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Rate-regulated activities

Date recorded:

Cover Note (Agenda Paper 9)

Background

The Board has been considering whether entities that operate in rate-regulated environments should recognise assets and liabilities arising from the effects of rate regulation. As part of this project, the Board has been developing an accounting model to provide information about those rights and obligations that are created by defined rate regulation.

The Board issued a Discussion Paper in September 2014, but has yet to decide whether to issue a second Discussion Paper or develop an Exposure Draft.

At this meeting the Board discussed the staff’s recommendations for the measurement of regulatory assets that are recognised in the model as well as the staff’s initial views on a high-level presentation and disclosure objective for the model and possible presentation formats for the statement(s) of financial performance.

Background and summary of decisions to date (Agenda Paper 9A)

Staff analysis

This paper provides background information on the model and summarises the Board’s tentative decisions to date.

Measurement (Agenda Paper 9B)

Background

In this paper, the staff discuss aspects of the measurement of regulatory assets and how to measure regulatory liabilities and possible related disclosures.  

Staff analysis

Estimating future cash flows

When measuring assets (or liabilities) by reference to estimate of uncertain future cash flows, both IFRS 15 Revenue from Contracts with Customers and IFRIC 23 Uncertainty over Income Tax require the use of either the most likely amount (statistical mode) or the expected value (statistical mean). The staff did not find any compelling reason to propose a different treatment for rate-regulated assets and liabilities.

Significant financing component and discount rate

In May 2018, the Board tentatively decided that the estimates of future cash flows should be discounted if there is a significant financing component. In most cases, a significant financing component is evidenced by the regulatory agreement establishing an explicit interest/ return rate to compensate the entity for the financing component. When this is not the case, an entity needs to determine whether the financing component is significant. For example, the financing component may not be significant when there is a short time between the origination and reversal of the timing difference. 

The staff consider that the regulated interest/ return rate is a ‘reasonable rate’ to use to discount the estimated future cash flows arising from a regulatory asset when that rate: (i) for short- or medium-term timing differences, is a reasonable approximation to the entity’s borrowing rate, and (ii) for long-term timing differences, is the same as the weighted average cost of capital (WACC) or other return rate applicable to property, plant and equipment and other assets within the regulatory capital base (RCB).

In rare cases when the interest/ return rate is significantly higher or lower than a reasonable rate, the paper sets out a number of recommendations for the assessment and recognition of the excess or deficit in the compensation which are summarised below in the “Staff recommendations” section.

Changes in estimated cash flows

Changes in the estimates of future cash flows can occur for various reasons, such as (i) completing a rate review after finalising the financial statements, (ii) variances between estimated and actual individual inputs used in the forecasts of the cash flows, and (iii) other changes in facts and circumstances. The staff have not identified any reasons for accounting for changes in estimated amounts in the model differently from other changes in accounting estimates.

Changes in interest or return rates

Typically, regulatory agreements update periodically the interest/ return rates to reflect changes in market rates. Those revised rates apply prospectively to both old and new regulatory assets and liabilities. Consequently, the discount rate used to measure the outstanding regulatory asset balance should also be changed to reflect the revised regulatory interest/ return rate to avoid creating an artificial gain or loss at the date of change.

Measurement of regulatory liabilities

Regulatory liabilities arise when an entity carries out an activity to fulfil its regulatory service requirements in a later period than the period in which the entity charges customers for that activity through the rate(s). The regulatory obligations are fulfilled as the entity fulfils service requirements by delivering good and services and charges a rate(s) reduced by the incremental amount already included in the rate(s) in earlier periods. Consequently, the rate charged for delivering those goods and services is less than the amount that reflects the service requirements fulfilled during that period. The staff has not identified issues that would require regulatory liabilities to be measured on a different basis than regulatory assets.

