Many governments establish regulatory mechanisms to govern pricing of essential services such as electricity, water, transportation, etc. Such mechanisms endeavour to maintain a balance between protecting the consumers from unreasonable prices and allowing the providers of the services to earn a fair return. These rate-regulation mechanisms result in significant accounting issues for service providers.
Company X, the owner of electricity transmission infrastructure and related assets, has been licensed for twenty years to operate a transmission system in a particular jurisdiction. Only one operator is authorised to manage and operate the transmission system. Company X charges its customers for access to the network at prices that must be approved by the regulator. Pricing structures are defined in the law and related guidelines, and are determined on a ‘cost plus’ basis that is based on budget estimates. Once approved, prices are published and apply to all customers. Prices are not negotiable with individual customers. Prices are set to allow Company X to achieve a fair return on its invested capital and to recover all reasonable costs incurred. At the end of each year, Company X reports to the regulator deviations between the actual and budgeted results. If the regulator approves the differences as ‘reasonable costs’, they are included in the determination of rates for future periods. The key question is that, can an entity recognise this difference which it would attempt to recover through rates for future periods as assets and liabilities?
To deal with this issue, the International Accounting Standards Board (IASB) was working on the proposed IFRS for Rate Regulated Activities. Though the IASB paused its project, the ICAI recently issued the Guidance Note on Accounting for Rate Regulated Activities (GN). It is stated that the GN will apply both under the Indian GAAP and IFRS-converged standards (Ind-AS). Since the GN is still to be cleared by the National Advisory Committee on Accounting Standards (NACAS), the ICAI has not announced its applicability date. The GN applies to those activities of an entity which meet both of the following criteria:
(i) The regulator establishes the price the entity must charge its customers for the goods or services the entity provides, and that price binds the customers.
(ii) The price established by regulation (the rate) is designed to recover the specific costs the entity incurs in providing the regulated goods or services and to earn a specified return (costof- service regulation). The specified return could be a minimum or range and need not be a fixed or guaranteed return. The GN defines the ‘costof- service’ regulation as ‘a form of regulation for setting up an entity’s prices (rates) in which there is a cause-and-effect relationship between the entity’s specific costs and its revenues.’ However, the GN does not deal with regulatory mechanisms which prescribe rates based on targeted or assumed costs, such as industry averages, rather than the entity’s specific costs.
GN acknowledges that the rate regulation of an entity’s business activities creates operational and accounting situations which would not have arisen in the absence of such regulation. With cost-ofservice regulation, there is a direct linkage between the costs that an entity is expected to incur and its expected revenue as the rates are set to allow the entity to recover its expected costs. However, there can be a significant time lag between incurrence of costs by the entity and their recovery through tariffs. Recovery of certain costs may be provided for by regulation either before or after the costs are incurred. Rate regulations are enforceable and, therefore, may create legal rights and obligations for the entity.
The GN requires an entity to recognise regulatory assets and regulatory liabilities. Regulatory assets represent an entity’s right to recover specific previously incurred costs and to earn a specified return, from an aggregate customer base. Regulatory liabilities represent an entity’s obligation to refund previously collected amount and to pay a specified return. The following paragraphs explain the reasons provided in the GN for recognition of rate regulated assets and liabilities.
(1) The Framework, defines an ‘asset’ as follows: “An asset is a resource controlled by the enterprise as a result of past events from which future economic benefits are expected to flow to the enterprise.” In a cost-of-service regulation, the resource is the right conferred by the regulator whereby the costs incurred by the entity result in future cash flows. In such cases, incurrence of costs creates an enforceable right to set rates at a level that permits the entity to recover those costs, plus a specified return, from an aggregate customer base. For example, if the regulator has approved certain additions to be made by the entity in its assets base during the tariff period, which would be added to the asset base for tariff setting, the entity upon making such additions obtains the right to recover the costs and return as provided in the regulatory framework though the actual recovery through rates may take place in the future. While adjustment of future rates is the mechanism the regulator uses to implement its regulation, the right in itself is a resource arising as a result of past events and from which future cash inflows are expected.
(2) The cause-and-effect relationship between an entity’s costs and its rate-based revenue demonstrates that an asset exists. In this case, the entity’s right that arises as a result of regulation relates to identifiable future cash flows linked to costs it previously incurred, rather than a general expectation of future cash flows based on the existence of predictable demand. The binding regulations/orders of the regulator for recovery of incurred costs together with the actual incurrence of costs by the entity would satisfy the definition of asset as per the Framework since the entity’s right (to recover amounts through future rate adjustments) constitutes a resource arising as a result of past events (incurrence of costs permitted by the regulator for recovery from customers) from which future economic benefits are expected to flow (increased cash flows through rate adjustments).
(3) As regards the ‘control’ criterion in the definition of an asset as per the Framework, it may be argued that though the entity has a right to recover the costs incurred, it does not control the same since it cannot force individual customers to purchase goods or services in future. In this regard, it may be mentioned that the rate regulation governs the entity’s relationship with its customer base as a whole and therefore creates a present right to recover the costs incurred from an aggregate customer base. Although the individual members of that group may change over time, the relationship the regulator oversees is between the entity and the group. The regulator has the authority to permit the entity to set rates at a level that will ensure that the entity receives the expected cash flows from the customers’ base as a whole. Further, the Framework states that control over the future economic benefits is sufficient for an asset to exist, even in the absence of legal rights. The key notion is that the entity has access to a resource and can limit others’ access to that resource which is satisfied in case of the right provided by the regulator to recover incurred costs through future rate adjustments. Any issues regarding recoverability of the amounts should not affect the recognition of the right in the financial statements though they certainly merit consideration in its measurement.
