance quotes on a competitive basis and have

established or have access to standard lease agreements. Most of the terms and conditions

that were identified in 1999 as unduly favouring the lessor and/or exposing agencies to

unnecessary risk have been dealt with. However, the lease agreement used by one agency

contained several other unfavourable conditions such as inertia clauses and unfavourable

indemnity clauses.

Accounting Classification The manner in which some agencies had applied the Department of Treasury and Finance’s

lease versus buy analysis tool (Lease Calculator) resulted in incorrect accounting

classifications of leases. In some cases, the Lease Calculator had been adjusted to achieve an

operating lease classification.

5 Call Taking, Computer Aided Dispatch and related Communications (CADCOM) System.


Recommendations Agencies should:

! document their rationale for asset acquisition and replacement;

! ensure that comprehensive analyses of risks, benefits and costs are conducted prior to

entering into leasing arrangements to determine whether leasing is preferred to buying

and represents value for money - all alternative options should be considered;

! conduct a financial evaluation of all options available at the end of a lease term and

negotiate, as appropriate, with lessors at the expiry of the lease; and

! ensure that lease terms and conditions do not unduly favour the lessor or expose

agencies to avoidable risks.

The Department of Treasury and Finance should increase its focus on the regular review

and response to changes in accounting, financial and operational aspects of leasing.



Introduction

Background Public sector investment in assets such as roads, schools, and equipment is essential in

assisting in the delivery of services to the community and promoting economic development.

Government assets are typically financed by contributions from the Consolidated Fund,

borrowings, Commonwealth funds, asset sales, and other funds generated by agencies.

In recent years, the Government has implemented a number of policies, tools and guidelines

designed to improve the allocation of the State’s financial resources towards the acquisition

of assets. These include amongst others:

! Project Evaluation Guidelines (Department of Treasury and Finance, January 2002) –

providing a technical and procedural framework for the evaluation of new and existing

projects, including capital works and other expenditures requiring Cabinet approval.

! Capital User Charge (effective from July 1, 2001) – levied on the net assets of agencies

to provide an incentive for agencies to reduce their use of capital by disposing of surplus

assets or replacing them with more efficient assets. The capital user charge is currently

set at eight per cent of net assets.

The government asset acquisition or procurement process is also augmented by the ‘buying

wisely’ strategy which is about making sound purchasing decisions that achieve the best

overall result and value for money.

Whilst assets may be needed to deliver services, it is not essential that an agency own these

assets. Alternatives to asset ownership include both ‘non-asset’ solutions and the various

methods by which assets may be financed and acquired ie:

! using the private sector for service delivery (eg outsourcing);

! redesigning the delivery strategy to eliminate or reduce the need for assets (eg use of

telephone or web-based services);

! moderating the demand for services (eg introduction of user charge regimes); and

! choosing between buying and leasing.

Deciding which financing option to use to acquire assets can be a complex decision which

requires strategic asset planning and a thorough financial evaluation. In a report tabled in

Parliament in June 1999 titled Lease Now – Pay Later? The Leasing of Office and Other

Equipment, it was concluded that:

! public sector managers were often unsure or unaware of the costs and risks involved with

leasing; and

! very few of the leases examined were subjected to a thorough financial evaluation prior

to execution.


Leasing in the Western Australian public sector is now guided by the Department of Treasury

and Finance’s Project Evaluation Guidelines, which were issued in January 2002 but

previously existed in an exposure draft form since May 2000.

At June 30, 2002, public sector leasing commitments totalled $626 million. Although the

break-up of these figures by class of assets is not known, most of the commitments relate to

the leasing of office accommodation. However, the growth in value of new leases of office and

information technology equipment at the Departments of Education, Justice, and Planning

and Infrastructure, Central TAFE and the Police Service has been significant, as shown in

Figure 1.

80

70

60

50

40

30

20

10

0

Year 1999 2000 2001 2002

Val

ue

($m

)

Value of New Leases

#

# #

#

Cumulative Lease Value

Figure 1: Growth of Equipment Leasing in Selected Agencies The leasing of equipment has been growing since 1999, with the value of new leases jumping in 2000 due to the Department of Education’s Learning Technologies program and decisions by Central TAFE and the Police Service to lease all information technology equipment. New leases totalling $22.9 million in 2002 involved the Department of Education’s Notebooks for Teachers Program.

Source: Selected agencies and OAG

The Pros and Cons of Leasing Deciding whether to lease assets is not always easy and in each situation, the agency must

weigh the advantages and disadvantages. Whilst a leasing arrangement can be used to

overcome shortfalls in funding, it has the potential to cost an agency more in the long run

and constrain future budget flexibility by creating expenditure commitments in future years.

A lease is a rental agreement by which the legal owner of goods (lessor) allows another party

(the lessee) to use those goods for a stated period of time in return for a series of payments.

Leases are generally more expensive than borrowing or purchasing outright (in net present



INTRODUCTION (continued)

value terms)6 because they include a premium to compensate the lessor for assuming the

risks of ownership. The most significant risks of ownership7 are obsolescence and a less than

expected resale price when the owner disposes of the assets (‘residual value risk’).

An agency may determine that it would be highly exposed to these risks if it were to own the

assets and therefore, it may be prepared to pay a premium to transfer these risks to a lessor.

In these cases, leasing could be shown to be more cost effective.

In other cases, leasing can be cheaper than purchasing. Lessors make profits through a

combination of interest charges, tax benefits, and proceeds of asset sales or re-leases. Some

lessors have developed specialised distribution channels for disposing of assets and therefore,

can expect to obtain higher resale prices for second-hand assets than the lessee (agency)

could. In these situations, the benefits of higher disposal values are passed onto the lessee in

the form of reduced lease payments. As such, the total payments over the term of the lease

can be less than an outright purchase (in net present value terms).

Appendix 1 provides a summary of the advantages and disadvantages of buying and leasing.

Types of Leases The two main categories of leases are finance and operating leases. The difference between

these leases is established in Australian Accounting Standard AAS17 Leases and relates to

whether there has been a transfer of substantially all risks and benefits of ownership. Finance

leases are those leases where risks and benefits of ownership are transferred to the lessee8.

With operating leases, substantially all risks and benefits of ownership are retained by the

lessor.

Finance leases are akin to borrowing and are generally not supported by the Department of

Treasury and Finance (as per the Department’s Project Evaluation Guidelines). Without

retention of ownership risk by the lessor, agencies could be paying an unnecessary premium

over the Government’s borrowing rate because private sector financiers generally cannot

borrow at rates as favourable as the Government.

AAS17 requires leases to be classified as either operating leases or finance leases and

specifies certain accounting treatments and disclosures for each type. Appendix 2 details the

typical features and accounting treatments of operating and finance leases.

6 Net Present Value means the present value of annual net cash flows less the initial outlay. Present value represents the value in today’s dollars of the future payment discounted back to the present at the required rate of return.

7 Other risks of ownership include unsatisfactory performance, idle capacity, uninsured damage, and condemnation of the asset. See Appendix 5.

8 Under a finance lease, legal ownership may or may not eventually be transferred to the lessee.


Leasing in Other Jurisdictions Leasing in the Western Australian public sector remains the responsibility of individual

agencies, subject to guidelines issued by the Department of Treasury and Finance. A whole -

of-government leasing facility has been established but its use is not mandatory.

The Western Australian position contrasts with other jurisdictions, which have taken more

centralised approaches to leasing, in particular the Queensland Government. Refer to

Appendix 3.

Examination Focus and Approach At the time of the June 1999 report Lease Now – Pay Later? The Leasing of Office and Other

Equipment, agencies were generally leasing only personal computers and photocopiers.

However, since June 1999, there has been an increasing trend towards leasing expensive

assets such as medical equipment, research vessels, building construction, and assets

associated with systems development. Therefore, the financial consequences of the lease

versus buy decision are now more significant.

Additionally, in 2002, Audit reported to Parliament a number of instances where agencies had

not pursued the most cost effective financing option:

! metropolitan teaching hospitals - medical equipment valued at $3.1 million9; and

! Department of Fisheries – research vessel valued at $2.12 million10.

Against this background, a performance examination was conducted to assess:

! how agencies evaluated the strategic and financial impacts of assets financed by leasing;

! whether the method of asset acquisition achieved better value for money and complied

with State Supply Commission supply policies; and

! how well agencies managed leased assets to ensure that the government was not unduly

disadvantaged by leasing arrangements or exposed to unnecessary risks.

The following agencies with large portfolios of leased assets (primarily information

technology equipment) were selected:

! Department of Education

! Police Service

! Department for Planning and Infrastructure

! Central TAFE

9 Report No. 4 of 2002 Public Sector Performance Report 2002 tabled in September 2002.10 Report No. 9 of 2002 Report on Ministerial Portfolios at November 29, 2002 tabled in December 2002.



INTRODUCTION (continued)

The number and value of equipment leases held by each agency at December 31, 2002 is

shown in Table 1.

AGENCY NO OF CURRENT LEASES VALUE

Department of Education 827 $46.9 million

Police Service 477 $15.1 million

Central TAFE 51 $6.4 million

Planning and Infrastructure 160 $2.1 million

Table 1: Number and Value of Leases Current at December 31, 2002 The Department of Education is by far the largest lessee of the sampled agencies, with most of its leases held by schools.

Notes:

The figures for the Police Service do not include the lease of CADCOM, which was terminated on June 27, 2003.