Possible disclosures relating to measurement

The paper lists possible disclosures, including: (i) the method used for estimating future cash flows arising from regulatory assets and liabilities, (ii) instances where estimates of future cash flows have been prepared by grouping different timing differences, (iii) the regulatory interest/ return given on regulatory assets or charged on regulatory liabilities, (iv) instances when the regulatory interest or return given/charged is assessed as not being ‘reasonable’, (v) instances when there is no explicit financing component in the regulatory agreement, but the entity concludes the financing component is financing, (vi) reasons for changes in estimates of future cash flows and the corresponding effects in the entity’s financial statements, and (vii) changes in the regulatory interest/ return rates and effects in the entity’s financial statements.

Staff recommendations

The staff recommended that for each regulatory asset recognised, an entity should:

  • a) estimate future cash flows using either the most likely outcome method or the expected value method, depending on which method better predicts the amount and timing of the cash flows arising from a particular timing difference; and
  • b) apply that method consistently from the origination through reversal of the timing difference.

An entity should determine whether to consider the outcome of each timing difference separately or together with one or more other timing differences based on which approach better predicts the amount and timing of the resulting future cash flows.

The staff also recommend that, if the regulatory agreement does not provide explicit compensation for the effects of time between origination and reversal of a timing difference, an entity uses judgement to determine, based on its particular facts and circumstances, whether the financing component of the timing difference is significant.

When the financing component is significant, an entity should measure the regulatory asset by discounting estimated future cash flows using the interest/ return rate established by the regulatory agreement for those cash flows using the interest/ return rate established by the regulatory agreement for those cash flows unless (i) there is clear evidence to show that the regulatory interest/ return rate is set at a level that provides an excess or deficit in compensation because of an identifiable transaction or event; or (ii) the regulatory asset is not fully recoverable.

When the entity has clear evidence that the excess/ deficit in compensation arising from a regulatory interest/ return rate that is set significantly above or below a ‘reasonable rate’ results from an identifiable event or decision, including a partial disallowance the entity should:

  • a) measure the excess/ deficit directly, if that value can be measured by reference to the identifiable event or decision; or
  • b) measure the excess/ deficit indirectly as the difference between:
    1. the amount of the originating timing difference; and
    2. the present value of the regulatory asset, measured by discounting the future cash flows expected to result from the originating timing difference using a ‘reasonable rate’.
  • c) recognise the excess or deficit in profit or loss:
    1. for a partial disallowance – immediately; and
    2. for other events or decisions – in the period in which the identifiable event or decision occurs.

To account for changes in estimated future cash flows, the staff recommend that the model should adopt the treatment required by IAS 8, i.e. the effects of changes in estimates of future cash flows should be accounted for prospectively in profit or loss in the period of change, if the change affects only that period, or the period of change and future periods, if the change affects both. If the change gives rise to a change in a regulatory asset or liability, the entity should adjust the change in carrying value of the related asset or liability in the period of change.

In addition, the staff recommend that when the regulator changes the interest or return rates used to compensate the entity for the period between the origination and reversal of timing differences, the entity should (i) measure the outstanding regulatory asset balance using the revised interest or return rate to discount the estimated future cash flows, and (ii) recognise any resulting change in the carrying amount of the regulatory asset in the period of change.

Finally, in relation to regulatory liabilities, the staff recommend the model should apply the same measurement requirements as for regulatory assets.

Next steps

The Board will discuss at future meetings additional aspects of the model, including presentation and disclosures, interaction with other IFRS standards, transition and US GAAP comparison.

Discussion

Although Board members were generally supportive of the recommendations, the discussion focused in particular on whether the level of detail provided by the guidance and the resulting complexity of the model were appropriate.

Estimating future cash flows

One Board member challenged whether the choice between the most likely amount and the expected value methods when measuring regulatory assets and liabilities should depend on which method better predicts the amount and timing of cash flows, as described in the staff’s recommendation, or whether a cost-benefit assessment of applying each method should also be considered.

The staff confirmed that the method would be selected for each timing difference and should then be applied consistently throughout the life of that timing difference. The Board member asked the staff to consider the interaction between the definition of the unit of account as the individual timing differences and the operational application on a portfolio basis.

