Rate-regulated activities

Date recorded:

Education session — Agenda paper 9

The Board continued to discuss the proposed model for rate-regulated activities. The Staff presented the following paper in this meeting:

  • Measurement of regulatory assets: AP 9B

The Board commented on the Staff’s analysis but did not make any decisions.

AP 9A contained a summary of the Board’s discussions to date.

Measurement of regulatory assets — Agenda paper 9B


In this paper, the Staff explored some of the measurement issues in preparation for developing a measurement basis for regulatory assets. They focused on a regulatory asset that arises due to input cost variances, i.e. when an entity incurs actual costs in excess of estimates and the regulatory agreement allows the entity to increase the rate charged in the future to recover these costs. Specifically, the Staff looked at how time value of money and an entitlement to earn a return should be taken into account when measuring a regulatory asset.

When the regulation defers the recovery of costs over a period in which the time value of money is material, the regulatory agreement typically gives the entity the right to charge customers a rate that provides compensation for the effects of the deferral, reflecting the time value of money, the cost of borrowing and the risks associated with the related cash flows. In addition, the regulation often allows the entity to earn a return on top of time value of money in order to attract investments into essential public services.

Staff analysis and questions for the Board

The basic fact pattern used in the paper is the case of an entity incurring an extra CU100,000 above the estimated costs of providing a regulated service to customers in 20x1. The entity is entitled to charge a higher rate over 20x1 to 20x5 to recover the extra costs at CU20,000 per year. The prevailing market interest rate is 2%.

Given the mechanics of a present value calculation, if the future billings exactly compensate the entity for the time value of money (in other words, the entity bills CU20,000 plus 2% on the outstanding balance over 20x2 to 20x5), the present value of the future billings will equal the CU100,000 additional costs incurred in 20x1. In this paper, it is presupposed that the regulatory asset is initially recognised at the present value of expected future cash flows. Accordingly, no net gain or loss would result on initial recognition of the regulatory asset against the CU100,000 additional costs expensed.

By the same token, if the rate charged by the entity does not fully compensate for the time value of money, or the rate charged provides the entity with a return in excess of the time value of money (e.g. the entity is entitled to recover CU20,000 plus, say, 3.5% over 20x2 to 20x5), the present value of the future billings discounted at the prevailing market interest rate will be less, or more, than CU100,000, respectively. This would result in a day-1 loss or gain upon initial recognition of the regulatory asset.

It is precisely whether this day-1 gain or loss should be recognised that the Board’s view was sought. If the day-1 gain is instead deferred to be recognised over the term of recovery, another question was how the pattern of recognition should be determined.

Both questions effectively centred on what rate should be used to discount the future cash flows. The Staff preliminarily suggested using the prevailing interest rates in the relevant market that reflect the risks associated with the cash flows and the regulatory environment. This is the rate that would theoretically result from a separate financing transaction on similar terms with the entity’s customers, consistent with the approach used in IFRS 15 for trade receivables and contract assets.

The timing of recognition of the return earned by the entity also depends on the reason for the return and whether the return is commensurate with the risks faced by investors in that specific rate-regulated environment. For example, if the return relates to a bonus for exceeding a performance target in a particular period, it may be appropriate to recognise the gain in that period. Having said that, the Staff noted that it is often difficult in practice to disaggregate an overall rate adjustment which includes returns, penalties and other adjustments into its components. The Staff will address these aspects in a future meeting.

The Staff also observed that for many regulatory assets, particularly for input cost variances, the period between origination and reversal of the regulatory asset is relatively short, generally within one to two years. As such, the time value of money may not be material. In light of this, the Staff proposed that the Board consider providing a practical expedient to allow a regulatory asset to be measured at its nominal amount, similar to the one in IFRS 15.

Next steps

The Staff will discuss other measurement aspects of regulatory assets arising from different circumstances (e.g. when costs are incurred in constructing assets that will be used to deliver goods or services in future periods), as well as measurement aspects of regulatory liabilities at a future meeting.


Discounting the regulatory asset

In general, the Board agreed with taking time value of money into account when measuring the regulatory asset. This is consistent with established current Standards and reflects the economics of deferred recovery of payments made upfront. However, the tentative consensus around the table was that the Staff should clarify what the nature of the regulatory asset is first, in other words, is it similar to a trade receivable, a contract asset, a mix of the two, another type of financial asset or something totally different? Based on the nature of the asset, the Board could then establish an appropriate measurement basis for it, subject to allowing practical expedients in view of the complexity that could arise when other measurement aspects are taken into account.

Recognising a day-1 gain when the rate compensates for time value of money plus return

There was extensive discussion on this issue. There were mixed views on whether a day-1 gain should be recognised and whether there should be symmetry between recognising a day-1 gain and a day-1 loss (no one raised any objection to recognising a day-1 loss). Most members would prefer to have symmetrical treatment.

Furthermore, the Board generally agreed that three things need to be considered when assessing whether a day-1 gain should be recognised:

  1. Why did the regulator allow the entity to charge a higher rate? What does the extra return cover?
  2. Has the entity delivered the goods or services that entitles it to the higher rate? This is a similar concept to IFRS 15’s satisfaction of a performance obligation.
  3. What is the appropriate discount rate? This should be commensurate with the risks undertaken by investors in that specific rate-regulated environment.

Theoretically, if the extra return is to compensate the investors for risks associated with the project, the cash flows should be discounted at this discount rate and no day-1 gain would result. If, for whatever reason, an appropriate discount rate is reliably determined to be lower than the rate charged by the entity, a day-1 gain would result. Since the present value is determined using a discount rate that is commensurate with the risks associated with the asset, the present value is by definition the fair value of the regulatory asset. In this case, if the entity determines that the day-1 gain does not relate to any other goods or services that it has to deliver in the future, then the gain should validly be recognised in profit or loss on initial recognition of the regulatory asset. However, some Board members were not quite comfortable with why there is an extra gain if the rate that the entity is allowed to charge adequately compensates it for the risks associated with the project – i.e. no more, no less – and there is no other reason for granting the entity a higher return (e.g. bonus for good performance). They questioned whether this is a realistic case.

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