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August 2009

GAPs in GAAP – Accounting for rate-regulated entities

By Dolphy D’Souza, Chartered Accountant
Reading Time 4 mins
Many governments regulate the pricing of essential services such as natural gas, water and electricity. The objective is to provide price protection to consumers while providing a fair return to the supplier. These regulatory mechanisms have created significant accounting issues under IFRS, which does not have any elaborate guidance on the subject. The accounting for rate-regulated entities is now on the agenda of the International Accounting Standards Board (IASB) and a separate project has been set up to deal with it.

Accounting practices :

    Regulators often set prices in advance, based on estimated volumes, cost and a target rate of return. At the end of the period, the regulator and the entity determine the actual volumes, cost and return. This will give rise either to a surplus that needs to be refunded to the customer or a deficit that needs to be recovered from the customer. This is done by way of future price adjustments. The question to be addressed is whether these assets and liabilities can be recognised within the IFRS framework.

    In India, for example a power supply company recognised these assets/liabilities with the corresponding impact being adjusted against revenue. The following disclosure was made : “The Company determines surplus/deficit (i.e., excess/shortfall of/in aggregate gain over Return on Equity entitlement) for the year in respect of its licence area operations (i.e., generation, transmission and distribution) based on the principles laid down under the (Terms and Conditions of Tariff) Regulation, 2005 notified by MERC (Maharashtra Electricity Regulatory Commission) and the tariff order issued by it. In respect of such surplus/deficit, appropriate adjustments as stipulated under the regulations are made during the year. Further, any adjustments that may arise on annual performance review by MERC under the aforesaid tariff regulations are made after the completion of such review.” In the absence of similar disclosures by other companies, it is difficult to know the extent to which regulatory assets and liabilities are recognised on Indian balance sheet.

Are these assets and liabilities ?

    This will be addressed by the IASB in the ED. In 2005, the International Financial Reporting Interpretations Committee (IFRIC) was asked to provide guidance on the subject. The IFRIC concluded that regulatory assets and liabilities can only be recognised if they qualify under the IASB’s Framework.

    The main argument against recognising these rights and obligations as assets and liabilities under IFRS is that their recovery or payment is based only on future sales, over which the entity has no control or present obligation. Only in situations where there is a guarantee given to the entity by the regulator would an asset exist; however, that may not be the case in India.

    The IASB staff have put forward many arguments supporting the recognition of certain rate regulated assets and liabilities. The IASB and the FASB (US Financial Accounting Standards Board) have agreed to remove the misunderstood notion of control and to focus the definition of an asset on whether the entity has some rights or privileged access to the economic resource.

    With respect to liability recognition, the IASB and the FASB agreed, that their current respective definitions overemphasise the need to identify both the specific past events and the future outflow of economic benefits. Instead, the definition should focus on the economic obligation that presently exists.

    When considering recognition issues, the Board will also need to consider whether an asset or liability can be recognised where the regulatory approval for the specific matter is anticipated but has not been formally received, as formal approval is obtained after recognition of the asset or liability, and can sometimes take years.

    Whatever standard is finally issued, an assessment of the facts and circumstances of each regulatory mechanism will be required, as each jurisdiction is unique. As a result, regulators should pay close attention to this project to understand how their mechanisms affect the results of the rate-regulated enterprises in their jurisdiction.

    It has been estimated that the US electricity industry alone has reported regulatory assets and liabilities of $ 675 billion and $ 450 billion, respectively in 2007. In India, the corresponding numbers could be a fraction, but would nevertheless be staggering, to make accounting of rate-regulated entities a high-priority accounting issue. Also, in India, there is no guidance on rate-regulated entities. With India adopting IFRS in 2011, the accounting for rate-regulated entities in the country would be dictated by the final outcome of the IASB project. As an interim measure the ICAI should provide some guidance.

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