TAX NEWS - DECEMber 2009

Regulatory assets and liabilities – is the debate over?

Accounting for rate-regulated activities has been much debated since 2005, when the International Financial Reporting Interpretations Committee (IFRIC) was first asked to provide guidance on the recognition of regulatory assets and regulatory liabilities under IFRS. Since then, there has been an ongoing discussion as to whether these assets and liabilities meet the criteria for recognition under IFRS. In July 2009, the IASB issued an Exposure Draft (ED) to address the issue. With the comment period now closed, an early look at the responses indicates that this debate is far from over. In this article, we share our views on the key aspects of the controversial proposals.


Are the asset and liability definitions met?

As a result of this debate, the IASB articulated within the ED the reasons why it believes the current asset and liability definitions have been met.


Asset and liability definitions within the Framework for the Preparation and Presentation of Financial Statements (Framework)

Asset: a resource controlled by an entity as a result of past events and from which future economic benefits are expected to flow to the entity

Liability: a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits


The IASB's primary argument in support of recognising of a regulatory asset is that the regulator acts on behalf of the aggregate customer base and that the resource is a promise by the regulator that the costs the entity incurs will result in future cash flows. In addition, the Board has stated that, in assessing if an entity controls the resource, the "key notion is that the entity has access to a resource and can limit others' access to that resource."

Similarly, the Board concluded that the regulators authority to ensure that future cash flows from the customer base as a whole will be reduced meets the definition of a liability. Furthermore, the Board concluded that, "an economic obligation is something that results in reduced cash inflows, directly or indirectly, as well as something that results in increased cash outflows."

We do not believe that the existing asset and liability definitions (noted above) have been met. When an entity enters a regulated market, it agrees to accept the 'economic burden' of having to comply with operating conditions, one of which is the requirement to have its prices set in accordance with the regulator's guidelines. We believe that the regulator's ability to increase or decrease prices in the future does not create assets and liabilities, but instead is granting the regulated entity relief from the 'economic burden' of its operating conditions.

In addition, we believe that the Board has prematurely incorporated concepts that are currently being discussed in the Conceptual Framework project. As discussed above, the Board is interpreting the term 'control' within the asset definition to mean that an entity has access to a resource and can limit the access of others to that resource, and that a reduced cash inflow is a liability. We believe that these interpretations represent fundamental changes to the asset and liability definitions that should be addressed in the Conceptual Framework project, not in this ED.

An early look at some of the comment letters reveals that we are not alone in this view. The Australian Accounting Standards Board stated it has "serious concerns that the way in which the IASB has proposed assets and liabilities arise from regulation is not consistent with IASB's Framework and other IFRSs". Conversely, many respondents have stated they believe the existing asset and liability definitions are met.


Should regulatory assets and regulatory liabilities be recognised?

While we do not believe the current asset and liability definitions have been met, we believe that the economic impact of regulation should be reflected in the financial statements of regulated entities. Therefore, we support the recognition of regulatory assets and regulatory liabilities as their recognition provides decision-useful information for investors and stakeholders. We believe that the operating conditions that regulated entities must abide by do have an economic and operational impact, which justifies a departure from the Framework. However, we believe that the IASB should state that the proposals represent a departure from the existing Framework or change the Framework. Without making this clear, we believe that application by analogy may result.


What type of asset and liability is it?

Another shortfall of the ED is the Board's failure to clearly explain what type of asset and liability the regulatory assets and regulatory liabilities are. We believe this question must be answered in order to determine whether the proposed measurement basis is appropriate. The Board has proposed that regulatory assets and regulatory liabilities be measured at 'expected present value', which involves estimating future cash flows for various outcomes and assigning a probability to each outcome, as well as the risk of uncertainty and the time value of money. We do not believe the proposed measurement method is appropriate as it is a measurement method that is not used anywhere else in existing IFRS. We have urged the IASB to specify in the final standard if they believe regulatory assets are financial assets, intangible assets or accrued revenue and if regulatory liabilities are financial liabilities, provisions or deferred revenue. This will then provide a basis to determine an appropriate measurement method to be applied. Many other respondents raised similar concerns.


Scope

We believe the scope of any final standard should be limited to regulation where the rates are set based on cost. The ED defines cost-of-service regulation as "a form of regulation for setting an entity's prices (rates) in which there is a cause-and-effect relationship between the entity's specific costs and its revenues." It also specifies that regulatory mechanisms that determine rates based on targeted or assumed costs, such as industry average, rather than the entity's specific costs, are not within the scope of the ED.

Many entities within regulatory regimes that determine rates based on industry averages would state that there is a 'cause-and effect' relationship between their individual costs and the industry average as their individual costs would be an input factor to determine industry average rates. In addition, many hybrid and incentive based regulation schemes share similar characteristics with basic cost-of-service regulation and can often have the same economic effect. It is therefore unclear exactly where the boundary is to be drawn in determining if a particular activity is considered 'cost-of-service' regulation. As a result, we believe the IASB must provide further clarification on the scope, otherwise there is likely to be diversity in practise. Many other respondents echoed similar concerns.


Conclusion

The issue of whether regulatory assets and regulatory liabilities should be recognised under IFRS is a concern for most regulated entities, so we applaud the IASB for addressing the issue in a formal project. Thus far, the IASB has received over 100 comment letters on the ED, taking very divergent views. As a result, the future direction of the project is very uncertain and significant changes to the ED are possible. Entities affected by the proposals, particularly those in converting countries, should closely monitor development of the project as the Board addresses the comments received.