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Rate-regulated activities

Date recorded:

Cover Note (Agenda Paper 9)

This session was an education session at which the staff asked the Board for any suggestions to improve the understanding and clarity of the model that has been developed thus far. The Board is also asked whether any further analysis is required from the staff in respect of any of the topics discussed during this session. The Board was not asked to make any decisions.

Principles of the model: a summary (Agenda Paper 9A)

The purpose of this paper was to provide some background as to why the Board is developing an accounting model for regulatory assets and regulatory liabilities arising when an entity subject to defined rate regulation supplies goods and services and a summary of the principles that are underlying in the model.

In defined rate regulation the regulatory framework establishes a binding regulatory agreement through which the entity has a right to supply specified goods or services and charge a rate that is designed to compensate the entity for the goods or services with the aim of making it viable for the entity to fulfil specified requirements for quality, quantity and availability of supply of the goods and services.

The regulatory agreement establishes the total allowed compensation that the entity is entitled to charge to the customers for goods or services supplied during the period. It also determines in which periods that total allowed compensation is included in the rate charged to customers. Sometimes, the regulatory agreement includes some of the total allowed compensation in the rate charged to customers in a period that differs from the period when the goods and services are supplied. This causes timing differences that will be trued up later.

Variances between the estimated and actual amounts used in the rate calculation that are at the risk of customers and that exist at the end of an entity’s reporting period create rights or obligations for the entity to adjust the future rate charged to the customers as a result of goods or services already supplied. These rights and obligations are incremental to those reported applying IFRS 15 Revenue from Contracts with Customers. Although the adjustments to a future rate will give rise to incremental future cash flows, the right or obligation to make that adjustment does not give the entity the right to receive cash or the obligation to pay cash and is therefore not a financial instrument within the scope of IFRS 9 Financial Instruments. However, not recognising these incremental rights as assets and incremental obligations as liabilities gives users of financial statements incomplete information about an entity’s financial position and financial performance.

The staff developed a model whose purpose it is to supplement the information provided by IFRS 15 and other IFRS Standards. The core principle of the model is that an entity recognises regulatory assets (right to add an amount to a future rate), regulatory liabilities (obligation to deduct an amount from a future rate) and regulatory income or expense (the movement between opening and closing balances of regulatory assets and liabilities).

Board discussion

Board members were generally supportive of the description of the model’s principles described in Agenda Paper 9A and appreciated the clarifications and changes in wording proposed by the staff. 

One Board member noted that the Board should discuss issues brought by the duration and renewal of regulatory agreements in the future.

The Board discussed situations when there is a difference between the timing of depreciation of a property, plant and equipment (PP&E) asset and the time the regulatory agreement allows to include the expense in the rate charged to customers. For example, if two entities use different patterns of depreciation but are compensated in the same way, they would have different amounts of regulatory assets and liabilities on the balance sheet.  The staff noted that in such instance the two entities would also have a different PP&E balance and accordingly the overall picture would be the same. The staff was asked to clarify that the depreciation reflects the pattern of consumption of the asset.

Several Board members wanted a clarification of what is meant by “goods or services supplied during the period”. The staff noted their intention to have a wide interpretation, which would include not only the goods directly delivered to customers (e.g. water, electricity) but also wider services provided (e.g. providing a 24 hour access to the utility network). Board members also noted that there may be costs that are expensed in the period and do not relate to goods or services actually delivered to customers but would still be allowed in the total compensation that the entity is entitled to charge to customers. The staff clarified that if costs recognised as an expense in the current period are allowable under the regulatory agreement, the presumption is that they relate to goods or services provided in the period. The staff will review the wording used to clarify this point.

Two Board members raised concerns over the staff’s suggestion that the model should not describe the unit of account as ‘individual timing differences’. They noted that although there may be practical reasons for grouping individual items for measurement, presentation and disclosure purposes, this does not impact the Board’s tentative decision that that the model should use the individual timing differences that create the incremental rights and obligations arising from the regulatory agreement as its unit of account.

No decisions were made.

Scope and recognition principles (Agenda Paper 9B)

The paper sets out the Board’s tentative decisions with regards to the scope and recognition principles of the model described in Agenda Paper 9A and asks the Board whether it continues to find these decisions appropriate.

The paper then introduced two new topics for the Board to consider: derecognition and fines.

The staff’s preliminary view was that a regulatory asset or liability would be derecognised when an entity recovers part or all of a regulatory asset or fulfils part or all of a regulatory liability.

When a fine is imposed by the regulator, or another government body, the obligation is typically recognised as a liability until payment if the recognition requirements of IAS 37 Provisions, Contingent Liabilities and Contingent Assets are met. Even if the fine is deducted from future rates, the staff are of the view that an entity recognises a liability for the obligation to pay the fine. The staff recommend the Board extend the definition of the model’s definition of a regulatory liability that would include obligations to deduct fines from the future rate and introduce guidance clarifying that an entity applies the requirements in IAS 37 to the recognition of fines.

Board discussion

One Board member asked the staff to clarify in the definitions of regulatory asset and regulatory liability that the “rate(s) to be charged to customers in future periods” means the “rate(s) to be charged to customers in future periods for future deliveries of goods or services”.