Source: Selected agencies and OAG

In addition, the Department of Justice was selected to contrast their decision not to lease

information technology equipment with the agencies above and to examine the financing of

the construction of the Fremantle Justice Centre (with lease payments commencing in March

2001).

The examination looked at 85 lease contracts valued at $97.2 million entered into between

July 2001 and December 200211. Lease versus buy analyses (where conducted) were

reviewed and recalculated (where necessary) in accordance with AAS17.

The examination excluded leasing of office accommodation and motor vehicles.

The discount rates applied in the audit analysis of leases in this report are based on the

Western Australian Treasury Corporation’s lending rate to public sector agencies. See

Appendix 4 for more information.

On July 1, 2001, the Department of Treasury and Finance introduced an eight per cent

charge on the net assets held by an agency, known as the ‘capital user charge’ (CUC). The

Project Evaluation Guidelines require the CUC to be used as the agency’s benchmark rate

(discount rate) when comparing buy and lease options.

As the CUC rate of eight per cent is higher than the Western Australian Treasury

Corporation’s lending rate, agencies may be placed in the position of proceeding with and

being held accountable for a lease that is “preferred to purchasing from the perspective of

the agency, but will not be beneficial for the whole-of-government”. The guidelines state that

11 With the exception of the leases of CADCOM and the Fremantle Justice Complex, which were entered into prior to July 2001 but were current at December 31, 2002.


agencies will have to “use their discretion in these situations” and that the “lease/buy

decision is ultimately the agency CEO’s prerogative”. If an agency decides to proceed with a

lease, even though the analysis shows that leasing is preferred using the CUC but not when

using the lending rate, then it is required to document the reasons for doing so.

Audit observed that using the Western Australian Treasury Corporation’s lending rate would

lead to a lower figure for the discount rate than the use of the CUC. Agencies need to examine

the sensitivity of the lease versus buy analysis to the choice of discount rate.



Asset Management

Key Finding Only the Department of Justice applied asset management policies to support its lease versus

buy decision. The other four sampled agencies did not apply appropriate asset management

and replacement policy frameworks when making lease versus buy decisions.

Introduction Deciding on the most cost effective method of financing an asset acquisition is not always

easy. In some circumstances, leasing will be advisable; in others, buying the asset will be the

right decision.

The decision to buy or lease will be affected by the extent to which an asset is used and

replaced, and by the type of asset.

Asset Management Policies In the lease versus buy decision, the residual value of the asset is the most significant factor.

The estimate of residual value will be affected by the agency’s asset management and

replacement policies, and the impact of those policies on the useful life12 of the agency’s

assets. As demonstrated later in the report, in general terms:

! if the useful life of an asset to an agency equates to the economic life13 of the asset, then

leasing will be less attractive; and

! if the useful life of an asset to an agency is much less than the asset’s economic life then

leasing will be more attractive.

Table 2 shows a number of conditions that can either increase or decrease the useful life of

an asset to an agency.

12 Useful life is the period over which an asset is expected to provide benefits or be of value to an agency. 13 Economic life is the period over which an asset is expected to be economically useable by one or more users.


$ USEFUL LIFE % USEFUL LIFE % LEASING ATTRACTIVENESS $ LEASING ATTRACTIVENESS

! Systems in use and nature of services ! Systems or operations are not subject provided require most up-to-date equipment. to change.

! Optimal replacement period (eg after ! New assets can be given first to high warranty expires) may be shorter than an need individuals or departments and asset’s economic life – after which, costs of then rotated through the agency as they maintenance etc outweigh benefits. get older ie ‘cascade policy’.

! The asset is used more often by a large ! The useful life of the asset can be number of users leading to greater physical extended by making minor modifications wear and tear. or upgrades to the asset.

Table 2: Conditions that Increase and Decrease the Useful Life of an AssetThe useful life of an asset will vary amongst agencies, depending on conditions that exist in each agency.

Source: OAG

It is therefore important that agencies develop optimal use and replacement strategies for its

assets and document those strategies in an asset management and replacement policy. This

should then drive the decision to buy or lease assets.

For example, with the exception of the Department of Justice, all of the sampled agencies

lease their information technology equipment. However, only the Department of Justice

applied asset management policies dealing with the use and replacement of information

technology equipment to its lease versus buy decisions.

The Department of Justice has implemented a strategy of maintaining and replacing personal

computers on a three to four year life cycle and leveraging off the standard three-year

warranties applicable to personal computers. Cascade policies and memory upgrades are

used to extend the useful life of personal computers. This is also enabled by the existence of

a standard operating environment throughout the Department. The funds required to replace

personal computers can be staggered over a number of years, avoiding the constraints of

needing huge capital funding injections once every three to four years. Based on these

policies, the Department has decided against leasing information technology equipment.

Without the application of appropriate asset management policies, there is a greater risk that

agencies will make poor lease versus buy decisions. By leasing, agencies may be

unnecessarily surrendering assets well before the end of their useful life. There is also the

risk that the acquisition and replacement of assets will be driven by leasing rather than

operational need and optimal replacement times, and therefore resulting in additional costs.



ASSET MANAGEMENT (continued)

Expiry of Leases At the end of a lease term, lessees (agencies) normally have up to three options available.

Agencies can either:

1. return the assets to the lessor and buy or lease new assets;

2. purchase the leased assets from the lessor at a certain value; or

3. extend the term of the lease and pay reduced lease payments.

If an agency has strong asset management policies which have driven or have been

instrumental in determining their allocation of operational and capital funds, then the

decision to be made at the end of the lease may simply involve Option 1. That is, decide

whether the assets are still required and either buy new assets or enter into new leases for

new assets because funding has been allocated for that purpose.

However, without appropriate asset management policies and/or the availability of necessary

funds, then an agency that has chosen to lease (for whatever reason) may be forced into

Option 2 or 3.

Options 2 and 3 need to be carefully considered because they can negate any financial

benefits obtained from leasing. As stated in the Project Evaluation Guidelines, “it is the

actions of the lessee (or agency) at the end of a lease arrangement that generally determines

the overall financial performance of the lease”.

A sample of leases, which expired between July 2001 and December 2002, were examined

to assess the action taken by agencies.

Department of Education A sample of 26 leases relating to 1 048 information technology assets valued at $2.2 million

that expired between July 2001 and December 2002 was examined at the Department of

Education.

Around 60 per cent of the leased items were bought out at the end of the original lease term

– 627 items were purchased at amounts representing between 19 and 33 per cent of the

items’ original value. Most of these items were three-year old computers leased as part of the

Department’s Learning Technologies Program in schools. For example, 120 personal

computers valued at around $1 200 each in May 1999 were purchased by a school from the

lessor in May 2002 for $400 each.

This resulted in an additional net present value premium of up to 20 per cent compared with

purchasing the computers outright back in May 1999, thereby negating any benefits that may


have been obtained from leasing. Essentially, the Department of Education has paid twice for

the same assets – by paying an amount equivalent to the cost of buying the new assets plus

the cost of buying the assets second-hand (used). Only some schools had negotiated with

lessors to reduce the purchase amount.

A further 23 per cent of the leased items were leased for additional periods of up to 24

months at between 40 and 75 per cent of the original lease payment.

For example, in April 2002, one school agreed to pay $28 848 over 15 months for 48 three

year old computers (or $601 each). As these computers were valued at $92 000 (around

$1 917 each) in April 1999, the school is paying an additional 30 per cent (in net present

value terms) to keep the assets for a further 15 months. As stated in the Project Evaluation

Guidelines, “given that the asset is now worth typically 15 per cent of its original value, this

does not provide value…”.

The remaining 172 items were returned to the lessor.

Police Service In 2002, due to financial constraints, the Police Service implemented a decision to extend its

three-year leases of information technology assets for an additional 12 months at 50 per cent

of the original lease payments. By December 31, 2002, leases for over 7 500 items (originally

valued at around $15 million) had been extended.

This resulted in an additional net present value premium of up to 15 per cent compared with

purchasing outright, thereby negating any benefits that may have been obtained from

leasing. Costs were also incurred in upgrading computers prior to the end of the three-year

lease terms.

The Police Service advised that it was its intention at the beginning of the leasing

arrangement to lease the assets for three years and then to undertake a ‘refresh’. However,

circumstances outside of the leasing arrangement required the Police Service to reassess this

strategy.

Recommendations Agencies should:

! document their rationale for asset acquisition and replacement; and

! conduct a financial evaluation of all options available at the end of a lease term and

negotiate, as appropriate, with lessors at the expiry of the lease.



Lease Versus Buy

Key Findings ! Two of the sampled agencies do not conduct lease versus buy analyses prior to entering

into leasing arrangements. Consequently, these agencies are not able to demonstrate

whether value for money has been achieved.

! It was not always possible to conclude whether value for money had been achieved from

leasing due to unsound estimates used by those agencies conducting lease versus buy

analyses.

! Leasing decisions that did not adequately take into account the nature of the assets and

their importance to agencies resulted in additional costs.

! Leasing is often seen as the first and only option for dealing with the risks of asset

ownership, without consideration of alternative options for dealing with these risks.

Introduction The key to establishing whether leasing is more cost effective than purchasing outright is to

determine whether the amount being paid to transfer ownership risks represents value for

money. This first involves identifying the cash inflows and outflows (and their timing)

associated with each financing alternative and discounting the cash flows to calculate their

present worth.

The Project Evaluation Guidelines requires agencies to assess whether leasing is preferred to

buying after quotes for lease finance have been obtained. This is also required by State

Supply Commission guidelines which state that agencies should only enter into leasing

arrangements “after thorough examination of the financial implications, and having obtained

independent financial advice”.

