Rate-regulated Activities (Agenda Paper 9)

The purpose of the meeting is to provide additional analysis in response to questions raised at the May 2019 meeting and ask the Board for decisions on revised and new recommendations arising from this analysis, as well as to identify any further Board member’s concerns.

Next steps

The staff aim to ask the Board for permission to begin the balloting process for an exposure draft in Q3 2019, for an expected publication of the consultation document in Q1 2020.

Note: Agenda Papers 9A-C are based on Agenda Papers prepared for the May 2019 Board meeting. This summary covers only the additional material introduced for the June 2019 meeting.  

Principles of the model: a summary (AP 9A)

Background

For the purposes of identifying the total allowed compensation for the goods or services already supplied, the staff clarify that, as well as direct supply of goods or services to customers, the goods or services supplied encompass other activities that are also contemplated in the regulatory agreement. These include satisfying other government objectives (e.g. reducing greenhouse gases) or standing ready to repair damage to the network and restore services to customers after storms or other contingent events.

Concerning the period when those goods or services are supplied, the staff note that allowable expenses relating to the direct supply of goods or services to customers clearly relate either to goods or services already supplied or to goods or services to be supplied in the future. Consequently, their impact on the total allowed compensation for the goods or services already supplied is also clear.

For other allowable expenses indirectly attributable to the supply of goods or services, it may be less clear in which period those goods or services are supplied. In such cases, an entity needs to determine whether an allowable expense is part of the total allowed compensation for goods or services already supply or for goods or services to be supplied in the future.

For presentation or disclosure purposes, the model allows individual timing differences to be aggregated. For recognition and measurement purposes, the Board tentatively decided that the unit of account is the individual timing differences that create the incremental rights and obligations. However, the staff consider that including a general statement that the unit of account is individual timing differences would not be helpful. This is because the Board has already specified the appropriate unit of account for all particular decisions that require it. In addition, the staff do not believe it would be easy or useful to define ‘individual timing differences’.

Board discussion

Because the Board has decided that the model would use as its unit of account the incremental rights and obligations arising from individual timing differences, most Board members considered that the Exposure Draft should include a general statement to that effect, noting that this tentative decision could be reversed later depending on the comments received.

Board members also discussed the refined definition of goods or services supplied. It was clarified that the definition encompasses past work performed to “repair damage to the network and restore services to customers after storms or other contingent events” rather than simply “standing ready” to provide such services. Two Board members thought that some material should be included in the basis for conclusions to discuss how the Board arrived at the wider definition, and what its implications are when determining whether there is a regulatory adjustment.

Staff recommendation and Board decision

The staff recommend that the model does not include a general statement that the unit of account is individual timing differences. [Rejected: 11:3]

Scope, definitions of regulatory assets and liabilities, recognition and derecognition (AP 9B)

Background

The staff propose to revise the following definitions:

• Scope criteria: the model applies to defined rate regulation established through a formal regulatory framework that (a) is binding on both the entity and the regulator; and (b) establishes a basis for setting the rate that gives rise to rights to add amounts to, and obligations to deduct amounts from, future rate(s) because of goods or services already supplied or because of amounts already charged to customers. That basis gives rise to those rights and obligations by determining when (i.e. in which periods) the total allowed compensation for specified goods or services supplied is included in the rate(s) charged to customers.
• Regulatory asset: the present right to add an amount to the rate(s) to be charged to customers in future periods because the total allowed compensation for the goods or services already supplied exceeds the amount already charged to customers.
• Regulatory liability: the present obligation to deduct an amount from the rate(s) to be charged to customers in future periods because the total allowed compensation for the goods or services already supplied is lower than the amount already charged to customers.

As noted in Agenda Paper 9A, the staff proposes to clarify that when the regulatory agreement includes an expense or item of income in the calculation of the rate, that expense or income is presumed to form part of the total allowed compensation. Consequently, if a fine imposed on an entity will be ‘paid’ through a deduction from the determination of the future rate charged to customers, it is presumed to relate to the total allowed compensation already charged for the goods or services supplied during the period in which the entity carried out the action triggering the fine. The staff therefore think that the obligation to ‘pay’ the fine is captured within the definition of a regulatory liability and no specific requirements need be developed, although a reference to such fines in explanatory guidance would be helpful.