Regarding the staff’s proposal to require recognition of a present obligation for fines which will be settled through the deduction of the amount from the rates to be charged to customers in future periods, some Board members noted that an example would be more useful than a requirement given that the principles in IAS 37 and the regulatory model appropriately address the issue. Board members also noted that if fines are imposed on an entity and benefit the customers rather than the society as whole (because they are deducted from the rates to be charged to customers), it should be assumed that they are part of the total compensation.

No decisions were made.

Measurement principles (Agenda Paper 9C)

The model uses a cash flow-based measurement technique that would require an entity to estimate the future cash flows arising from regulatory assets or regulatory liabilities, updating those estimates if change occur. These estimated future cash flows are discounted, keeping the discount rate established at initial recognition unchanged, unless the regulatory agreement changes the future cash flows by changing the interest rate or return rate.

When measuring a regulatory asset, the starting point is to identify the amount that will be added to future rate(s), because the total allowed compensation for goods or services already supplied exceeds the amount already charged to customers for those services. The model requires an entity to estimate future cash flows arising from each regulatory asset recognised using either the ‘most likely amount’ method or the ‘expected value’ method. The entity would also consider the risks associated with those cash flows. Estimated cash flows would be updated at each reporting date.

Once an entity has estimated the amount and timing of the future cash flows arising from a regulatory asset, the entity would then consider the effects of the time value of money and risks inherent in the cash flows between the time the regulatory asset or regulatory liability comes into existence and it is recovered or fulfilled through the future rate(s) charged to the customer. The interest rate or return rate to reflect the time value of money is typically reviewed intermittently and updated to reflect changed circumstances.

When measuring regulatory liabilities, the entity applies the same requirements for the estimation of future cash flows as for regulatory assets. As regards the interest rate or return rate, the rate should be adequate to sufficiently charge the entity for the time value of money and risks inherent in the cash flows.

In terms of describing the measurement basis, the staff suggest to specify the measurement basis that the model’s cash flow-based measurement technique applies, as a modified historical cost measurement basis (modified to updated it for changes in estimates of future cash flows).

Board discussion

The Board discussed the risks that an entity would consider when estimating future cash flows. The following observations were made:

  • The uncertainty over whether certain costs are allowable or not under the regulatory agreement should also be taken into consideration.
  • One Board member considered that any significant uncertainty about the outcome of the regulatory rate approval process should be taken into account when estimating cash flows, rather than through a premium to the discount rate.
  • One Board member challenged the assumption that demand risk is typically low and questioned whether some impairment test would be necessary when that is not the case. The staff did not favour this approach, noting that the most likely amount or expected value that will be used to estimate the cash flows take into consideration the risks to which the entity is exposed and additional disclosures around those will be required. One Board member noted the need for the Basis for Conclusions to comment on the reason for not having specific requirements in relation to demand risk.

The Board also discussed the recommendation not to require discounting of the estimated cash flows if the effects of the time value of money and risks inherent in the cash flows are not significant. It should be clarified whether this requirement is (i) an absolute practical expedient, or (ii) allowed as long as the entity has a reasonable basis to consider that the effects are not significant, or (iii) allowed if the entity can prove that the effects are not material.

Board members discussed the need to complement the description of “typical” transactions and circumstances in the model with references to the objectives and principles that the model is trying to achieve in order to cover a wide range of situations and avoid a rule-based approach.

The staff confirmed that there could be situations in which an entity is required to calculate an implicit regulatory rate of return. This question will be addressed at a later stage.

One Board member disagreed with the staff’s assertion that an excess charge on a time band with a net liability position would be rare. They also asked to consider when determining whether a regulatory liability is onerous as to whether the same rate applies to an entity’s regulatory assets and liabilities.

One Board member wanted a stronger rationale to describe the measurement basis as a modified historical cost measurement basis than currently presented by the staff, while another agreed with the assessment although noted that they would not describe the basis as “modified”.

The staff recommended in December 2018 that regulatory assets and regulatory liabilities that relate to expenses or income that will be included in/deducted from the future rate(s) when cash is paid/received should be measured at the same amount as the underlying liability or asset. Board members expressed mixed views during that meeting. The staff has now clarified that such approach is an exception to the measurement approach used in the model for all other regulatory assets and liabilities. As a result, the staff intends to ask the Board to reconsider this recommendation. Board members welcomed this clarification and the proposed future discussion. Some members noted the need for a cost-benefit assessment to find the right balance between the need for transparency to the users of financial statements and the operational costs to preparers.

No decisions were made.

Summary of tentative decisions made to date (Agenda Paper 9D)

This paper was provided for information purposes only and summarised the Board’s tentative decisions to date and outlined staff views on the consistency of those decisions with the refined description of the model in Agenda Papers 9A–C.

There was no discussion on this paper.

Rate-regulated Activities: principles of the model—how the description has evolved (Agenda Paper 9E)

This paper was provided for information purposes only and outlined the refined principles summarised in Agenda Papers 9A–C using a slide presentation.

There was no discussion on this paper.

Rate-regulated Activities: examples of the model’s application (Agenda Paper 9F)

This paper was provided for information purposes only and contained numerical examples illustrating the application of the model’s principles.

There was no discussion on this paper.

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