The decision to buy or lease should be well documented. If a decision is made which takes

into account reasons beyond the financial outcome of a lease versus buy analysis, then those

reasons and how they affected the decision should also be documented.

The Project Evaluation Guidelines issued by the Department of Treasury and Finance include

a chapter on the Analysis of Leases and the use of a Lease Calculator to assist agencies in

conducting a lease versus buy analysis.

The Lease Calculator is a spreadsheet application consisting of a number of worksheets. Users

are required to enter the terms of the lease (purchase price, number of payments, lease

payments per period in advance or arrears, financier’s benchmark and lease margin rates,

and other lease costs if any) and minimum and maximum residual values.


The Lease Versus Buy Analysis From discussions with management and review of leasing transactions, leasing is often seen

as the favoured option even before an analysis is performed. The attractiveness of not having

to find the money up front creates a strong incentive for agencies to lease. Therefore, there

is a risk that procurement choices will be distorted towards leasing, with lease versus buy

analyses either not performed or structured to support a decision to lease.

This examination identified that two of the sampled agencies do not conduct formal lease

versus buy analyses prior to entering into individual lease transactions. In the absence of

lease versus buy analyses, these agencies did not know whether a premium was being paid

for leasing and whether it represented value for money for the intended benefits being

provided. Table 3 provides a summary of leasing policies in place at the sampled agencies.

AGENCY

Department of Education Leasing is at the discretion of management. The examination of a sample of 17 lease transactions (valued at $4.6 million), excluding the Notebooks for Teachers Program, identified that formal lease versus buy analyses were not performed.

Police Service All orders for IT equipment valued over $300 are leased. No lease versus buy analyses have been conducted since a formal lease versus buy decision was made in October 1999.

Department for Planning Leasing is at the discretion of management but only and Infrastructure after a formal lease versus buy analysis has been

performed. Independent advice is sought for lease transactions over $50 000.

Department of Justice In accordance with the Department’s IT Strategic Plan, IT equipment is not leased.

Central TAFE Leasing is only entered into after a formal lease versus buy analysis has been performed by the Department of Treasury and Finance.

FINDINGS

Table 3: Leasing Policies at Sampled Agencies Lease versus buy analyses are not always performed.

Source: OAG

The availability of the Lease Calculator means that some agencies are however, now able to

conduct lease versus buy analyses which they may not have in the past. The Department for

Planning and Infrastructure conducts a lease versus buy analysis prior to entering into a

leasing transaction. If the Lease Calculator shows that leasing is not beneficial, then the

transaction will not proceed.



LEASE VERSUS BUY (continued)

Central TAFE is the only sampled agency that uses the whole-of-government leasing facility

established by the former Department of Industry and Technology. In using the facility,

Central TAFE is provided with the results of analyses conducted by the Department of

Treasury and Finance using the Lease Calculator.

Estimating Residual Value The lack of formal lease versus buy analyses at the Department of Education, for example,

has resulted in the Department failing to identify at least three finance leases valued at

$2.5 million (from a sample of 17 valued at $4.6 million) which cost up to four per cent more

than the purchase option, before taking into account the residual value of the assets. Many

other leases at the Department of Education appeared to be cheaper than purchasing but this

was before the residual value of the assets was taken into account. It was therefore not

possible to conclude whether value for money had been achieved.

The estimate of residual value is critical in the lease versus buy analysis. A lower agency

estimate of residual value will favour leasing, that is, leasing is financially beneficial if the

residual value the agency places on the asset is much lower than the resale value that the

lessor can achieve. Therefore, the outcome of the lease versus buy analysis can be heavily

influenced by the agency’s estimate of residual value.

For example, in one of the sampled agencies conducting lease versus buy analyses, the same

residual value estimate had been used regardless of the type of asset. Items such as desktop

computers, servers, and survey equipment had been analysed using an estimated residual

value of five per cent, even though each of these items would be expected to have different

useful lives and/or market values. Explanations of the basis for the estimate could not be

provided by the agency.

Table 4 compares the residual values of five per cent for a sample of leased assets with the

residual values at which the agency would have been financially indifferent between buying

and leasing, that is, the point at which the costs of buying and leasing are equal (point of

‘financial indifference’)14. The table illustrates that differences in residual value estimates, as

small as 0.4 per cent, could have affected the financial outcome of the agency’s lease versus

buy analyses.

14 The Lease versus Buy Analysis Model developed by the Queensland Treasury Corporation calculates the residual value estimate at which an agency should be financially indifferent between buying and leasing.


Equipment Purchase Price Estimate of Residual Residual Value Break-Even

Desktops x 20 38 200 1 910 (5%) 2 063 (5.4%)

Desktops x 84 164 694 8 235 (5%) 13 505 (8.2%)

Survey Equipment 60 534 3 027 (5%) 3 390 (5.6%)

Desktops x 28 58 080 2 904 (5%) 3 891 (6.7%)

Table 4: Point of Financial Indifference or Residual Break-Even The financial outcome of a lease versus buy analysis is extremely dependent on residual value estimates. In some cases, the residual value estimate at which the agency would be financially indifferent between buying and leasing is not much higher than the actual estimate used by the agency.

Source: OAG

In practice, estimating residual value can be extremely difficult and it is not unreasonable to

expect estimates of residual values for the same class of assets to differ amongst agencies.

Although the Department of Treasury and Finance’s Lease Calculator takes into account a

range of possible residual values and assigns probabilities to those values, it is still necessary

for an agency to input an initial estimate into the Lease Calculator.

Refining the residual value estimate can take time and money and may not necessarily add to

the value of the lease versus buy analysis. Lease versus buy decisions should therefore be

based on a comprehensive analysis of benefits and risks as well as costs, taking into

consideration:

! the type of asset and its importance to the agency; and

! the way the asset will be used by the agency (as defined in its asset management policies).

Type of Asset Specialised assets such as custom-built fisheries vessels or purpose-built facilities such as

courthouses often do not have a well-developed second-hand market. In these cases, the

private sector would find it difficult to sell or re-lease the asset at the end of its lease term

and assume residual value risk. As such, the value of the asset to the agency will most likely

be greater than the value placed on the asset by the lessor. The lessor would therefore seek

to run the lease for most of the asset’s economic life and/or recoup the whole cost of the asset

plus a profit or interest component from the lessee.

Leasing these types of assets without the retention of any significant level of risk by the lessor

(or private sector) will therefore generally not offer a substantive financial benefit, as

demonstrated in the acquisition of the Fremantle Justice Centre by the Department of Justice.

Specialised assets and its effects on the leasing decision have now been documented in the

Department of Treasury and Finance’s Project Evaluation Guidelines.




Department of Justice – Fremantle Justice Centre

Planning for the replacement of the Fremantle Courthouse commenced in July 1995. A large number of possible sites were investigated by the Department of Justice in the ensuing years. Finding a suitable site proved difficult because the city of Fremantle is a densely developed area and most sites are privately owned, multi-tenanted and/or unavailable. Consequently, a decision was taken in early 1997 to consider private sector involvement in the construction of the Fremantle Justice Centre (FJC).

The Department of Justice was allocated $15.5 million in capital works funding, if necessary, to acquire the Fremantle Justice Centre.

In late 1997, property owners/developers were invited to lodge expressions of interest to develop FJC. A number of options were put to the market for procuring FJC including a once-off purchase by the State or a private sector owned development which is leased to the Department under a build, own, operate, and transfer (BOOT) scheme.

Short listed respondents were then issued a Request For Proposal (RFP) in May 1998. However, the request for a once-off purchase price did not appear in the RFP. An addendum was issued in July 1998 making such a request. The request was later withdrawn after objections were received from some respondents who were not in a position to sell the land which was to be the subject of its proposals. The Department was therefore ”locked‘ into leasing FJC.

In December 1998, a successful contractor was selected. The successful respondent was also able to offer to transfer the building to the Department at the end of a 25-year lease term.

Negotiations commenced in early 1999 to establish a leasing arrangement for the FJC. Various lease finance alternatives were examined by both the Department of Treasury and Finance and the Western Australian Treasury Corporation. The WATC advised that these alternatives would cost between $4.63 and $10.04 million (or 31 and 68 per cent) more than if the government had funded the construction of the FJC and would involve no significant risk retention by the lessor.

Further negotiations took place and a final lease agreement was signed in November 1999, with lease payments commencing in March 2001 following the construction of the centre. The lease has been classified as a finance lease in the Department of Justice‘s Statement of Financial Position (balance sheet). The terms of the agreement mean that the Department will be paying around $3.6 million (or 25 per cent) more than a government funded buy option.

The Department of Justice advised that the procurement of the FJC achieved a transfer of other risks associated with site availability, site location, design and construction, planning and zoning, and maintenance; though, these were not quantified and therefore, the extent to which value for money is achieved is not clear. It is possible that some or all of these risks could have been transferred via other contractual arrangements without the need for private finance.

The Department of Justice also advised that it has applied the lessons learnt from the procurement of the FJC to the acquisition of Acacia Prison. Formalised structured risk identification and evaluation processes were established early and continually monitored throughout the project delivery period.


The importance of the asset to the operations of the agency is also a significant factor in the

lease versus buy analysis. If an agency could not operate effectively without an asset and the

costs of replacing the asset or dismantling the asset and returning it to a lessor were

significant, then the agency would be less likely to replace the asset before the end of its

economic life15. Any leasing arrangement for such an asset would not provide value for

money and would most likely involve a significant premium because the residual value placed

on the asset by the lessor would be far less than the value or importance of the asset to the

agency.