The staff does not propose any changes to the tentative decisions made in relation to recognition, nor the development of any further requirements for derecognition of regulatory assets and liabilities.

Board discussion

Board members welcomed the revised definitions. The model will not apply to two-party agreements that may have similar rights and obligations to a regulatory agreement (e.g. between a manufacturer and wholesaler) but do not involve a regulator. One Board member wanted the Standard to clarify the distinction between price regulation and rate regulation—unlike price regulated entities, obligations are imposed on risk-regulated entities. Although this does not need to be part of the scope criteria, this should be brought out.

Staff recommendations and Board decisions

The staff recommend that:

• a) The Board updates its previous tentative decisions about the scope criteria and the definitions of regulatory assets and liabilities to reflect refined descriptions. [Approved: 14:0]
  
• b) Explanatory guidance about the meaning of total allowed compensation for goods or services supplied include a reference to fines payable through the rate(s), but there is no need to develop separate requirements for these fines. [Approved: 14:0]
  
• c) The Board retain its previous tentative decisions about recognition.
• d) No further requirements need to be developed for derecognition of regulatory assets and liabilities. [Approved: 14:0]

Measurement principles (AP 9C)

Background

The paper includes additional information to support the views previously affirmed by the staff that:

• there should be no distinction between regulatory assets and liabilities treated by the regulatory agreement as part of the regulatory capital base (RCB) and those treated as operating items;
• the measurement technique should be described as a modified historical cost measurement basis; and
• regulatory assets or liabilities that relate to expenses or income that will be included in/ deducted from the future rate(s) when cash is paid/ received, including those arising from deferred tax liabilities/assets, should be measured at the same amount as the related liability or asset, as an exception to the general measurement approach used in the model.

The staff also clarify that the risks to which the amount and timing of cash flows resulting from regulatory assets and liabilities include demand risk, customer credit risk, non-performance risk and regulatory risk.

Board discussion

Board members discussed regulatory risk, noting that if that risk was very high, this could mean that the regulatory agreement is not in scope of the model because it cannot be shown that it is binding the regulator. For this reason, one Board member wanted to move the guidance included in paragraph 26 of the Agenda Paper on the characteristics of the broader regulatory framework to the supporting guidance on scope definition.

Board members agreed that the measurement technique is a historical cost measurement basis, although a minority believed it should not be described as a “modified” basis.

The Board welcomed the analysis that for some regulatory assets and regulatory liabilities, expenses or income will be included in or deducted from future rate(s) when cash is paid or received, but the related liabilities and assets will be recognised and measured using requirements in other IFRS Standards. Some board members noted that this created an exception from the model and a difference with IFRS 15, and therefore the rationale for this decision should be clearly explained. One Board member also wanted the guidance to include practical examples showing how this requirement would be applied over a longer term of 4 to 5 years.

Staff recommendations and Board decisions

The staff recommend to:

• a) measure all regulatory assets and liabilities, except those covered in (c) below by:
  • (i) considering all the estimated future cash flows arising from the regulatory assets, including the cash flows relating to the regulatory interest or return; and
  • (ii) discounting the estimated future cash flows using the regulatory interest or return rate unless there is any indication that the regulatory interest or return rate is not adequate;
    [Approved 14:0]
• b) describe the measurement basis as a modified historical cost measurement basis; and [Approved 11:3] and
• c) measure regulatory assets and liabilities that relate to expenses or income that will be included in/deducted from the future rate(s) when cash is paid/received by:
  • (i) using the same measurement basis that the entity uses when measuring the related liability or asset; and
  • (ii) adjusting the measurement of the regulatory asset or liability to reflect any risks that are not present in the related liability or asset.
    and [Approved 11:3]
    

Measurement: discounting estimated cash flows (AP 9D)

Background

The staff suggest removing the practical expedient that would allow entities not to discount if the effects of the time and risks were not significant, as it imposed an additional layer of assessment upon entities.

The staff also analyses the process an entity should follow to assess whether the rate of interest or return is adequate: an entity should first seek to understand the process the regulatory agreement has followed to derive the rate applicable to each time band. If, as a result of this understanding, the entity has a valid expectation that the rate provides adequate compensation, it would recognise the interest or return over time at that rate. If there is an indication that the rate is not adequate, the entity should establish the minimum rate that it determines would be necessary to compensate it for the time and risks specific to the cash flows of the regulatory asset. If the rate provided is less than this minimum adequate rate, the entity measures the regulatory asset at its present value using the minimum adequate rate to discount the expected cash flows and thereafter recognises interest income at that same rate. If the rate provided is greater than the miminum adequate rate, the entity uses the rate provided by the regulatory agreement as the discount rate.

