Cover note and summary of the model — Agenda paper 9

In the December 2016 Board meeting, the Staff presented an overview of the proposed new accounting model for rate-regulated activities. The purpose of this session is to present a more detailed analysis on various aspects of the proposed model. The following topics will be discussed at this meeting:

• The model’s general approach — Agenda paper 9A
• Scope of the model — Agenda paper 9B
• Recognition of regulatory assets and regulatory liabilities — Agenda paper 9C

In addition, AP 9D contains several examples to illustrate the application of the recognition criteria described in AP 9C.

Appendix A contains a summary of the proposed model.

The Staff intends to discuss the following topics at a future Board meeting: (a) measurement, impairment and derecognition; (b) presentation and disclosure; (c) interaction with other Standards; (d) assessment of the model’s consistency with the revised Conceptual Framework; (e) comparison with the FASB’s equivalent standard: Topic 980 Regulated Operations; (f) transition and withdrawal of IFRS 14 Regulatory Deferral Accounts; and (g) whether the next consultation document should take the form of a second DP (the first DP on this topic was issued in September 2014) or an ED.

The model’s general approach — Agenda paper 9A

Background

This paper summarises the objective, underlying principle and general approach of the model. See AP 9 to the December 2016 Board meeting for an overview of the core features of the model.

Staff analysis

The Staff has applied the principles of IFRS 15, together with the Board’s latest thinking in the Conceptual Framework project, when developing the core principle and general approach of the model.

This was done in response to stakeholders’ request that the proposed accounting model should:

1. recognise as regulatory assets and regulatory liabilities only those regulatory adjustments that are consistent with the definitions of assets and liabilities in the Conceptual Framework (i.e. balance sheet-side recognition);
2. use the principles of IFRS 15 to provide a principle-based framework for recognising regulatory adjustments (i.e. income statement-side recognition); and
3. provide transparent and understandable information about the effects of the rate regulator’s intervention on the entity’s financial position, performance and cash flows.

The Staff emphasises throughout the paper that it is the imposition of the rate-setting mechanism on the entity and the customer base that creates the regulatory asset/liability.

• The notion of a ‘customer base’ means that the entity’s customers are seen as a single body. This means that the entity’s rights and obligations are not affected by individuals leaving or joining the customer base. The ability to subject the current customer base to the same rate adjustments ensures the continued existence of the entity’s right to charge a higher rate, or obligation to charge a lower rate, in the future.
• At inception of the regulatory agreement the agreement is executory, as neither the entity nor the customer base has performed, and no regulatory asset/liability should be recognised.
• Once either the customer base or the entity has started to perform, any imbalance between the current rate and the services delivered will be adjusted in the future through the rate-setting mechanisms. An imbalance could be caused, for example, by the entity not meeting performance targets or consumption being different from expectations.
• If an imbalance in performance exists, the agreement ceases to be executory and a regulatory asset/liability should be recognised. The asset is the entity’s right to be compensated for past performance. The liability is its obligations to the customer base for which it will not be compensated. In each case the corresponding entry is recognised in the income statement.
• The Staff believes that this approach is consistent with the asset and liability definitions in the Conceptual Framework, as well as the core principle of IFRS 15 (reworded to reflect the specific nature of this project): that an entity should recognise regulatory performance adjustments to depict the transfer of rate-regulated goods or services to the customer base in an amount that reflects the compensation to which the entity expects to be entitled in exchange for those goods or services.

The Staff also analysed whether a rate-regulated entity should apply the requirements of other Standards, including IFRS 15, without amendment, before applying the model. They concluded that although the rights and obligations created by the regulatory agreement complement those created by its contracts with individual customers, they are distinct and subject to different risks. Consequently, the Staff concluded that reporting the relationship between them separately would make it easier to compare financial reporting across rate-regulated entities that are subject to different levels of rate regulation and is more transparent.

Staff recommendation

The Staff will ask the Board whether it agrees with the suggested approach.