The leasing of the infrastructure for the Police Service’s CADCOM system is an example

where the importance of the asset to the agency’s operations was not fully considered at the

time the decision to lease was made. The CADCOM example also raises concerns in

establishing a leasing arrangement for assets associated with the development of a new

system.

Police Service - CADCOM

In 1997, the Police Service commenced plans to implement the Call Taking, Computer Aided Dispatch and related Communications (CADCOM) system. This system would replace existing technology that had reached the end of its useful life and suffering from a number of critical functional shortcomings including insecure voice transmission and inefficient and ineffective processes for locating vehicles.

Following a procurement process, a contractor was engaged in May 2000 to supply CADCOM (in stages) at a total cost of $88.7 million (comprising hardware and software infrastructure $44.4 million, service provision $42.3 million and contingencies of $2 million). The infrastructure would include a digital trunked radio network, automatic vehicle location system and a geospatial information system.

Prior to this engagement, a number of processes were undertaken to establish the most suitable method of financing the infrastructure component of CADCOM. In October 1999, a lease versus buy analysis conducted by the Police Service concluded that —in the absence of a risk transfer…we believe the [third party operating lease] financing transaction would effectively be in the form of a finance loan“. Savings provided by a government purchase compared with leasing ranged from $4 to

continued p26 was obtained that established that the proposed six-year leasing facility could be A lease financier was selected in March 2000 and independent accounting advice

proposed, as this would not be supported by the Department of Treasury and Finance. similar financing facility on either a six or ten year term. No finance lease was to be taken to the market with tenders called for the provision of an operating lease or To confirm the analysis, the concept of an operating lease facility for CADCOM was

purchased outright. residual value at the end of the lease term. It was recommended that CADCOM be $6.3 million (or 8 to 12 per cent). The analysis assumed a ten-year lease and a nil

15 The Australian Accounting Standard AAS17 ‘Leases’ states that these circumstances could lead to the lease being classified as a finance lease.




continued from p25

treated as an operating lease. However, this advice was subject to significant qualifications and a need to consider:

! The importance of CADCOM to the Police Service‘s operations.

! The impact on Police Service operations and the costs of having to dismantle CADCOM when it is required to be returned to the lessor after six years.

It is not known whether these concerns were addressed. A lease facility of $48 million was established in June 2000.

After the well-publicised concerns over the project management of CADCOM, a failure of a major sub-contractor and problems experienced by the contractor in developing the system, the Police Service sought advice in December 2002 from the Western Australian Treasury Corporation (WATC) on the continued financing of the CADCOM infrastructure. By this time, an amount of $13.4 million had been ”drawn-down‘ on the facility.

The WATC concluded that the Police Service could save between $4.2 and $8.2 million (or between 7 and 13 per cent) by not continuing with the leasing facility. This was based on advice from the Police Service that the CADCOM infrastructure would be needed beyond six years.

By not continuing with the facility, the Police Service would also avoid the additional cost of purchasing the CADCOM infrastructure from the lessor after six years. The WATC advised that:

—As the equipment forms an integral part of the Police Service communication systems, the purchase option provisions under the operating lease could pose a serious cost risk to the Police Service“.

On June 27, 2003, a payment of $17.6 million, representing unpaid principal, interest and ”break costs‘, was made to the lessor to terminate the lease of CADCOM. This payment concluded stages 1A and 1B of CADCOM. Interest and penalties will be borne by the contractor under an earlier agreement signed in July 2000 that extinguishes any and all damages, claims, liabilities or expenses of the government and the contractor in relation to CADCOM.

Stage 1C of CADCOM appears in the 2003-04 Capital Works Program with an estimated total cost of $59.8 million. It is now encompassed in the Metropolitan Police Radio Network Project.

Some assets, by their very nature, lose saleability very quickly. With these assets, lessors

would be less likely to offer an operating lease and/or assume substantial residual value risk.

This examination identified a number of assets that consistently failed to offer any

substantive financial benefits from leasing. These included photocopiers and some projectors.

All leases involving these assets were finance leases. Information provided by the

Queensland Treasury Corporation confirmed that after three years, photocopiers on average

have retained only six per cent of their value and only two per cent after four years.


Use of Assets The way an agency uses it assets and the optimal time to replace those assets (as established

in its asset management policies) will impact on the lease versus buy analysis. As discussed

in the earlier chapter, four of the five sampled agencies did not apply asset management

policies to their lease versus buy decisions and therefore, it was difficult for these agencies to

demonstrate that the most appropriate decision has been made.

For example, assume an agency is deciding whether to lease a desktop computer for three

years. If the agency has a ‘cascade’ policy (ie new assets are given first to high need

individuals and then rotated through the agency as they get older), then the asset will still be

useful to the agency after the end of the three-year lease term.

Figure 2 compares the market value of a desktop computer over three years with a profile of

the value to an agency (Agency 1) that is able to use the computer for four years. At the end

of three years, “… the residual value of the equipment to the [agency] is higher than the

disposal or market value of the [computer] … [and] leasing [will not be] offering a valuable

service as transfer of disposal risk is not required”16.

In simple terms, for possibly around the same amount of money (net present value), the

agency can obtain four years of use of a computer if it buys compared with only three years

from leasing. Obviously, other factors such as possible increases in maintenance would need

to be considered.

80%

70%

60% 50%

40%

30%

20%

10%

0% 1 3

Market Value

Agency 1

Agency 2

Year

Val

ue

(%)

2

Figure 2: Comparison of Market Value and the Values of a Desktop Computer to Agencies with Different Residual Values (as a percentage of the original purchase price) The estimate of residual value is critical in a lease versus buy analysis.

Agency 1 is able to use a desktop computer for more than three years and therefore, it can obtain greater value by holding onto the computer rather than disposing of it after three years. The computer is worth more to the agency than the market value after three years. In these cases, leasing will not be attractive.

Agency 2 is not able to effectively use a desktop computer for more than three years. If the lessor can dispose of the asset for a higher value than Agency 2, then the lessor may pass the benefit of this higher value onto Agency 2 in the form of reduced lease payments. In this case, leasing can be more attractive than buying.

Source: OAG and Queensland Treasury Corporation

16 Project Evaluation Guidelines, Department of Treasury and Finance.




On the other hand, an agency (Agency 2) may need to replace desktop computers every three

years due to its operational and system needs. In this case, the term of the lease equates to

the useful life of the asset to the agency. Whether leasing is more attractive than buying will

depend on whether the lessor can achieve, at the end of the lease term, a higher price (from

the market) than what Agency 2 expects it can achieve.

What Agency 2 expects to achieve may be irrelevant or negative if, by leasing, it is seeking

to transfer the responsibility for disposing of assets because the costs to the Agency if it were

to dispose of the assets itself would outweigh the expected proceeds from disposal. To obtain

value for money in these instances, the agency will need to ensure that competitive lease

quotes are sought from a number of lease financiers and that these quotes are within certain

parameters. Lease quotes and parameters are discussed in the following chapters.

If an agency is seeking to transfer residual value risk, then it is important to also consider all

options for dealing with residual value risk. Leasing should not necessarily be the first and

only option. The various methods available for disposing of assets and the likely proceeds

from each alternative should be considered.

Alternative Options For larger transactions, a meaningful and proper lease versus buy analysis should require

agencies to apply State Supply Commission’s Guidelines for the Disposal of Goods to the buy

option, which outline a number of disposal methods available to agencies, including:

! transfer to another public authority;

! inviting competitive offers; and

! trade-ins.

These methods can reduce residual value risk by guaranteeing a certain level of proceeds or

benefit to government at the time of disposal and therefore, influence the lease versus buy

decision.

The Department of Education’s Notebooks for Teachers Program is one example where the

State Supply Commission disposal guidelines should have been considered.


Department of Education – Notebooks for Teachers Program

The Notebook for Teachers Program is a voluntary program designed to improve teachers‘ skills in information technology and thereby provide opportunities for improved educational outcomes. The program, which was launched in December 2001, provides teachers with access to leased notebooks and software that can be used at school and home for three years. Teachers are required to contribute $7.30 gross per week (around $5 after tax). Around 16 000 notebooks will be required to meet the demand from teachers. The net cost to Government is budgeted at $23.5 million over three years.

The program is being rolled-out in stages on a school-by-school basis and was expected to be completed by December 2002. According to the Department of Education, due to less than expected demand from teachers, only 11 614 notebooks had been rolled out at February 2003.

A lease versus buy analysis conducted by the Department prior to calling for quotes for leasing finance indicated that leasing would be less expensive than an outright purchase. However, the Department‘s analysis was based on —empirical evidence of the resale value of notebooks in the current market [indicating] that the [Department] is having difficulty disposing of notebooks for values close to $200“.

Using the Department‘s residual value estimate of $200 per notebook, Audit analysis of the leasing agreements (valued at $24.7 million) underpinning the staged rollouts of notebooks showed that leasing was providing a cost benefit of around five per cent.

Audit sought advice from the Western Australian Treasury Corporation (WATC) on residual values and/or how to minimise or transfer residual value risk. WATC advised Audit that if the Department were to consider the option of purchasing the notebooks, it could have established a residual value for the notebooks by —seeking bids from the market“. The bid documents would —specify that the Department, in three years time, would deliver the notebooks to the successful tenderer in good working order“. It could be expected —that potential tenderers will be encouraged at the prospect of an ongoing and reliable supply of notebooks from the Department as it will provide them with the prospect of business continuity and this should be reflected in the tender pricing in due course“. Therefore, the tender price that may have been achieved could have affected the outcome of a lease versus buy analysis.