If the rate provided is set a level that provides excess compensation (charge) for an identifiable transaction or event, the entity recognises a regulatory asset (liability) for the excess compensation (charge) arising from the identifiable transaction or event in the relevant period.

The paper also clarifies that if the regulatory agreement changes the rate of interest or return, an entity updates the discount rate it uses to measure the regulatory asset or liability. This would not result in a change to the carrying amount of the regulatory asset, except if the change causes the return to no longer be adequate (in which case, the entity would recognise a partial disallowance as noted above).

Board discussion

Some Board members would have liked the suggested practical expedient to be included in the Exposure Draft in order to collect feedback from stakeholders on whether this would simplify or add complexity to the model.

Most Board members agreed with the practical approach recommended by the staff to include an indicator-based adequacy assessment in the model to determine whether the regulatory interest rate or return rate is adequate, noting that it would be impossible to identify the exact correct rate. Two Board members disagreed on the basis that such an approach was inappropriate and unnecessary. They do not believe that gaining an understanding of the regulatory process would provide information on whether the rate is adequate or not for financial reporting purposes given that regulators want to protect the financial viability of regulated entities, whereas this objective should not be taken into account when determining the adequate rate. In addition, they noted that doing an adequacy assessment for each time band would not be onerous given that the number of time band is expected to be limited.

On the measurement of regulatory liabilities, one Board member wanted the basis of conclusions to highlight that instances where an excess charge on a net regulatory liability position to be rare. Otherwise there could have an onerous liability.  

Staff recommendations and Board decisions

The staff recommend that the model does not include:

• a separate step that requires an entity to assess whether the effects of the time value of money and risks inherent in the cash flows are significant; [Approved: 14:0] and
• a practical expedient that would avoid the need for discounting if the effects of the time and risks were not significant. [Approved: 14:0]

The staff recommend that the model:

• applies an indicator-based approach to assessing whether the regulatory interest rate or return rate is adequate and includes guidance on indicators to consider in making that assessment; [Approved: 12:2]
• specifies that the minimum adequate rate is one that the entity would expect to receive for a stream of cash flows with the same timing and uncertainty as those of the regulatory asset; [Approved: 12:2] and
• requires initial and subsequent measurement using the minimum adequate rate when an entity concludes that the rate of interest or return provided by the regulatory agreement is inadequate. [Approved: 12:2]
• applies the same measurement requirements for regulatory liabilities as for regulatory assets, i.e. requires measurement of regulatory liabilities to employ a discount rate equal to the rate of interest or return provided by the regulatory agreement, except in the limited circumstance where that rate reflects the impact of an identifiable event or transaction, the impact of which should be recognised separately. [Approved 14:0]

Presentation and disclosure (AP 9E)

Background

The staff considered two approaches to presenting regulatory income/expense that arises when related income or expense is presented in other comprehensive income (OCI):

• (i) present it in OCI so that the regulatory income/expense and the related income or expense are both presented outside profit or loss; or
• (ii) present it in profit or loss immediately below revenue, like all other regulatory income/expense (tentatively decided by the Board in November 2018).

The staff favour the former approach because it gives users of financial statements clearer and more understandable information without imposing two much costs. Consequently, if the expense or income presented in OCI in accordance with other IFRS Standards is subsequently reclassified to profit or loss, the related regulatory income/expense is also reclassified.

The staff are also asking the Board to prescribe that any interest or return accrued on regulatory assets or liabilities be disclosed as a separate caption in the breakdown of regulatory income/expense or in the reconciliation of opening/closing balances, and not be combined with the originations captions or the recovery or fulfilment captions. In the staff’s view, the benefits of this additional granularity outweigh the costs because entities commonly disclose interest amounts separately from the amounts on which the interest accrues for other types of assets and liabilities.

Board discussion

Board members were divided on whether to present regulatory income/expense that arises when related income or expense is presented in OCI (i) in OCI (‘approach 1’), or (ii) in profit or loss with other regulatory income/expense (‘approach 2’). Such related income or expense includes items in relation to pensions (expected to be a common situation), cash flow hedging (less common) and foreign exchange.