Scope of the model — Agenda paper 9B

Background

This paper discusses the scope of the model.

Staff analysis

The Staff argue that a cornerstone of the model is that a regulatory agreement creates rights and obligations for the entity that are distinguishable from those of an entity that is not subject to rate regulation. Without a rate-setting mechanism, the entity would be free to negotiate the price and the performance specifications with individual customers. The Staff argues that the scope of the model should require an entity to carry out activities that are subject to a formal regulatory pricing framework that is binding on both the entity and the rate regulator, ruling out self-regulating entities. This is because when an entity can modify the price and the performance specifications for its goods or services its rights and obligations would not be sufficiently distinguishable from those of an entity that is not subject to defined rate regulation.

In addition, the Staff argues that the rate-setting mechanism must clearly establish a right and obligation on the part of the entity to adjust the price to make good the imbalance in the performance between the entity and the customer-base. Such a requirement is necessary to exclude, for example, market regulation that merely caps the price that an entity could charge, but which does not establish any rights or obligations. To this end, the Staff argues that the rate-setting mechanism should include the features set out in (b) below.

Staff recommendation

The Staff recommends that the scope of the model require:

1. an entity to carry out activities that are subject to a formal rate-setting framework that is binding on both the entity and the rate regulator; and
2. the rate-setting framework to include a rate-setting mechanism that:
   1. establishes how the regulated rate is calculated;
   2. identifies how the rate reflects the satisfaction of the entity’s regulatory obligations; and
   3. adjusts the future regulated rate for the effects of imbalances in performance between the entity and its customer-base.

Recognition of regulatory assets and regulatory liabilities — Agenda paper 9C

Background

This paper analyses the recognition criteria for regulatory assets and regulatory liabilities.

Staff analysis

The Staff believes that the recognition criteria should clearly reflect the supplementary approach taken by the model and that regulatory adjustments must create a right for or obligation of the entity as set out in APs 9A and 9B.

The paper sets out the staff view on how the recommended approach to accounting for costs incurred in acquiring, constructing or enhancing the entity’s own assets is consistent with IFRS 15’s requirements on costs incurred to fulfil a contract, and IAS 20’s requirements on the recognition of government grants related to an entity’s own asset. In short, if the amounts are not included in the cost of another asset by applying another Standard (given that the model takes a supplementary approach), the entity should assess whether the entity is entitled to recover specified costs through the rate to be charged to the customer base in terms of the regulatory agreement. If so, the costs should be recognised as a regulatory asset with a corresponding adjustment in profit or loss. Such an asset would then be amortised in the same way as an IFRS 15 contract asset. The Staff believes that the recognition of a regulatory asset in this case is justified as there is an ‘imbalance’ between the performance of the entity and the customer base – the entity has satisfied (at least partially) its regulatory obligations (through delivering services using the new assets), but the customer base will only pay for it in the future through an increase in rate. The same logic applies to the case where the customer base prepays (through the regulated rate) the future construction costs, in which case a regulatory liability is recognised which will be amortised to profit or loss as the entity uses the new asset to transfer services to the customer base.

With regard to the recognition of regulatory assets, there was some concern about how its recoverability would affect recognition, especially in cases where the increase in rate is not yet approved or may be renegotiated by the regulator. The Staff believes that the guidance on constraining the amount of variable consideration in IFRS 15 could be applied in this case. The Staff also plans to include some factors that are specific to the rate-regulated environment that would affect the likelihood and magnitude of the revenue reversal through regulatory adjustment.

Staff recommendation

The Staff recommends that the model require an entity to recognise a regulatory asset/liability only when:

1. the regulatory adjustment represents a right or obligation arising from the extent to which the performance of the entity exceeds, or has been exceeded by, the performance of the customer base;
2. the resulting regulatory asset or regulatory liability has not already been recognised as an asset or a liability by applying other Standards; and
3. it is highly probable that a significant reversal in the amount of cumulative compensation recognised will not occur.