Recommendation Agencies should ensure that comprehensive analyses of risks, benefits and costs are

conducted prior to entering into leasing arrangements to determine whether leasing is

preferred to buying and represents value for money. All alternative options should be

considered.



Lease Contracting

Key Findings ! The sampled agencies were seeking lease finance quotes on a competitive basis.

! The sampled agencies have established or have access to standard lease agreements.

Most of the terms and conditions that were identified in the 1999 Report as unduly

favouring the lessor and/or exposing agencies to unnecessary risk have been dealt with.

However, the lease agreement used by one agency contained several other unfavourable

conditions.

Introduction Once the most competitive quote or tender has been sought and accepted for the supply of

an asset, it is then necessary to seek competitive quotes for lease finance and determining

which quote is preferable (in accordance with State Supply Commission supply policies and

guidelines).

Competitive Quotes Prior to seeking competitive quotes for lease finance, agencies are required to obtain the most

competitive quote or tender for the supply of the asset that may be the subject of lease

financing. State Supply Commission supply policies on Open and Effective Competition need

to be applied.

In the report tabled in Parliament in June 1999 titled Lease Now – Pay Later? The Leasing of

Office and Other Equipment, the following point was made:

“Obtaining a competitive equipment purchase price is fundamental to obtaining,

and assuring, value for money. An informed individual wanting a new car would

first seek the lowest purchase price and then, if borrowing money, the cheapest

source of finance. The same principal applies to equipment leasing”.

This examination identified that the sampled agencies had obtained competitive quotes and

tenders for the supply of assets that were then leased. In some cases, whole-of-government

common use contracts or agency specific panel contracts for the supply of various assets had

been used. The next step, that is, obtaining the cheapest source of finance, is discussed in

the next section.


Lease Quotation Procedures In the June 1999 Report titled Lease Now – Pay Later? The Leasing of Office and Other

Equipment, concerns were raised that agencies had directly negotiated lease finance with just

the one lessor, rather than seeking competitive bids. It was recommended that agencies be

provided access to competitively priced finance.

In late 2000, the former Department of Industry and Technology (DOIT) established a whole-

of-government Common Use Rental Facility comprising a panel of pre-selected lease

financiers and standard lease terms under a Master Rental Agreement17. However, the facility

is non-mandatory and since its introduction, only 15 agencies have used the facility to lease

assets valued at around $26 million.

This examination identified that, amongst the sampled agencies, only Central TAFE was using

the non-mandatory Common Use Rental Facility. The Police Service and the Departments of

Education, and Planning and Infrastructure continue to operate their own facilities that were

established prior to the common use facility. These lease finance facilities comprise:

! panels of lease financiers (pre-selected through a tender process); and

! standard lease terms under a Master Rental Agreement.

As such, lease finance quotes were being sought on a competitive basis and preferred quotes

were selected on the basis of lowest lease payment per period.

Standard Lease Agreements Lease agreements have the potential to contain a variety of terms and conditions that are not

appropriate for public sector agencies (such as onerous rights of entry) or could significantly

increase the costs of leasing and therefore affect the outcome of a lease versus buy analysis.

In the June 1999 Report tabled in Parliament titled Lease Now – Pay Later? The Leasing of

Office and Other Equipment, examples were provided of inappropriate terms and conditions

found in many public sector leasing agreements. These included ‘inertia clauses’ where the

lease is automatically rolled over beyond its expiry date at the existing payment rate, unless

agencies advise otherwise by a specified notification date.

It was recommended that agencies should have access to standard lease agreements that are

commercially balanced. Agencies should not automatically accept the lessor’s proposed terms

and conditions.

The Police Service and the Departments of Education, and Planning and Infrastructure have

lease finance facilities comprising standard lease terms under a Master Rental Agreement.

The non-mandatory whole-of-government lease facility established in late 2000 includes a

Master Rental Agreement. This agreement has been vetted by the Crown Solicitor’s Office.

Central TAFE has entered into leases under the Department of Treasury and Finance Master

Rental Agreement.

17 On February 2, 2003, the Department of Industry and Technology ceased operating as a department. Its procurement related functions were transferred to the Department of Treasury and Finance.



LEASE CONTRACTING (continued)

A review of these agreements identified that while there were differences in the lease

agreements used across the sampled agencies, most did not contain unfavourable terms and

conditions. Table 5 provides a list of ‘unfavourable’ terms and conditions and whether or not

they have been dealt with by the agencies.

Terms and Conditions Education Police Planning & Treasury & Infrastructure Finance

Unfavourable Conditions identified in the June 1999 report titled Lease Now – Pay Later? The Leasing of Office and Other Equipment.

Inertia Clauses – where the lease is automatically & (18 & & rolled over beyond its expiry date at the existing payment rate, unless lessees advise otherwise by a specified notification date. If the lessee misses the notification date, then it will be paying new asset rental payments for assets that are now three years or older.

Onerous Return Conditions –– where the lessee & & & & is required to return the asset at the lessee’s expense to a location that is not convenient to the lessee or the location is not advised until the end of the lease term. This can be costly if the location is, for example, interstate.

Other Unfavourable Conditions

Interim Rentals – where the lease term must & & & & commence on nominated payment dates. If the lessee takes delivery of the asset prior to a nominated payment date,then it must make an additional payment (interim rental) to cover the period between the delivery date and the next nominated payment date. The incidence of interim rentals can be high given that in practice, lessees are rarely able to ensure that delivery dates coincide with payment dates. Interim rentals can negate the benefits (if any) from leasing and significantly reduce their cost effectiveness.

Bundling Services – where the lessor includes & & & & additional services (such as maintenance) together with the finance component of the lease under one costing and one contract. The lessee is therefore unable to assess the cost effectiveness of the additional services and the financing component independently of one another.

Indemnities – where the lessee is required to provide & ( & & non-standard indemnities relating to changes in the treatment of the lease for tax purposes or any other unspecified ‘increased cost event’.

Table 5: Extent of Unfavourable Conditions in Lease Agreements used by Sampled Agencies The lease agreement used by the Police Service contains more unfavourable conditions than the agreements used by the other sampled agencies.

Key: & Denotes condition has been dealt with by the agency.

( Denotes condition has not been dealt with by the agency and appears in the agreement used by the agency.

Source: OAG

18 The Police Service has advised that it has not yet missed a notification date and therefore, has not incurred any additional costs as a result of the inertia clause.


Prior to its merger with the Department of Transport to become the Department for Planning

and Infrastructure, the Ministry for Planning (MFP) in 1996 established its own lease facility

with a lease financier. The lease agreement for this facility includes inertia clauses, interim

rentals, onerous return conditions and unfavourable indemnity clauses.

The Department for Planning and Infrastructure has ceased entering into leases under this

agreement. All leases are transacted under the facility established by the former Department

of Transport. At June 30, 2003, there were 21 leases that remain subject to the MFP

agreement.

Recommendation Agencies should ensure that lease terms and conditions do not unduly favour the lessor or

expose agencies to avoidable risks.



Accounting Classification

Key Finding The manner in which some agencies had applied the Department of Treasury and Finance’s

lease versus buy analysis tool (Lease Calculator) resulted in incorrect accounting

classifications of leases.

Introduction Accounting Standard AAS17 ‘Leases’ requires leases to be classified as either operating

leases or finance leases and specifies certain accounting treatments and disclosures for each

type. See Appendix 2.

The classification of a lease depends upon its economic substance. Where substantially all

risks and benefits of ownership19 remain with the lessor, then the lease is an operating lease.

Where the risks and benefits effectively pass to the lessee, then the lease is a finance lease.

AAS17 includes guidelines to assist in determining whether substantially all risks and

benefits of ownership have been transferred from the lessor to the lessee. If a lease is non-

cancellable and satisfies either one or both of two other tests, then it is likely that the lease

is a finance lease. See Appendix 5.

Agency Classification of Leases The classification of a lease would appear to be secondary to the more important question of

whether leasing offers better value for money than a government-funded buy option.

However, discussions with public sector managers indicated that the need to keep debt off the

whole-of-government balance sheet has been a consideration. Therefore, agencies will seek

to obtain operating leases because, unlike finance leases, they do not appear on an agency’s

Statement of Financial Position (balance sheet).

In addition, the lease classification will assist in determining whether residual value risk has

been retained by the lessor. The lease classification accounting standard is therefore

essentially used as the ‘parameter’ for determining whether a lease quote is acceptable. As

such, agencies may be driven to adjusting underlying calculations or erroneously interpreting

the results of a lease versus buy analysis.

An indicator of whether a lease may be a finance lease is if it satisfies the 90 per cent test –

the present value at the beginning of the lease term of the minimum lease payments equals

or exceeds 90 per cent of the fair value of the leased asset at the inception of the lease. Or in

simple terms, whether the lessee is more or less paying the full cost of the asset, in which

case, the lease is no different from a buy option, except for the fact that with a finance lease,

title to the asset may not eventually be transferred to the lessee.

19 The risks of asset ownership include those associated with unsatisfactory performance, obsolescence, idle capacity, losses in realisable value, uninsured damage and condemnation of the asset. The benefits include those obtainable from the use of the asset and gains in realisable value.