Another Board member asked whether the intention was to provide more guidance on how to select the most appropriate method, which the staff confirmed, noting that the most likely amount was expected to provide a reasonable outcome for most timing differences whereas for ad hoc or one-off timing differences, the expected value might be more appropriate. The method selected would depend on the facts and circumstances, including the statistical distribution of the possible outcomes. It was noted that IFRS 15 Revenue from Contracts with Customers already provides relevant guidance on that matter. Another Board member stressed that the guidance would not need to be extensive because rate-regulated entities already routinely prepare such cash flows estimations.

It was also discussed that the selection of the most appropriate method would not be a free choice.

One Board member noted that, in spite of the fact that the cash flows arising from regulatory assets and liabilities are less risky and volatile than those arising from variable consideration, the model is based on the same complex principles as those used in IFRS 15. The Board member wanted the staff to clarify why the use of the two measurement methods is useful for regulatory assets and liabilities as well as whether the grouping of regulatory assets and liabilities together will be restricted.

Significant financing component and discount rate

In relation to the flow chart for the assessment of a significant financing component included by the staff in the agenda paper, the Board discussed the suggestion from one Board member that future cash flows should be discounted only if there is a significant financing component and the interest rate is not reasonable compensation. Another Board member disagreed noting that it would be very judgemental to start the assessment whith the question of whether there is a significant financing component rather than by assessing whether the regulatory agreement includes an explicit financing component, as recommended by the staff. The staff stressed that the assessment of whether the rate provided in the regulatory agreement is a reasonable rate aims at identifying both rates which are too low and rates which are too high.

Another Board member challenged whether the guidance should be limited to a requirement to take into consideration any significant financing component in the measurement of the cash flows and should remain silent on how to do so given that it can be extremely complex in practice to assess what a reasonable rate is. Others noted that the complexity could be reduced by filtering out the exceptions that require further assessment of the significant financing component rather than taking all timing differences through the full decision tree.

Another Board member asked the staff to consider whether it should be assumed that when the period of the timing difference is 12 months or less, there is no significant financing component. The Board member also challenged whether it would be appropriate to use the regulated entity’s borrowing rate to assess whether the regulated rate is a reasonable rate to use to discount the cash flows arising from assets. The staff suggested that guidance could be provided on the circumstances under which the borrowing rate woud be reasonable proxy (i.e. in a low-risk environment).

One Board member noted that an entity’s weighted average cost of capital (‘WACC’) can include risks, such as country risk for the local subsidiary of a wider group, that would not be taken into account by the rate regulator when agreeing the regulated interest and asked whether in such instances a loss would be recognised on day one or over time. The staff acknowledged that the answer would depend on the particular facts and circumstances, and that the WACC was viewed as a reasonable proxy.

The Board members discussed what would happen when there is an explicit financing component in the regulatory agreement and the entity assesses that the regulatory interest is a reasonable rate. In the staff’s view, the entity would not have to discount the cash flows in practice in such circumstances, because accruing and then discounting the estimated cash flows using the same rate would have no impact on the amount of the timing difference. Some Board members challenged whether this was correct as the amount of the timing difference is an estimate rather than an incurred amount.

Changes in estimated cash flows and interest or return rates

Board members agreed with the recommendation to apply IAS 8 requirements on changes in estimates.

One Board member stressed that when the regulatory rate is variable, whether the rate is a reasonable rate should be re-assessed. The application guidance should also clarify that instances where the rate regulator changes the rate or the compensation not in accordance with the framework agreement should be treated as modifications rather than changes in estimates, and whether changes in estimates also include upwards adjustments.

One Board member noted that the correction of previous “bad” or “wrong” estimates could impact the income statement significantly and therefore proposed that changes in estimates should be distinguished in the income statement from new amounts recognised. The staff agreed that specific disclosures would be required.

Decision

All Board members supported the recommendation that the model should apply the same measurement requirements for regulatory liabilities and regulatory assets. The Board supported all other staff recommendations with 13 to 1 votes, subject to (i) the development of further guidance to help entities assess which measurement method would provide the best outcome, (ii) consideration that not all timing differences would be subject to the thought-process developed to assess significant financing components.

