2008 utilities ifrs north america

8/8/2019 2008 Utilities Ifrs North America

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Application o IFRS to rateregulations in North American

utilities companies

UtilitiesIFRS


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November 13, 2008

Greetings:

During the last several months there has been a great deal o discussion about International Financial ReportingStandards (IFRS) and what the adoption o these standards means or North American regulated utility companies.The issuance o the SECs roadmap has provided a potential timerame or the transition to IFRS and hashighlighted the importance o understanding the impact o IFRS on nancial reporting.

Regulated utilities that ollow the accounting guidance o FAS 71, Accounting or the Eects o Certain Typeso Regulation, have a signicant consideration when considering the adoption o IFRS: will companies be ableto recognize regulatory asset and liabilities within the Framework o IFRS? The answer to this question is notcurrently clear and the impact o the loss o regulatory accounting on regulated utilities cannot be overstated.The recognition o regulatory assets and liabilities was considered by the International Financial ReportingInterpretations Committee (IFRIC), but the IFRIC decided not to issue urther guidance in this area.

The attached paper provides a history o regulatory accounting and IFRS, explains the challenges o supportingregulatory accounting within the IFRS Framework, and it highlights important next steps or North Americanregulated utilities in evaluating the path orward.

We look orward to working with members o the utility industry in resolving this complex question. Finally, mythanks to the partners and managers whom authored and edited this whitepaper.

Best regards,

Michael (Casey) A. HermanLeader, US Utilities Assurance Practice

pwc

PricewaterhouseCoopers LLP

One North Wacker

Chicago, IL 60606

Telephone (312) 298 2000

Facsimile (312) 298 2001

www.pwc.com


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The trillion dollar question:

As International Financial Reporting Standards (IFRS)

expand as the generally accepted accounting principlesaround the globe, companies and industries in variouscountries are evaluating their existing accounting policiesand how they may need to change to t within theramework o IFRS. For many monopoly utility companies,this evaluation has highlighted a serious issue andconcern on the lack o specic guidance within the IFRSrules and ramework or accounting or the impacts orate regulation.

In the US, regulated companies ollow the accountingrules outlined in Statement o Financial AccountingStandards No. 71, Accounting or the Eects o CertainTypes o Regulation (FAS 71), which establishes criteriathat must be met to recognize regulatory assets andliabilities. The FAS 71 ramework has been adopted byother countries (e.g., Spain, India, Canada) where localgenerally accepted accounting principles provide nospecic accounting guidance or regulated entities. Theissue is signicant not only to the nancial reporting othese companies but also to the regulatory reporting andcompliance, economic analysis, treasury strategy andother critical aspects o managing the business. GAAPnancial statements, using FAS 71, are without questionthe primary source o inormation used by externalparties in analyzing investing, lending, credit rating and

ratemaking issues or these companies. The US investorowned utility industry estimates that the combinedbalances o regulatory assets and liabilities in the US are$675 and $475 billion, respectively.1 We understand thatmany users o nancial statements in North America,including regulatory bodies and sta as well as equityand debt analysts, have indicated that they would likelyrequest disclosure as to the eect o uture recoveriesand reunds i this accounting is not supported underIFRS. This disclosure may be in the ootnotes to nancialstatements o companies applying IFRS or through othermethods o disclosure.

IFRS has developed around the concepts detailed inthe Framework or the Preparation and Presentation oFinancial Statements (the Framework) which is theunderlying basis or the IFRS accounting model. IFRSrelies more on the Framework in establishing specicstandards and guidance rather than on specic, otenindustry ocused, rules that are prevalent in US GAAP.

As a result, the accounting rules that exist in IFRS tendto be more principles based, in comparison to USGAAP which relies more heavily on specic rules and

industry practices as a basis or the accounting model.The standard setters or IFRS oten rown upon industryspecic standards because they may be inconsistent withe principles o the ramework and a general philosopho the IASB that the Framework should accommodate aaccounting issues and judgments.

