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 was to present a more detailed analysis on various aspects of the proposed model. The following topics were 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 contained several examples to illustrate the application of the recognition criteria described in AP 9C.
Appendix A contained 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
This paper summarised 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.
The Staff had 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:
- recognise as regulatory assets and regulatory liabilities only those regulatory adjustments that were consistent with the definitions of assets and liabilities in the Conceptual Framework (i.e. balance sheet-side recognition);
- use the principles of IFRS 15 to provide a principle-based framework for recognising regulatory adjustments (i.e. income statement-side recognition); and
- 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 emphasised throughout the paper that it was the imposition of the rate-setting mechanism on the entity and the customer base that created the regulatory asset/liability.
- The notion of a ‘customer base’ meant that the entity’s customers were seen as a single body. This meant that the entity’s rights and obligations were not affected by individuals leaving or joining the customer base. The ability to subject the current customer base to the same rate adjustments ensured 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 was executory, as neither the entity nor the customer base had performed, and no regulatory asset/liability should be recognised.
- Once either the customer base or the entity had started to perform, any imbalance between the current rate and the services delivered would 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 existed, the agreement ceased to be executory and a regulatory asset/liability should be recognised. The asset was the entity’s right to be compensated for past performance. The liability was its obligations to the customer base for which it would not be compensated. In each case the corresponding entry would be recognised in the income statement.
- The Staff believed that this approach was 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 reflected the compensation to which the entity expected 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 complemented those created by its contracts with individual customers, they were 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 were subject to different levels of rate regulation and would be more transparent.
The Staff asked the Board whether it agreed with the suggested approach.
All but one Board member agreed with the general direction of the model. Most of the time was spent debating how the customer base in a rate regulated environment differs from other customer bases, e.g. a big brand entity would also likely have a consistent population of customers and hence would be able to pass on revenue adjustments arising from past events to its future customers. Most of the Board members believed that the crux of the difference lies in the presence of a tripartite agreement in a rate-regulated environment between the regulator, the service providing entity, and the customer base, which contractually binds the three parties to future rate adjustments. Without this agreement, a non-rate regulated entity does not have an enforceable right and/or obligation to adjust future prices for past events (which is what gives rise to the regulatory asset and liability in the first place).
A question also arose on what do the rate regulated services encompass – is it just to deliver electricity, or does it include something else, e.g. repairing assets (as the future rate may be adjusted to compensate the entity for the costs incurred)? Does repairing the assets represent a performance obligation that is separate from the delivery of electricity? The Staff agreed to explore that further.
The Staff will also explore how to simplify and refine the principle in the model and will consider how to incorporate the uncertainty of future revenue adjustments into the model.
Scope of the model — Agenda paper 9B
This paper discussed the scope of the model.
The Staff argued 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 argued 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 argued 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 argued that the rate-setting mechanism should include the features set out in (2) below.
The Staff recommended that the scope of the model require:
- 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
- the rate-setting framework to include a rate-setting mechanism that:
- establishes how the regulated rate is calculated;
- identifies how the rate reflects the satisfaction of the entity’s regulatory obligations; and
- adjusts the future regulated rate for the effects of imbalances in performance between the entity and its customer-base.
All but two Board members were in favour of continuing with the development of the scope criteria based on the rights and obligations that are enforceable on the regulator, entity and the customer base.
Some Board members suggested that the model should clearly distinguish market regulation from rate regulation and should clearly exclude the former from its scope. The Board also debated whether the feature that ‘customers have little or no choice but to purchase the goods/services from the entity’ should be elevated to a scope criterion as opposed to being a common feature of defined rate regulation. Quite a few Board members and the Staff observed that the ‘little or no choice’ issue is subject to significant judgement (e.g. there is only one ferry operator (subject to rate regulation) that provides river-crossing services, but people can also take a train that takes much longer to cross the river – where does one draw the line as to whether a customer has little or no choice but to take the ferry?) and that this feature would be unlikely to have an impact on whether the entity would otherwise be within the scope of the model. The Staff further noted that this feature will be taken into account in the measurement aspect when assessing the impact of uncertainty of future rate adjustments.
The Staff agreed that they will have to refine the scope as they develop the general principles further (as discussed in paper 9A), and that they will explore whether the application of the model should be made mandatory for all entities that fall within its scope.
Recognition of regulatory assets and regulatory liabilities — Agenda paper 9C
This paper analysed the recognition criteria for regulatory assets and regulatory liabilities.
The Staff believed 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 set 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 believed 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.
The Staff recommended that the model require an entity to recognise a regulatory asset/liability only when:
- 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;
- the resulting regulatory asset or regulatory liability has not already been recognised as an asset or a liability by applying other Standards; and
- it is highly probable that a significant reversal in the amount of cumulative compensation recognised will not occur.
The Board did not vote on this paper. The Staff were asked to bring back further analysis for discussion.
A few Board members were hesitant about anchoring the recognition of a regulatory asset/liability on the ‘imbalance of performance’ between the customer base and the entity. This was mostly because they struggled with what exactly is the performance of the customer and that of the customer base (which might not be payment for services as proposed by the Staff), and when does one assess the performance from an individual customer’s perspective as opposed to from the customer base’s perspective. Some Board members also reiterated the concerns noted in paper 9A about what exactly are the performance obligations encompassed by the rate-regulated services.
The Board also asked the Staff to analyse further how the variability and uncertainty in future rate adjustments would impact measurement before assessing whether it would be appropriate to apply the constraint principle in IFRS 15 to this model. They were hesitant to make it a recognition criterion as opposed to a consideration within the measurement aspect.
The Staff were further asked to explore 1) whether an entity would be within the scope of the model if it were subject to substantial demand risk, e.g. the rate is adjusted for capital investments but not for differences in actual versus expected consumption; and 2) what role, if any, asymmetry would play in the recognition of a regulatory asset versus a regulatory liability.