Proponents of approach 2 noted that this approach would be clearer as it would enable users of the financial statements to calculate total revenue adjusted for regulatory income/expense by simply adding the two line items in revenue. They also thought it would be simpler to apply in practice, and given that such items may be infrequent and/or immaterial, preferable. In addition, they considered that this approach better reflects the supplemental approach to IFRS 15 taken by the model.  They also thought that under approach 1, regulatory items presented in OCI would be recycled through revenue in future periods once billed, whereas the related income or expense is not always be recycled (e.g. for pensions accounted for under IAS 19).

Proponents of approach 1 noted that it would avoid creating additional accounting mismatches. The staff also highlighted that no feedback has been received so far that this approach would not be operationally feasible.

Board members did not have any comments on the staff’s recommendation in relation to the disclosure of regulatory interest or regulatory return.

Staff recommendations and Board decisions

The staff recommend that:

• d) An entity should present:
  • (i) in OCI all regulatory income/ expense related to items of expense or income presented in OCI, and present them immediately above or below the related expense or income; and
  • (ii) in profit or loss all other regulatory income/expense, immediately below the line item(s) for revenue.
    [Approved: 8-6]
    
• e) An entity should disclose any regulatory interest or regulatory return accrued on regulatory assets or liabilities as a separate caption in:
  • (i) the breakdown of regulatory income/expense for the period; or
  • (ii) the reconciliation of the carrying amounts of regulatory assets and of regulatory liabilities from the beginning to the end of the period.
    [Approved: 14-0]
    

Rate-regulated Activities: US GAAP comparison (AP 9F)

This paper summarises the similarities and differences between the proposed model and US GAAP requirements.  

The staff note that in both models:

• the objective is to reflect the economic effects on financial reporting of timing differences caused by rate regulation;
• uncertainty regarding recovery can call into question whether an entity should apply either model;
• a binding regulatory agreement is present;
• regulatory assets are consumed as the amounts are recovered through the rates; if recovery is no longer probable the amount is written-off;
• explicit and implicit disallowances are recognised immediately.

Some of the differences highlighted by the staff include:

• The IFRS model involves a supplementary approach, the US GAAP model a cost deferral approach.
• The scope of the IFRS model focuses on the total allowed compensation an entity becomes entitled as a result of a regulatory agreement while the US GAAP model focuses on the ability to recover costs.
• When existence is uncertain, the IFRS model requires to recognise if ‘more likely than not’ that right or obligation exists, the US GAAP model generally only considers ‘incurred costs’ (with some exceptions) and requires to capitalise these if they are ‘probable’ of recovery through rates.
• The IFRS models require to measure at discounted estimate of future cash flows, the US GAAP model at amount of incurred costs with, in most scenarios, no resulting regulatory interest and no discounting.
• Presentation in the IFRS model is made as a separate line item below revenue, with no adjustment to revenue or expenses. The US GAAP model prescribes a net presentation (i.e. allowable expenses entitled to be included in future rates are netted off respective line item) and allows adjustments to revenue.

Board discussion

Board members welcomed the comparison, because the US GAAP model is currently the main model used throughout the world for rate-regulated activities. However, it was also noted that many countries have developed an approach or national GAAP that is specific to their own regulatory environment and, although based on US GAAP, is not a direct application of it. On that basis, several Board members considered that it was not necessary to perform any additional assessment of the impact of adopting the proposed model for entities that currently use a model derived from US GAAP. The staff also noted that the US GAAP model was developed for a “cost deferral” type of regulation, whereas the proposed model intends to captures incentive-based regulations as well. As such, it will be necessary to communicate with IFRS reporters to explain the differences. However, because costs incurred form a large part of the total allowed compensation in most regulatory environments, it is expected that the proposed model will deliver similar accounting outcomes in many cases. Any differences would most likely reflect differences in regulatory environments, and therefore differences in the economics of entities, rather than accounting differences.

The Board was not asked to make any decisions.

Rate-regulated Activities: summary of tentative decisions made to date (AP 9G)

This paper is provided for information purposes only, and summarises the Board’s tentative decisions to date and outlines staff views on the consistency of those decisions with the refined description of the model in Agenda Papers 9A–E.