The Project Evaluation Guidelines state that “some financing proposals may appear to

[satisfy] the 90 per cent rule but can be manipulated in an entirely legitimate fashion to

comply simply by artificially increasing the lease rate (and hence residual) until the test is

satisfied”.

The Lease Calculator allows the lease rate to be altered until the test is overcome – the

Calculator asks the user to keep revising the lessor’s margin within certain parameters so that

a leasing proposal will result in an operating lease. It is not until it has reached 95 per cent

does the Lease Calculator classify a lease as a finance lease.

For example, the examination identified that:

! One of the two agencies using the Lease Calculator to perform a lease versus buy analysis

was revising the lessor’s margin (and therefore, lease rate) to overcome the 90 per cent

test. In a sample of nine leases, seven achieved an exact 90 per cent present value with

the use of inconsistent lessor’s margins. However, applying AAS17 resulted in all nine

leases satisfying the 90 per cent test and therefore, likely to be classified as finance leases.

! In another agency, a sample of five lease versus buy analyses conducted on its behalf by

the former Department of Industry and Technology was selected. Despite the Lease

Calculator showing that two leases had satisfied the 90 per cent test, the agency was

advised that the leases were operating leases because the lessor’s margin was less than

four per cent. In one instance where the Lease Calculator showed the lease to be an

operating lease, the lease margin had been set at 3.99 per cent.

The Project Evaluation Guidelines and Lease Calculator allow the lease margin to be

“pushed” up to four per cent “to qualify as an operating lease”. “Independent auditing

advice suggests that lease margins beyond 4 per cent are not acceptable to use as a

discount factor in the 90 per cent rule”. The Department of Treasury and Finance was not

able to produce the “independent auditing advice” when requested by Audit.

Agencies need to consider the purpose and implications of adjusting variables in the lease

versus buy analysis. As discussed in Appendix 5, if a lease fails the guidelines for

classification as an operating lease, then it is highly likely that the lessor is not carrying any

significant residual value risk. Therefore, the agency may have to re-consider whether leasing

is appropriate and whether other benefits from leasing are being sought. The agency would

also have to ensure that the type of asset and the manner in which the agency will be using

the asset makes it suitable for leasing. Alternative options may also need to be considered or

lease quotes re-negotiated with lessors.



ACCOUNTING CLASSIFICATION (continued)

If lessors are not able to obtain adequate resale values for leased assets, then they will not

be able to offer lease rates that enable leases to be classified as operating leases. This

situation is being experienced in other jurisdictions, particularly for information technology

equipment where significant drops in the prices of new computers are flowing through to the

second-hand market. For example:

! Due to the state of the second-hand IT market, the Queensland Treasury Corporation

(QTC) is finding it difficult to establish three-year operating leases for IT equipment. QTC

is assessing leases on the basis of 24, 30 and 36 month lease terms and is now finding

that only leases of 24 and 30-month terms are likely to meet the guidelines for

classification as an operating lease. The QTC has noted a survey20 that showed many

organisations (both private and public) are getting at least four years useful life out of a

personal computer. Therefore, leasing personal computers for 24 and 30-month terms

forces agencies to surrender the computers well before the end of their useful life.

! In June 2003, the New South Wales Department of Commerce cancelled the tender

process for a new IT leasing facility. Tenders submitted did not pass the tests for

classification as operating leases. Over the next few months, NSW Treasury, in

conjunction with the Department of Commerce, will work with agencies and lessors to

identify ways in which to restructure the facility and operating arrangements to address

the issues that resulted in the abandonment of the recent tender process.

If leasing is offering some other benefit or transfer of risk other than ownership risk, then

agencies may be willing to pay a premium. However, the value for money case would depend

on whether leasing is providing benefits that outweigh the extra costs of private finance.

Recommendation The Department of Treasury and Finance should increase its focus on the regular review and

response to changes in accounting, financial and operational aspects of leasing.

20 SG Cowen, 2002


Appendix 1 – Advantages and Disadvantages of Buying and Leasing

! Flexibility in the use and replacement of assets

! Unrestricted access to benefits of ownership

! May be less costly in the long run

! Requires initial capital outlay

! Possible financial and operating issues if assets become obsolete well before the end of its economic life

! Risks of ownership are retained by the lessor

! May offer a cheaper method of acquisition

! Minimises obsolescence concerns

! Limits control of assets

! Lease payments may be excessive

! Short lease terms may force lessees to unnecessarily surrender assets well before the end of their useful life

DISADVANTAGES

ADVANTAGES

BUYING LEASING

Buying and leasing offers a range of financial and operating benefits, but each have their own disadvantages.

Source: OAG and Queensland Treasury Corporation



Appendix 2 – Finance and Operating Leases

! Lessor retains the risks and benefits of ownership of the asset.

! Lease term is less than 75 per cent of the remaining economic life21 of the asset.

! There is no guaranteed buy-out or residual value available to the lessee at the end of the lease.

! Lease may be cancellable without significant penalty.

! Leased assets are usually returned to the lessor at the end of the lease period.

An operating lease is considered a true hiring arrangement for accounting purposes. Therefore, the leased assets and corresponding lease liabilities do not appear on the balance sheet of the lessee. The lessee is required to disclose lease commitments in a note to the financial statements.

! As the lease payments effectively represent the whole cost of the leased asset plus an interest component (present value of lease payments 90 per cent or greater of fair value of the asset), then the risks and benefits of ownership are essentially shifted to the lessee.

! Legal ownership of the asset may or may not be eventually transferred to the lessee.

! There may be a predetermined residual value at the end of the lease term, for which the lessee (in accordance with market convention) must buy the leased asset irrespective of its deemed value.

! Lease is non-cancellable.

This is essentially a loan arrangement in which the lessor finances the purchase of the leased goods by the lessee. The leased asset (and the associated lease liability) is capitalised in the balance sheet of the lessee. The interest component of each lease payment is treated as an expense item in the lessee’s statement of financial performance.

OPERATING LEASES FINANCE LEASES

FEATURES

ACCOUNTING TREATMENT

The main difference between operating and finance leases relates to who carries the risks and benefits of ownership.

Source: OAG, Queensland Government Leasing in the Queensland Public Sector December 2001 and AAS 17

21 Economic Life is the period over which an asset is expected to be economically useable by one or more users.


Appendix 3 – Leasing in Other Jurisdictions

Queensland In August 1998, the Queensland Government released a policy governing leasing in the

Queensland public sector. A whole-of-government leasing facility was established by Queensland

Treasury and Queensland Treasury Corporation (QTC). The policy requires that entities funded

from the Consolidated Fund (typically government departments and their commercialised business

units) transact all their leases through QTC. The Queensland Government decided that QTC was

ideally placed to provide this function.

In March 2002, Queensland Treasury decided that all future leases entered into by departments

would be underwritten through QTC with no private sector involvement. QTC acts as a lessor in

its own right, capable of taking both a debt and equity position in transactions and to also take on,

if necessary, residual value risk for certain classes of assets. Private sector financiers can

participate in lease transactions to statutory bodies (including local government) and government

owned corporations. In these cases, QTC remains the lessor and the identity of the participant is

normally not disclosed to the agency (lessee).

The QTC has developed a Lease versus Buy Analysis Model which assists agencies to determine

whether to lease or buy assets, taking into account agencies’ estimated future values, and to assist

in determining the classification of leases based on the requirements of AAS17.

To obtain reliable estimates of residual values, the Queensland Treasury Corporation has

established an Asset Valuation Panel comprised of three auctioneers from Queensland and New

South Wales. Every quarter, the panel provides average gross residual values for a range of assets

based on current market conditions.

New South Wales The New South Wales Department of Commerce manages a number of operating lease facilities

covering various types of assets. For example, the information technology leasing facility,

comprising a panel of five lease financiers, is valued at $300 million over four years. The use of

the facility is mandatory for all Consolidated Fund agencies. Although there are no government

policies on leasing in NSW, agencies are required to be in a position to justify their decisions to

lease assets. The facility has been structured so that all leases can be classified as operating leases,

with panel members required to submit quotes within established minimum residual values and

maximum lease rates.

Victoria In December 2002, the Victorian Department of Treasury and Finance established a new

information technology leasing facility with one lease financier only. Victorian Government

departments must use the facility if leasing information technology equipment.



Appendix 4 – Discount Rates

Introduction The lease versus buy analysis involves the identification of the cash inflows and outflows (and their

timing) associated with each financing alternative and discounting the cash flows to calculate their

present worth.

The discount rates applied in the audit analysis of leases in this report are based on the Western

Australian Treasury Corporation’s lending rate to public sector agencies. This recognises that the

Government incurs a ‘finance’ cost on capital funds either directly, as an interest expense on public

borrowings; or indirectly, as interest foregone on funds that would otherwise have been available

to the Government for other purposes.

This method establishes the premium, if any, from leasing which can then be evaluated to

determine whether it represents value for money for the level of risk that is being retained by the

lessor. It is used by both the Western Australian and Queensland Treasury Corporations in the

analysis of public sector leasing. It is also recommended by the Australian National Audit Office22.

This approach to discount rates also complies with the Accounting Standard AAS17 ‘Leases’ which

requires the use of the implicit lease interest rate (where residual values can be reliably estimated)

or the lessee’s incremental borrowing rate.

Capital User Charge Because of the restraints on the level of capital that can be raised by government, agencies should

only acquire assets once it has been established that the asset or project will deliver a benefit to

the State (ie the investment decision - the decision as to whether to acquire the asset or not). This

will ensure the most efficient and effective use of the government’s limited capital.