4. The Framework defines a liability as ‘a present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.’ In cost-of-service regulation, an obligation arises because of a requirement to refund to customers excess amounts collected in previous periods. In such cases, collecting amounts in excess of costs and the allowed return creates an obligation to return the excess collection to the aggregate customer base. For example, if the tariffs initially set assume a certain level of costs towards energy purchased but the actual costs incurred by the entity are less than such assumed levels, the entity would be obliged to make a refund following the ‘truing up’ exercise by the regulator. Such obligation is a present obligation relating to amounts the entity has already collected from customers owed to the entity’s customer base as a whole, not to individual customers. It is not a possible future obligation because the regulator has the authority to ensure that future cash flows from the customer base as a whole would be reduced to refund amounts previously collected. The obligation exists even though its amount may be uncertain. An economic obligation is something that results in reduced cash inflows, directly or indirectly, as well as something that results in increased cash outflows. Obligations link the entity with what it has to do because obligations are enforceable against the entity by legal or equivalent means.
Potential inconsistency with Framework
The IASB has been working on proposed IFRS for Rate Regulated Activities, since 2008. It issued an exposure draft of proposed IFRS in July 2009; however, it has not been finalised till date and the project has been paused. One key reason for the delay arises from strong view that regulatory assets and regulatory liabilities do not meet the definition of an asset and liability under the IASB Framework for Preparation and Presentation of Financial Statements. The proponents of this view make the following arguments:
1) One of the essential characteristics of a regulatory regime is that entities entering it get access to a large customer base in a market that requires a significant investment in infrastructure (i.e., natural ‘barriers to access’). In return, the entity agrees to accept the ‘economic burden’ of having to comply with operating conditions, one of which is the requirement to have the prices of the goods or services it delivers approved by the regulator. This ‘economic burden’ does not lead to a recognisable liability on day one, but may require the recognition of a liability if it leads to contracts becoming onerous as defined by AS-29 Provisions, Contingent Liabilities and Contingent Assets. Under Indian GAAP, any price paid to receive the right to operate in this regulated market will meet the definition of an intangible asset. However, if the regulator allows an entity to increase its future prices, this is not creating a separate asset, but granting the entity relief from the ‘economic burden’ of its operating conditions to put them partly in the same position as an entity in an unregulated market and allowing them to generate a normal return.
2) A cause-and-effect relationship between a cost incurred and future rate increases may not be sufficient enough to justify the recognition of an asset, as this would apply to every entity reconsidering price setting for future periods based upon current year’s performance. For example, Widget Limited (the company) is
‘widget maker.’ It is not involved in rate regulated activity and does not have one-to-one contract with customers. The company is a dominant market participant having some monopolistic features. The company believes that it has incurred too many raw material costs in the current period. The company may make business decision to increase the price for transactions beginning the next year. The question is whether it is appropriate to recognise the incremental increase in sales price multiplied by the expected volume of sales for next year given that the link/reason the dominant market participant increased its price was because this year’s costs were too high (and therefore this year’s ‘reasonable profit’ expected by equity holders was not achieved).
3) To support recognition of regulatory assets/ liabilities, the GN argues that the regulator negotiates rates on behalf of the whole customer base and a regulated entity therefore is comparable to an entity negotiating future prices with a specific customer, thereby binding both the entity and the customer. However, the contrary view is that rate regulation is a condition of the entity’s entry into the regulated market (i.e., a condition of the operating license) and does not create a separate asset. The entity has control over the right to operate in the regulated market, not over the future behaviour of its customers. Since the regulator did not guarantee the future recovery of any costs incurred, an asset controlled by the entity is not being created.
The Framework for Preparation and Presentation of Financial Statements under Indian GAAP is similar to that under IFRS. Therefore, one may argue that the GN is not in accordance with the Indian Framework, which is the base document and serves as a guiding principle in drafting of standards.
Conclusion
Whilst the author does not believe that the existing asset and liability definitions are met, one can understand why the standard-setter considered the recognition of regulatory assets and regulatory liabilities for entities that meet certain conditions, to provide decision-useful information. The author believes that the only way this can be done under the existing Framework is to state that the proposals in the GN are a departure from the Framework, and to provide clear guidance on the scope of the standard and to prohibit analogising. While all entities have the right to increase or decrease future prices, regulated entities have the following characteristics to justify a departure from the Framework: (a) Their prices and operational decisions are restricted and governed by the law and require regulatory approval.
The economic impact of the regulation is to ensure that the regulated entity earns a specified return. (c) As noted in the GN, the regulator does act on behalf of the aggregate customer base with respect to price. Most importantly, the author believes a departure from the Framework is justified because the requirements would result in financial information that presents the economic effects of the regulation — that the entity will achieve a specified return.
A perusal of publicly available Indian GAAP financial statements of few companies engaged in power distribution indicates that they have recognised regulatory assets/ regulatory liabilities. From an Indian GAAP perspective, the Guidance Note is not expected to have any significant impact on these companies and would not change anything (other than legitimising current accounting practice). Therefore the author believes that the standard-setters should not have issued the Guidance Note in the first place and should actively participate in the ongoing effort of the IASB in developing a global standard for rate regulation.
