This Comment Letter was sent by BDO Global Coordination B.V. to the International Accounting Standards Board on 20 November 2009, on behalf of BDO International.
Dear Sir
Exposure Draft ED/2009/8 Rate-regulated Activities
We are pleased to comment on the above exposure draft (the ED) issued by the International Accounting Standards Board (IASB), on behalf of BDO International.
The question of whether rate regulated assets and liabilities should be recognised by entities that report in accordance with IFRS is a significant issue for entities in a number of jurisdictions that are in the process of adopting IFRS, in particular those whose standards currently permit the recognition of regulatory assets and liabilities. We note that the lack of guidance in IFRS appears to have led to divergence in practice in those jurisdictions that are already applying those accounting standards. Therefore we believe guidance is needed for rate-regulated activities.
We also acknowledge that this is an issue that has been discussed in the past and the reason previous guidance had not been issued was that many feel very strongly that regulatory assets and liabilities do not meet the definition of an asset or liability under the Framework. That debate continues today. In fact in our discussion of these proposals amongst BDO member firms, we did not reach agreement that the definition of an asset or liability is met and so we are not in a position to express support for the proposals in the ED. However it is acknowledged that rate-regulation creates a different economic environment from those entities that do not operate under rate-regulation, and the existence of this different economic environment is reflected in our responses to questions raised in the ED. Those that believe that it is appropriate to recognise regulatory assets and liabilities believe it is this different economic environment that leads to the definitions of an asset and a liability under the Framework being met.
If the Board does take its proposals forward and issues a final standard, we consider that it is essential that there is a prohibition on the application by analogy of the guidance in that new standard to any transactions or circumstances which are not covered by what needs to be a narrow scope in the standard itself. We note that such a prohibition is not without precedent, having been included in IFRIC 10.
Our responses to the specific questions raised in the ED are set out in the attached Appendix.
Yours sincerely
BDO Global Coordination B.V.
Appendix
Question 1
The exposure draft proposes two criteria that must be met for rate-regulated activities to be within the scope of the proposed IFRS (see paragraphs 3–7 of the draft IFRS and paragraphs BC13–BC39 of the Basis for Conclusions).
Is the scope definition appropriate? Why or why not?
There are many forms of rate regulation and there are those who believe that limiting the scope of the proposals to cost-of service regulation will compromise comparability. However as noted above the reason that some believe that regulatory assets and liabilities meet the definition of an asset and liability under the Framework is that entities subject to rate regulation operate in a different economic environment than entities that do not. Therefore it is important that the scope of these proposals be limited to forms of rate regulation that truly create this different economic environment. Cost-of-service regulation does this. However other forms of regulation, such as an incentive-based system, where there is not a direct cause-and-effect relationship between costs and rates, create an environment that is closer to that of entities that are not subject to rate regulation. As a result, we agree that the scope of the proposed IFRS be limited to cost-of-service regulation.
However we believe the paragraph 3(a) should refer to the “….the price, or the maximum or minimum price, that an entity may charge” rather than the “price the entity must charge”. We note that paragraph 17 refers to situations where the regulatory rate would be set at such a level that it would affect demand (the inference would appear to be that demand would be reduced by an excessively high price). If such a situation arises an entity may be permitted to choose to charge a rate lower than the amount set by the regulator in order to not impact demand. We note that if a regulator required a particularly low price which resulted in increased demand, this could also have an adverse effect on the entity through the need for it to bear an additional step up in its fixed costs.
Question 2
The exposure draft proposes no additional recognition criteria. Once an activity is within the scope of the proposed IFRS, regulatory assets and regulatory liabilities should be recognised in the entity’s financial statements (see paragraphs BC40–BC42 of the Basis for Conclusions).
Is this approach appropriate? Why or why not?
Given the scope is limited to cost-of-service regulation, some agree with the Board’s conclusion that once the scope criteria have been satisfied, assets and liabilities exist that meet the criteria for recognition. However, those who disagree with the recognition of rate regulated assets and liabilities consider that not requiring separate recognition criteria conflicts with the requirements of the Framework, and do not believe this approach is appropriate.