Once the decision to acquire the asset is made, the objective of the lease or buy decision will then

be to finance the asset acquisition at a rate which represents best value for money. Financing the

asset acquisition in a way that does not represent value for money will adversely affect the benefits

expected as a result of the investment decision.

On July 1, 2001, the Department of Treasury and Finance introduced an eight per cent charge on

the net assets held by an agency, known as the ‘capital user charge’ (CUC). The capital user charge

is intended to represent the opportunity cost of holding an asset and is deemed to be the rate of

return which could be achieved if the funds tied up in an asset were realised and placed in a

comparable investment. The Project Evaluation Guidelines require the CUC to be used as the

agency’s benchmark rate (discount rate) when comparing buy and lease options.

The CUC is currently applied on the net assets held by an agency. Assets subject to an operating

lease are ‘off balance sheet’ and therefore, do not attract the CUC. As such, the Project Evaluation

Guidelines issued by the Department of Treasury and Finance state that the “[CUC] favours

leasing”23.

22 Asset Management Handbook, Australian National Audit Office, June 1996 23 There are also no CUC implications if an agency borrows funds to purchase an asset or enters into a finance lease (because the asset

and the corresponding liability net each other off in the balance sheet).


As the CUC rate of eight per cent is higher than the Government’s own borrowing rate, agencies

may be placed in the position of proceeding with and being held accountable for a lease that is

“preferred to purchasing from the perspective of the agency, but will not be beneficial for the

whole-of-government”. The guidelines state that agencies will have to “use their discretion in

these situations” and that the “lease/buy decision is ultimately the agency CEO’s prerogative”. If

an agency decides to proceed with a lease, even though the analysis shows that leasing is

preferred using the CUC but not when using the lending rate, then it is required to document the

reasons for doing so.

Audit observed that using the Western Australian Treasury Corporation’s lending rate would lead

to a lower figure for the discount rate than the use of the CUC. Agencies need to examine the

sensitivity of the lease versus buy analysis to the choice of discount rate.

A number of leases reviewed as part of this examination were transacted before the introduction

of the CUC, and therefore, it was not applied to lease versus buy analyses performed by Audit and

other agencies. For those leases transacted after July 1, 2001, Audit has used the Western

Australian Treasury Corporation’s lending rate to public sector agencies in lease versus buy

analyses, in accordance with widely accepted practice (as discussed above) and to assess financial

outcomes from a government perspective.

The value for money case for leasing depends on whether it brings benefits that outweigh the

extra costs (if any) of private finance. The use of the Western Australian Treasury Corporation’s

lending rate allows these extra costs (if any) to be quantified in a transparent manner, which can

then be used to assess whether the benefits (if any) from leasing represent value for money.



Appendix 5 – Risks and Benefits of Ownership and Accounting Classification

Overview In accordance with Australian Accounting Standard AAS17 ‘Leases’, the classification of a lease

depends upon its economic substance. Where substantially all of the risks and benefits incident to

ownership of the leased asset effectively remain with the lessor, the lease is an operating lease.

Where substantially all of these risks and benefits effectively pass to the lessee, the lease is a

finance lease.

The terms and conditions of the lease agreements used by the agencies sampled in this

examination result in most of the risks and benefits of ownership passing to the agencies (see table

below); except for residual value (disposal) risks and benefits (ie losses or gains in resale price

when the owner disposes of the asset), which remain with the lessor.

However, if this residual value risk is small or negligible, then the lessor is effectively not carrying

any risk, and therefore, the lease is a finance lease.

Risks and Benefits Who Carries the Why? of Ownership Risk or Benefit?

Idle Capacity – if the leased Agency (lessee) Since the lease agreement is non-cancellable, assets are not being used or the agency assumes the risk and costs of are no longer required. idle capacity.

Unsatisfactory Agency (lessee) The agency is responsible for putting the assets Performance – the asset in ‘good working order’, taking care of the does not perform as assets, and maintaining them. The agency required. cannot return the assets because the lease is

non-cancellable nor can it obtain replacements.

Obsolescence Agency (lessee) The agency cannot return the assets because the lease is non-cancellable nor can it obtain an update. The costs of upgrades are borne by the agency.

Uninsured Damage Agency (lessee) The agency is responsible for the costs of insuring the asset or may choose to self-insure. In the event of loss or damage, the agency must replace the asset and/or indemnify the lessor.

Use of the Asset (benefit) Agency (lessee) The agency has control over the use of the assets. Its use cannot be interfered with by the lessor.


Introduction AAS17 includes criteria to assist in determining whether substantially all risks and benefits of

ownership have been transferred from the lessor to the lessee. If a lease is non-cancellable and

satisfies either one or both of two other tests, then it is likely that the lease is a finance lease.

Non-Cancellable Leases A true operating lease is generally short term and cancellable by the lessee at short notice with

little or no cost. A lessee would be expected to pay a higher premium to lease equipment that could

be returned at any time.

To avoid paying this higher premium, the sampled agencies have entered into lease agreements

that do not allow the lease to be terminated prior to the end of the lease term (ie ‘non-cancellable’)

or impose significant penalties if assets are returned before the end of the lease term. These

penalties include:

! the present value of future lease payments; and

! ‘break’ costs to compensate the lessor for any adverse changes in interest rates.

These penalties would be expected to discourage cancellation in normal circumstances and

therefore, the first guideline in AAS17 is satisfied, that is, the leases are deemed to be ‘non-

cancellable’.

With non-cancellable leases, assets can be leased at a lower cost than a true operating lease.

However, non-cancellable leases would not be recommended for agencies subject to fluctuations

in staff numbers and size of operations and therefore, constant changes in asset requirements.

The 75 Per Cent Test Once it has been established that a lease is non-cancellable, the first other test in AAS17 relates

to how much ownership risk has been transferred.

The 75 per cent test involves determining whether the lease term exceeds 75 per cent of the

economic life of the leased asset. For example, if the economic life of an asset is four years (ie the

period over which the asset is operational and functional and could be used by one or more users)

and an agency leases it for three or more years, then it has satisfied the 75 per cent test. The non-

cancellable lease may need to be classified as a finance lease.

The 75 per cent test is based on the premise that after 75 per cent of the economic life of an asset

has passed, the residual value of the asset will be very low and the lessee will have used a

substantial portion of the economic benefits embodied in the asset. Therefore, the risk of

significant adverse movements in the resale value of the asset is smaller and as such, there is less

ownership risk to be transferred. With such leases, the lessor will attempt to obtain the whole cost

of the leased asset from the lessee through the lease payments because the lessor will most likely

not be able to re-lease the asset to another lessee.



APPENDIX 5 – RISKS AND BENEFITS OF OWNERSHIP AND ACCOUNTING CLASSIFICATION (continued)

Establishing the economic life of an asset can be extremely subjective and may differ from one

agency to another based on their past experiences with a certain type of asset. The Department of

Treasury and Finance’s Project Evaluation Guidelines do not provide agencies with any guidance

on establishing economic life.

Both the Queensland Treasury Corporation and the Victorian Department of Treasury and Finance

suggest that public sector agencies seeking guidance should refer to the Effective Life24 of

depreciating assets as determined by the Commissioner of Taxation. The term ‘effective life’ is

analogous with ‘economic life’.

Based on this approach, most leases entered into by the sampled agencies meet or exceed 75 per

cent of the economic life of the leased asset and therefore, could be classified as finance leases. For

example, the ‘effective life’ of a desktop computer is four years. A laptop computer has an ‘effective

life’ of three years.

However, a more conclusive indicator of whether a lease may be a finance lease is if it satisfies the

90 per cent test.

The 90 Per Cent Test The second other test, the 90 per cent test, establishes whether the lessor is attempting to obtain

most, if not all, of the cost of the leased asset from the lessee25, or in simple terms, whether the

lessee is more or less paying the full cost of the asset. That is, if the present value at the beginning

of the lease term of the minimum lease payments equals or exceeds 90 per cent of the fair value26

of the leased asset at the inception of the lease, then the non-cancellable lease is likely to be a

finance lease.

To obtain the present value, agencies are required to discount minimum lease payments at the

interest rate implicit in the lease, provided the estimate of residual value is reliable. If not, then the

incremental borrowing rate must be used.

Using the incremental borrowing rate instead, in accordance with AAS17, resulted in all sampled

leases across the sampled agencies, with the exception of the Department of Education’s Notebooks

for Teachers program, satisfying the 90 per cent test.

24 Effective Life relates to the total estimated period the asset can be used by any entity for the purpose of producing assessable or exempt income. Therefore, the effective life of an asset may include a period of time between when the taxpayer expects to dispose of the asset and when the asset’s effective income-producing life is over.

25 By recovering most, if not all, of the cost of the leased asset, the lessor has minimised or removed its exposure to residual value risk, that is, it will no longer matter if there is a loss in resale price at the end of the lease term because the lessor has already recovered its investment in the leased asset.

26 Fair value means “the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction”.


Appendix 6 – Status of Auditor General’s 1999 Recommendations

Agencies should:

! improve the planning for, and coordination of, equipment procurement;

! undertake a rigorous financial evaluation of procurement options;

! obtain competitive prices for equipment and finance when leasing;

! seek commercially balanced lease contracts and not automatically accept the lessor’s proposed terms and conditions;

! arrange for managers to have access to appropriate financial and legal advice when entering into lease contracts;

! monitor the budgetary impacts of increasing levels of equipment leasing.