In contrast, in issuing FAS 71 the FASB recognized thatcost based regulation or monopoly service providerscreates a unique economic environment by whichconsumers cannot infuence the price they pay or aproduct, and service providers cannot impact protsthrough price adjustments. In issuing FAS 71 in 1982,the FASB created a standard that refected the uniqueeconomic eect o the cost-o-service regulatoryenvironment in which rate regulated companies operateThe FASB noted that [r]egulation creates dierentcircumstances that require dierent accounting(paragraph 59, FAS 71) and that allowable costs arethe principal infuence o price and revenue in a costregulated environment. The standard is largely basedon the US ratemaking process, but is also used asauthoritative literature in Canada, India and othercountries with similar regulatory regimes.

The question that will need to be answered upon adoptio IFRS is quite simple. Although there is no specic

accounting guidance or rate regulated companieswithin IFRS, does the IFRS Framework support similaraccounting or costs and revenues as exists under FAS71? It is, or the industry, the $1.1 trillion question.

How we got to this point:

Earlier this year, the International Financial ReportingInterpretations Committee (IFRIC) considered thepotential need or urther guidance in this area. The IFRIis an IASB sponsored committee established to address

emerging issues and provide guidance or existing IFRSprinciples. During its meeting in May 2008, the IFRICnoted that in act there was diversity in the industryamong regulated entities reporting under IFRS, wherebysome entities were recognizing certain regulatory assetsand liabilities and others were not. The IFRIC notedthat as more jurisdictions adopt IFRS, the dierences in

1 Edison Electric Institute.


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interpretation had the potential o becoming more diverse.The issue has been around or a number o years, but notully resolved by standard setters or the industry.

IFRIC has considered the question o regulatoryaccounting beore. In 2005, the IFRIC considered addinga project to its agenda because it was asked to clariywhether a regulatory asset meets the requirements orrecognition. Specically, the IFRIC was asked to considerwhether the concepts o FAS 71 could be applied as anaccounting policy decision in the absence o specicguidance in IFRS. However, at that time, the IFRICconcluded that the recognition criteria or regulatoryassets and liabilities in FAS 71 were not ully consistentwith recognition criteria in IFRS. Instead, the IFRICconcluded that expenses incurred in perorming price-regulated activities should be recognized in accordancewith applicable IFRS.

The IFRIC decided not to add a project on regulatoryassets to its agenda in 2005. When explaining its decisionnot to add the FAS 71 project to its agenda,the IFRIC stated that entities applying IFRS shouldrecognize only assets that qualied or recognition inaccordance with the IASBs Framework and relevantaccounting standards.

Dierences emerged on how companies interpreted theIFRICs comments. Many companies interpreted theoriginal agenda decision as meaning that it was generally

inappropriate to recognize regulated assets. Otherslooked to the Framework and concluded that some otheir pre-existing regulatory assets met the denition oassets and continued to recognize recoverable costs asassets on the balance sheet. The IFRIC acknowledgedthis diversity in practice in its recent deliberations.However, the IFRIC decided not to add this item toits agenda. We will explore two o these actors below.

Potential reasons for different accounting practices

Dierent regulatory regimes:

There are signicant dierences in regulatory regimesor monopoly service providers around the world andthese dierent ratemaking approaches may appropriatelygive rise to dierent accounting conclusions. It ispossible that the initial consideration by the IFRIC o

the recognition o regulatory assets and liabilities as theoriginal consideration did not specically consider theormat o rate making and the associated legal structure

supporting the regulatory environments utilized bythe majority o the enterprises that ollow FAS 71 andcomparable cost based standards. As an example,incentive based regulation is common in Europe.Under incentive based regulation, revenues are basedon recovery o a deemed level o ecient operatingcosts plus a notional cost o capital. Under this type oregulation, the company keeps any prot rom reducingoperating costs below the assumed level o eciency orthrough having a cost o capital lower than that assumedby the regulator. There is no explicit recovery o anenterprises specic costs o providing the regulatedservice, the lynchpin concept within FAS 71.