Presentation and disclosure objective – education session (Agenda Paper 9C)

Staff analysis

In this paper, provided for educational purposes, the staff seeks comments from Board members on three topics: (a) the staff’s initial views on a high-level presentation and disclosure objective for the model; (b) exploring presentation formats for the statement(s) of financial performance; and (c) the staff’s initial views on some gross versus net presentation issues.

Staff’s initial views on a high-level presentation and disclosure objective

The staff suggests the following high-level presentation and disclosure objective for the model:

  • An entity shall present and disclose information that enables users of financial statements to assess and distinguish between:
    • fluctuations in revenue and expenses compensated for through the rate-adjustment mechanism; and
    • fluctuations in revenue and expenses for which there is no compensation.
    This information will be useful because it will allow users to assess the amounts, timing and uncertainty of future cash flows arising from regulatory assets and regulatory liabilities.

Exploring presentation formats for the statement(s) of financial performance

The Board tentatively decided that the unit of account of the model is the individual timing differences.  However, the staff believes that aggregating information relating to groups of timing differences for presentation and disclosure will help to provide understandable information in a clear and concise way. For example, regulatory assets and regulatory liabilities could be aggregated into groups that have similar risk characteristics and similar cash flow timing patterns in the statement of financial position.

The staff has found that the basis for aggregation/disaggregation of information in the statement(s) of financial performance is less straightforward and has therefore explored alternative presentation formats. The two presentation formats highlighted in the paper include the presentation of revenue, regulatory income/ (expense) and operating expenses as separate line items. In addition, in the second format regulatory interest income/ (expense) is presented in a separate line item from regulatory income/ (expense). The staff has also included an example of supplementary disclosures including a breakdown of the regulatory income/ (expense) total amount and a reconciliation of the carrying amounts of regulatory assets and regulatory liabilities at the start and end of each year.

Gross versus net presentation issues

The staff brings to the attention of the Board a couple of gross versus net presentation issues arising from interactions with other IFRS Standards.

IAS 20 Accounting for Government Grants and Disclosure of Government Assistance permits an entity to choose, when accounting for grants related to assets: (a) a net presentation approach; i.e. to deduct the grant in arriving at the carrying amount of the asset; or (b) a gross presentation approach; i.e. to recognise the asset at its full cost in accordance with IAS 16 Property, Plant and Equipment and recognise a grant liability.

The staff’s initial view is that the model should remove the net presentation option in IAS 20 for regulated entities applying the model to the acquisition or construction of assets that will be used to provide regulated services, in particular because the supplementary approach of the model requires the entity to recognise the construction cost of the asset in accordance with IAS 16, without modification, before applying the model.

The staff also considered an issue arising from transfer of assets from customers. In some regulated industries, such as utilities, an entity may receive from its customers or other parties (e.g. property developers) items of property, plant and equipment or, alternatively, cash contributions for the acquisition of construction of such assets. In such instances, the regulatory agreement deducts the contribution from the regulatory carrying amount of the asset. In the past, a divergence had arose with some entities recognising the transferred item at a cost of nil (similar to the net presentation approach of IAS 20) and some recognising it at fair value (a gross presentation approach). The publication in 2009 of IFRIC 18 Transfer of Assets from Customers, which has since been withdrawn as a consequence of issuing IFRS 15 Revenue from Contracts with Customers, had aimed to reduce this divergence by requiring entities to apply a gross presentation approach.

The staff’s initial view is that, to enhance consistency and comparability, the model should also require entities to use a gross presentation approach. The staff will conduct more research and outreach to consider this issue further before bringing a more detailed analysis to the Board.

Discussion

The Board discussed the disclosure objective and disclosure requirements, noting in particular that the model supplements the requirements of other Standards, and therefore disclosures would come in addition to those prescribed by IFRS 15 in particular.

Decision

No decisions were made.

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