Question 3
The exposure draft proposes that an entity should measure regulatory assets and regulatory liabilities on initial recognition and subsequently at their expected present value, which is the estimated probability-weighted average of the present value of the expected cash flows (see paragraphs 12–16 of the draft IFRS and paragraphs BC44–BC46 of the Basis for Conclusions).
Is this measurement approach appropriate? Why or why not?
We note that the measurement of regulatory liabilities on initial recognition and subsequently at their expected present value is consistent with the guidance in IAS 37. However, we do not consider that the guidance in IAS 37 is relevant to regulatory assets. We note that throughout its basis for conclusions, the Board seeks to justify the recognition of regulatory assets on the basis that they are similar to intangible assets (see BC 21). In addition, paragraph 16 permits some regulatory assets to be included in the cost of property, plant & equipment. As a result, we believe that if they are to be recognised at all, the regulatory assets should initially be measured at cost and subsequently measured at cost less amortisation and impairment, consistent with IAS 16 and IAS 38.
We also note that, based on the arguments presented in the basis for conclusions, it would appear that this standard is not needed as there is a basis to recognise regulatory assets and liabilities under IAS 38 and IAS 37 respectively. We are not convinced that this is the case, in particular for regulatory liabilities (we can see a better link between regulatory assets arising from specific recoverable expenditure and the recognition criteria contained in IAS 38) but if it is the case that recognition is covered by IAS 37 and IAS 38 then, rather than the IASB issuing a new standard, it would appear that the IFRIC should be issuing an interpretation.
Question 4
The exposure draft proposes that an entity should include in the cost of self constructed property, plant and equipment or internally generated intangible assets used in regulated activities all the amounts included by the regulator even if those amounts would not be included in the assets’ cost in accordance with other IFRSs (see paragraph 16 of the draft IFRS and paragraphs BC49–BC52 of the Basis for Conclusions). The Board concluded that this exception to the requirements of the proposed IFRS was justified on cost-benefit grounds.
Is this exception justified? Why or why not?
On a conceptual basis, these regulatory assets should be presented separately from property, plant and equipment. However, we agree with the Board’s conclusion that this exception was justified on cost-benefit grounds, in particular given that, from a regulatory basis, these costs are often included in the depreciation base of the assets. We also note that, if the measurement of regulatory assets was modified to be consistent with IAS 16 and IAS 38 (as noted in our response to Question 3), the difference discussed in paragraph BC52 would no longer exist.
Question 5
The exposure draft proposes that at each reporting date an entity should consider the effect on its rates of its net regulatory assets and regulatory liabilities arising from the actions of each different regulator. If the entity concludes that it is not reasonable to assume that it will be able to collect sufficient revenues from its customers to recover its costs, it tests the cash-generating unit in which the regulatory assets and regulatory liabilities are included for impairment in accordance with IAS 36 Impairment of Assets. Any impairment determined in accordance with IAS 36 is recognised and allocated to the assets of the cash-generating unit in accordance with that standard (see paragraphs 17–20 of the draft IFRS and paragraphs BC53 and BC54 of the Basis for Conclusions).
Is this approach to recoverability appropriate? Why or why not?
We believe that this approach to recoverability is appropriate.
However, in addition, an entity’s non-performance could be a potential indicator of impairment which does not appear to be considered in paragraphs 17-20 of the draft IFRS. Therefore we suggest the Board considered amending paragraphs 17 -20 to include this as an indicator of impairment.
Question 6
The exposure draft proposes disclosure requirements to enable users of financial statements to understand the nature and the financial effects of rate regulation on the entity’s activities and to identify and explain the amounts of regulatory assets and regulatory liabilities recognised in the financial statements (see paragraphs 24–30 of the draft IFRS and paragraphs BC59 and BC60 of the Basis for Conclusions).
Do the proposed disclosure requirements provide decision-useful information?
Why or why not? Please identify any disclosure requirements that you think should be removed from, or added to, the draft IFRS.
In general we believe the proposed disclosure requirements provide decision useful information, with the exception of paragraph 26(c). We consider that disclosure of how those financing costs included in the cost of the asset have been determined would be appropriate, and that to require disclosure of a different amount in accordance with IAS 23 is overly onerous with little benefit to users of financial statements.