In contrast to this model is the cost-o-service rateregulation model that is common in the US. US rateregulation o monopoly service providers generallyallows utility companies to set rates at levels that providrecovery o all prudent operating expenditures in additioto a return on rate base (conceptually a return on thenet assets utilized in delivering the regulated servicewhich is based on the weighted cost o equity anddebt capital). The operating expenditures used in thecalculation o rates are based on the companys historicor projected expenditures. Balancing accounts are otenprovided or expenses that are volatile and cannot be

reliably estimated (e.g. uel) to ensure there is no over- ounder-recovery. For those expenses that can be reliablyestimated, adjustments are generally permitted onlywhen there is a signicant variance such as in the caseo a major storm. The underlying basis or rate settingand or the application o FAS 71 is the cause andeect relationship between costs and rates. This causeand eect relationship is updated to refect changes toestimated costs and rate base as oten as is necessaryto ensure airness among the parties.

Although similar on the surace, the cost-recoveryrelationship is more direct under a rate regulationmodel than under the incentive model. This dierence cahave a signicant impact on a companysaccounting conclusions.

Additionally, regulation o public utilities in the US isvested in public utility commissions o each state. Thereis a considerable body o case law supporting the


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legal enorceability o historical actions taken by theseregulators. State regulatory laws generally prohibit theconcept o retrospective ratemaking. Thereby a current

commission decision cannot retroactively reverse theactions o a previous commission order. The eect o thisprohibition is that once a commission provides or therecovery o a previously incurred cost in uture rates,state laws support the legality o that recovery andgenerally prohibit uture commissions rom reversingthe previous conclusion.

Dierent interpretations o the ramework:

The IFRS Framework denes assets as resources anentity controls as a result o past events and rom

which uture economic benets are expected to fowto the entity [F.49(a),53-59]. There are three elementsto the denition:

A past event: There needs to have been a past event,usually a transaction. A cost incurred through cashoutfow or accounting charge would meet this criteria.

Probability o uture economic benet: There needs tobe a probability o uture economic benet beyond thecurrent accounting period. I the uture economic benetis uncertain and its outcome depends on a uture eventnot wholly within the companys control, then it is acontingent asset, and must be virtually certain o recoverybeore it can be recognized.

Control: Control is usually in the orm o legal rights butsubstance and economic reality are an important part othe consideration.

The rst two criteria are somewhat straightorward. Thequestion o control is more complex and is a key issue orrecognizing regulatory assets. The question that arisesis whether the company actually controls the regulatoryassets that have been recognized.

FAS 71 requires that it is probable that uture revenuein an amount at least equal to the capitalized cost will

result rom inclusion o that cost in allowable costsor rate making purposes. Although this denition issimilar to the Framework requirement, when the utureeconomic benet is not controlled by the entity theIFRS Framework requires a higher level o assuranceo recovery (virtually certain) than is required by FAS71 (probable). A utility company considers its history o

recovery o regulatory assets as part o its decision tocontinue ollowing FAS 71 and when considering uturecapitalization. The primary uncertainties o realization ar

uture actions o the regulator and the continued use oelectricity by customers. As discussed above, there is aconsiderable history o state law supporting enorceabilo commission actions ordering the prospective recovero incurred costs. In addition, in the large majority ocases, there is a strong history o ull collection oregulatory assets. For a portion o the assets capitalizedthis virtually certain threshold will be supportable or somtime horizon or recovery period. However, the change indenition rom probable to virtually certain could impactthe recognition o a population o regulatory assets thatcannot be supported at this higher level o certainty.

Below is a high level discussion o the issues involvedwith meeting the IFRS threshold:

Does a company control the recovery o regulatoryassets? Several views exist around this question. Onthe one hand, the regulator has the power to create,adjust or eliminate regulatory accounts which have beenrecognized pursuant to a previous rate case. However, aregulators authority is usually subject to administrativeand judicial review which provides the company anappeals process when management believes a decisionis unair and as previously mentioned, there are statelaws protecting regulated entities rom the reversalo rate orders which established cost recoveries. In

this environment, the regulator retains an element ocontrol over recognized assets even when those assetsare recognized pursuant to authority granted in a ratecase. However, that authority is generally limited to theprudence test and certain assets will meet the virtuallycertain criteria based on acts and circumstances.