The Treasury Department27 should: ! obtain more comprehensive data regarding

equipment leasing in order to monitor potential budgetary impacts; and

! expedite development of practical financial evaluation guidelines that are appropriate to an environment of ongoing budgetary constraint.

The Department of Contract and Management Services28, in consultation with the Treasury and the State Supply Commission, should put in place arrangements for agencies to have access to:

! standard form equipment lease contracts with commercially balanced terms and conditions;

! competitively priced lease finance.

Four out of five sampled agencies did not apply asset management policies to lease versus buy decisions.

Some agencies still do not conduct lease versus buy analyses.

Sampled agencies are seeking asset and lease finance quotes on a competitive basis.

Sampled agencies have established or have access to standard lease agreements. However, the lease agreement used by one agency contained several unfavourable conditions.

Agency management have access to financial and legal advice.

Some agencies still do not conduct lease versus buy analyses and therefore, do not know whether a premium is being paid to lease rather than buy.

The Department of Treasury and Finance does not consider it possible at this time for it to monitor leasing given the current non-mandatory status of the whole-of-government leasing facility.

Tools and guidelines have been issued but problems with these and the manner in which they are applied are not resulting in the most cost effective outcomes.

A Master Rental Agreement is available. This agreement has been vetted by the Crown Solicitor’s Office and address the concern raised previously. The lease agreement used by one agency, however, contained several unfavourable conditions.

A non-mandatory whole-of-government lease facility has been established.

16-17

20-22

30-31

31-33

20-22

34-36

31-33

31

RECOMMENDATIONS ATUS REFERENCE PAGES

ST

27 Now Department of Treasury and Finance. 28 Now part of Department of Treasury and Finance.



Previous Reports of the Auditor General

1997 On Display – Public Exhibitions at: The Perth Zoo, The WA Museum and the Art Gallery of WA April 9, 1997

The Western Australian Public Health Sector June 11, 1997

Bus Reform – Competition Reform of Transperth Bus Services June 25, 1997

First General Report 1997 – covers financial statements and performance indicators of departments, statutory authorities (excluding hospitals other than Wanneroo Hospital) and subsidiary bodies August 20, 1997

Get Better Soon – The Management of Sickness Absence in the WA Public Sector August 27, 1997

Waiting for Justice – Bail and Prisoners in Remand October 15, 1997

Report on Controls, Compliance and Accountability Audits 1997 – Public Property Management – Management of Information Technology Systems – Payroll and Personnel Management– Purchasing Goods and Services November 12, 1997

Public Sector Performance Report 1997 – Examining and Auditing Public Sector Performance – Follow-ups of Previous Performance Examinations – Sponsorship in the Public Sector November 13, 1997

Private Care for Public Patients – The Joondalup Health Campus

1998 Report on Ministerial Portfolios – Audit Results – Consolidated Financial Statements

– Summary of the Results of Agency Audits

Selecting the Right Gear – The Funding Facility for the Western Australian Government’s Light Vehicle Fleet

Report on the Western Australian Public Health Sector

Sale of the Dampier to Bunbury Natural Gas Pipeline (Special Report)

Weighing up the Marketplace – The Ministry of Fair Trading

Listen and Learn – Using customer surveys to report performance in the Western Australian public sector

Report on the Western Australian Public Tertiary Education Sector

Do Numbers Count? – Educational and Financial Impacts of School Enrolment

Report on Controls, Compliance and Accountability Audits 1998 – Control of Agency Expenditure – Human Resource Management – Administration of Superannuation Systems

Public Sector Boards – Boards governing statutory authorities in Western Australia

Send Me No Paper! – Electronic Commerce – purchasing of goods and services by the Western Australian public sector

Accommodation and Support Services for Young People Unable to Live at Home

Public Sector Performance Report 1998 – Monitoring and Reporting the Environment

November 25, 1997

April 8, 1998

May 20, 1998

May 20, 1998

May 20, 1998

June 17, 1998

June 24, 1998

August 12, 1998

August 19, 1998

October 14, 1998

November 18, 1998

November 18, 1998

November 26, 1998

– Recruitment Practices in the WA Public Sector – The Northern Demersal Scalefish Fishery December 9, 1998

Report on Audit Results 1997-98 – Financial Statements and Performance Indicators

1999 Report on the Western Australian Public Health Sector – Matters of Significance

– Summary of the Results of Agency Audits

Proposed Sale of the Central Park Office Tower – by the Government Employees Superannuation Board

Lease now – pay later? – The Leasing of Office and Other Equipment

Getting Better All The Time – Health Sector Performance Indicators

Report on the Western Australian Public Tertiary Education Sector – 1998 Annual Reporting Cycle

December 9, 1998

April 21, 1999

April 21, 1999

June 30, 1999

June 30, 1999

June 30, 1999


1999 (continued) Fish for the Future? – Fisheries Management in Western Australia

Public Sector Performance Report 1999 – Controls, Compliance and Accountability Audits – Follow-up Performance Examinations

A Stitch in Time – Surgical Services in Western Australia

Report on Ministerial Portfolios to November 5, 1999 – Issues Arising from Audits – General Control Issues – Summary of the Results of Agency Audits

2000

October 13, 1999

November 10, 1999

November 24, 1999

November 24, 1999

Public Sector Performance Report 2000 – Emerging Issues – Management Control Issues April 5, 2000

Report on the Western Australian Public Health Sector and of Other Ministerial Portfolio Agencies for 1999

A Means to an End – Contracting Not-For-Profit Organisations for the Delivery of Community Services

Private Care for Public Patients – A Follow-on Examination of the Joondalup Health Campus Contract

Report on Western Australian Public Universities and TAFE Colleges – 1999 Annual Reporting Cycle

Bus Reform: Further down the road – A follow-on examination into competition reform of Transperth bus services

Surrender Arms? – Firearm Management in Western Australia

Second Public Sector Performance Report 2000 – Administration of Legislation – Financial and Management Control Issues

A Tough Assignment – Teacher Placements in Government Schools

Report on Ministerial Portfolio at December 1, 2000 – Summary of Audit Results

April 5, 2000

June 14, 2000

June 21, 2000

June 21, 2000

June 28, 2000

September 13, 2000

October 11, 2000

October 18, 2000

– Accountability Issues (Corporate Governance, Accounting for GST Transitional Loan) December 20, 2000

2001 Sale of the Gas Corporation’s Businesses (Special Report) February 14, 2001

On-line and Length? – Provision and Use of Learning Technologies in Government schools May 23, 2001

Implementing and Managing Community Based Sentences May 30, 2001

Public Sector Performance Report, 2001 – Administration of Legislation – – Financial and Management Control Issues – Follow-up Examination June 20, 2001

Report on Public Universities and TAFE Colleges – 2000 annual reporting cycle June 20, 2001

Lifting the Rating: Stroke Management in Western Australia August 22, 2001

Good Housekeeping: Facilities Management of Government Property and Buildings August 29, 2001

Second Public Sector Performance Report 2001 – Management , Compliance and Control Issues – Follow-up Performance Examinations September 19, 2001

Righting the Wrongs: Complaints Management in the Western Australian Public Sector October 17, 2001

Third Public Sector Performance Report 2001 – Appointment and Use of Contract Staff – Management of Mobile Phones in Government – Ombudsman’s Statistics and ComplaintsAutomated Register Project – The Perth Convention Centre November 7, 2001

Life Matters: Management of Deliberate Self-Harm in Young People November 28, 2001

First Byte: Consortium IT Contracting in the Western Australian Public Sector December 5, 2001

Report on Ministerial Portfolios at November 30, 2001 – Summary of Audit Results – Accounting and Contemporary Issues – Summary Results of Agency Audits December 19, 2001


2002 Level Pegging: Managing Mineral Titles in Western Australia June 19, 2002

Report on Public Universities and TAFE Colleges and of other Ministerial Portfolio Agencies for 2001 August 14, 2002

A Critical Resource: Nursing Shortages and the Use of Agency Nurses August 14, 2002

Public Sector Performance Report 2002 – Agency Management of Fringe Benefits Tax – Common Use Contracts in Government – Procurement of Medical Equipment – Follow-up Performance Examination September 25, 2002

A Measure of Protection: Management and Effectiveness of Restraining Orders October 16, 2002

Grounds for Improvement: Government Owned or Controlled Contaminated Sites November 13, 2002

Management of Hospital Special Purpose Accounts November 27, 2002

Second Public Sector Performance Report 2002 – Management of Confidential Personal Information in Government Electronic Databases – Management of Intellectual Property by the Department of Agriculture – Performance Examination: Family Centres December 4, 2002

Report on Ministerial Portfolios at November 29, 2002 December 11, 2002

2003 Customer Calling: Call Centres and the Delivery of Customer Benefits April 2, 2003

Contracting Not-For-Profit Organisations for Delivery of Health Services April 16, 2003

Supplementary Report on Ministerial Portfolio Agency Audits for 2001-02, primarily the Public Health Sector June 11, 2003

Public Sector Performance Report June 25, 2003 – Management of Marine Safety and Seas Search and Rescue – Regulation of the Taxi Industry and Small charter Vehicles – Security of the Government Internet Gateway

Report on Public Universities and TAFE Colleges for 2002 August 13, 2003

The above reports can be accessed on the Office of the Auditor General’s web site at www.audit.wa.gov.au/

On request these reports may be made available in an alternative format for those with visual impairment.

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