Question 7
The exposure draft proposes that an entity should apply its requirements to regulatory assets and regulatory liabilities existing at the beginning of the earliest comparative period presented in the period in which it is adopted (see paragraph 32 of the draft IFRS and paragraphs BC62 and BC63 of the Basis for Conclusions). Any adjustments arising from the application of the draft IFRS are recognised in the opening balance of retained earnings.
Is this approach appropriate? Why or why not?
We agree with the proposed transitional provisions.
The exposure draft includes proposed amendments to IFRS 1 First-time Adoption of International Financial Reporting Standards (see paragraph C1 of the draft IFRS). These amendments are the result of the Board’s exposure draft Additional Exemptions for First-time Adopters published in September 2008. These amendments reflect the comments received on that exposure draft and the Board’s redeliberations.
If the Board does issue an IFRS based on the exposure draft, we agree with the proposed amendments to IFRS 1. However, we believe the word ‘separately’ should be removed from paragraph D25, as this appears inconsistent with paragraph 16 of the proposed IFRS which allows certain regulatory assets to be recognised in property, plant & equipment or intangible assets.
Question 8
Do you have any other comments on the proposals in the exposure draft?
Our other comments on the exposure draft are as follows: It appears that paragraphs 13(c) and 13(d) are describing two components of a total discount rate. Furthermore, paragraph 15 describes the ‘rates used to discount the estimated cash flows’. If the Board’s intention is for 13(c) and 13(d) to be the total discount rate, then the Board might consider clarifying that the rate used in paragraph 15 is the sum of 13(c) and 13(d) not one or the other. An alternative view is that paragraph 13(d) may be interpreted to be an adjustment similar to the ‘preferable’ means of risk adjustment under US GAAP. We do not believe the Board’s intention is for this alternative view and, if the Board decides to continue with an IAS 37 approach to measurement (and not the approach we have included in our response to question 3), we suggest that the Board considers amending paragraph 13 so that the present value guidance is consistent with the present value guidance in IAS 37.
Paragraph 14 requires an entity to ‘determine a range of possible outcomes and estimate the cash flows it will recover or refund for each outcome’. Paragraph 17 describes how the actions of the regulator may cause variable demand levels, which in turn could result in regulatory assets not being fully recoverable. The proposed standard then requires impairment tests on those assets where recoverably is not assured. However it is not clear from the guidance if the Board’s intention is for the ‘range of possible cash flows’ in 14 to capture the effects of the regulatory actions that 17 describes. If this was not the Board’s intention, then there appears to be an internal inconsistency in the proposed standard because it ignores the effect of regulatory action in 14 but then requires a separate impairment test under 17 just for that purpose. Therefore we suggest this potential inconsistency be addressed either in the basis of conclusions or through clarification in the guidance to eliminate the difference.
Paragraph 21 states that if an entity’s underlying activities no longer meet the criteria set out in paragraph 3 an entity is required to derecognise the entire carrying amount of the regulatory assets or regulatory liabilities at that time. However, the approach which should be followed is not clear in circumstances where an entity derecognises regulatory assets or regulatory liabilities for that reason, but its activities subsequently again meet the criteria in paragraph 3. It would be helpful for further guidance to be included in any IFRS that is issued to address this point. Paragraph 27(a)(ii) states ‘the amount of cost incurred in the current period … or regulatory liabilities to be recovered or refunded in the future’. It would appear that the drafting of this paragraph needs to be revisited, as it is not clear how a cost incurred could be recorded as a regulatory liability to be refunded. Paragraphs 2(a) and 8 refer to a regulatory liability as being previously collected amounts to be refunded in the future.
The term ‘price cap’ plan is introduced in paragraph B4(c). This term is used throughout the document but is not defined until mid-way through paragraph BC12 in the basis for conclusions. We suggest that this term is included in the Appendix A Defined Terms.
ED-2009-8 Rate-regulated Activities.pdf
ED-2009-8 Rate-regulated Activities Basis of Conclusions.pdf
ED-2009-8 Rate-regulated Activities Illustrative Examples.pdf
BDO Comment Letter 2009 17.pdf