In certain circumstances, a company may recognizeregulatory assets based on the past practices o theregulator or recovering these costs, either whendealing with the company or with other companies inthe jurisdiction. The actual recovery o the cost will beconrmed by the regulator in a uture rate case. More

judgment is required in these situations to determine iregulatory assets are supportable under US GAAP. Forassets or liabilities recognized based on managementsjudgment as to the probability o a uture rate action, theevidence supporting recovery will need to be evaluated the higher threshold o certainty required by IFRS.


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Recovery o most regulatory assets is also dependanton uture delivery o electricity to customers, by eitherthe legacy utility company or an alternative provider. For

example, in nearly all US cases, when state deregulatoryactions allowed retail customers to switch their utilityservice to an alternative provider, that alternative providerhas been required to collect transition charges romthe customers, which represent, in part, the continuedcollection o regulatory assets. Although recovery isdependant on the uture perormance o the business andconsumption o electricity by customers, these variablesare highly predictable in most settings, at least or aperiod o time.

This discussion highlights the issues and illustrates thejudgments that will need to be made about recognition oregulatory assets within the IFRS Framework. We expectthat diversity in practice will emerge i clarication is notprovided as to how the principles o the IFRS Frameworkinteract with these unique assets.

Next steps or regulated companies

The IFRIC met in early November 2008 and decided notto add this project to its agenda. During the meetingmembers o the Committee expressed widely divergingviews on whether regulatory assets and liabilities metthe denitions o assets and liabilities outlined in the

Framework. However, members agreed that companiesshould evaluate their individual acts and circumstancesagainst the Framework in determining whether regulatoryassets and liabilities should be recognized.

Although the IFRIC chose not to add this project to itsagenda, the International Accounting Standards Board(the IASB) may decide to evaluate the accountingor regulatory assets and liabilities and issue a newaccounting standard.

Industry groups in North America are starting to getinvolved to manage the issues associated with theadoption o IFRS and the potential write-o o signicant

regulatory accounts. The American Gas Associationsubmitted a letter to the IFRIC expressing its concernsand providing some background and inormation aroundregulatory schemes in the US and common types oregulatory assets. The Edison Electric Institute alsosubmitted a letter to the IFRIC addressing how

regulatory assets and liabilities t into the IFRS

Framework. Several Canadian organizations andcompanies are getting involved as well, as Canadiancompanies are required to adopt IFRS in 2011.

At this time, is unclear whether the IASB will considerdeveloping a standard or regulatory accounting or evenamend and clariy language within the Framework toassist regulated companies in determining the appropriaaccounting treatment. It is possible that North Americanregulated companies will have to analyze regulatoryaccounts against accounting guidance as it exists todayBased on discussions at several o the IFRICs meetingsthere appears to be support or alternative views aboutthe recognition o regulatory assets and liabilities and,as noted, practice is currently inconsistent. Given thedivergence in views that continue to exist, it is clear thaturther study o the matter is important.

The mandatory adoption o IFRS in the US may seemlike a distant event, however, the impact o this issueon the nancial statements o regulated entities cannotbe understated. Companies should begin to evaluatetheir regulatory assets within the IFRS Framework toidentiy the challenges that they may ace in meeting thisdenition. This issue could be the single largest changeto nancial reporting impacting regulated companiessince the issuance o FAS 71.


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pwc.com 2008 PricewaterhouseCoopers LLP. All rights reserved. PricewaterhouseCoopers reers toPricewaterhouseCoopers LLP (a Delaware limited liability partnership) or, as the context requires, thePricewaterhouseCoopers global network or other member rms o the network, each o which is a

separate and independent legal entity. LA-09-0130 lt

To have a deeper conversation about how thissubject may aect your business, please contact:

David EtheridgeUtilities Sector LeaderPricewaterhouseCoopers [email protected]

Casey HermanUtilities Sector Assurance LeaderPricewaterhouseCoopers [email protected]

Craig KingUtilities Sector Tax LeaderPricewaterhouseCoopers LLP213.356.6619

[email protected]

Mark FaganUtilities Sector IFRS LeaderPricewaterhouseCoopers [email protected]

Danah Al-HusainiUtilities Sector Senior ManagerPricewaterhouseCoopers [email protected]

2008 utilities ifrs north america

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