Accounting for rate-regulated entities

It can reasonably be concluded now that a single set of high-quality global accounting standards is a myth. When the International Accounting Standards Board (IASB) marketed International Financial Reporting Standards (IFRS) as representing such standards, it seemed that the myth would turn into reality. Over time, individual countries (India included) adopted the jugalbandi approach of introducing local components into IFRS standards and opting for carve-outs for some standards.

The US seems to be hesitating on permitting entities resident in the US to opt for IFRS to present their financial statements. Having opted for the convergent approach, the Institute of Chartered Accountants of India (ICAI) has kept itself busy keeping pace with the standards and interpretations issued by the IASB. It has recently issued a Guidance Note on Rate-regulated activities. The Guidance Note (GN) would be applicable to companies who operate in rate-regulated entities (RREs) such as fertilisers, roads, bridges and power plants.

Guidance Note

The GN would be applicable to operating activities where 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 and the price established by regulation is designed to recover the specific costs the entity incurs in providing the regulated goods or services and to earn a specified return.

The specified return could be a minimum or range and need not be a fixed or guaranteed return. In some RREs, the price to be charged is dependent on an open bidding process with the award going invariably to the lowest bidder.

The other criterion of the price being designed to recover costs would also be bet. The scope of the GN does not clarify whether such entities would also be covered, though it does state that entities in the telecommunications sector regulated by the Telecom Regulatory Authority of India (TRAI) would not be covered.

The rate regulation can be made either by the cost-of-service regulation or the price-cap approach. Under the cost-of-service regulation (also referred to as return-on-rate-base regulation) rates are set to give the entity the opportunity to recover its costs of providing the good or service plus a fair return. Under price cap regulation, the regulator caps the rates at which the entity can charge for the goods or services. In such cases, while the initial rates may reflect the cost of service, subsequent increases or decreases may be made in accordance with a formula. The regulatory mechanism provides for a rate review or ‘truing up' exercise at periodic intervals to adjust the rates, downward or upward, to ensure recovery of costs and a reasonable return on investment.

One of the accounting issues that could arise for RREs is that the time-lag between the incurrence of costs and recoveries could vitiate the matching concept principle. While the revenue and expense would be recognised when the right to receive or incur it is established, whether the time-lag could be reflected as assets or liabilities is the issue to be tackled.

Assets and liabilities

The GN clarifies that 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. In cost-of-service regulation, an obligation arises because of a requirement to refund to customers amounts collected in previous periods. In such cases, collecting amounts in excess of costs and the allowed return creates an obligation to return the payments to the aggregate customer base.

On initial recognition and at the end of each subsequent reporting period, an entity should measure a regulatory asset or regulatory liability at the best estimate of the amount expected to be recovered or refunded or adjusted as future cash flows under the regulatory framework. A regulatory asset or regulatory liability should not be discounted to its present value.

Illustrative Examples

It is both noteworthy and surprising that the ICAI has chosen to bring out this GN though the project of the IASB on RREs has been suspended for the present. The GN does not differ from the IASB draft substantially. If the ICAI wants to go ahead with this GN irrespective of the status of the IASB equivalent, it should provide illustrative examples tuned to Indian conditions. Such examples are an integral part of the IASB standard. RREs are subject to a lot of regulation and would expect these examples for clarity in accounting.

(The author is a Bangalore-based chartered accountant.)

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