• Kelly Martin, Partner |
  • George Hay, Partner |
6 min read

There have been significant developments in the IASB’s project to create a new accounting standard for rate-regulated activities. These will affect sectors including water, electricity, gas networks and certain airports in the UK. We discuss the key impacts below – and ask what this means for the new standard.

‘Direct’ vs ‘indirect’ relationships

From a UK perspective, the most significant decision the IASB has taken relates to the treatment of differences between accounting depreciation and regulatory recovery period.

The proposal in the Exposure Draft (ED) Regulatory Assets and Regulatory Liabilities was that if a regulatory agreement treats depreciation of an asset as an allowable expense, then timing differences between accounting depreciation and regulatory depreciation would give rise to regulatory assets and liabilities. The ED proposed that such timing differences would be tracked at the level of individual assets, effectively matching each fixed asset with a corresponding item in the regulatory asset base.

This would have presented significant challenges in regulatory regimes such as those in the UK in which regulatory asset bases are maintained on an aggregated basis – not split into individual components – and are very often not aligned or comparable to the accounting fixed asset register.

In its meeting in October 2022, the IASB decided to limit this requirement to cases in which there is a direct relationship between the accounting and regulatory asset bases. If there is only an indirect relationship, then this becomes a disclosure-only question with explanatory disclosures required in the notes to the financial statements.

Unintended consequences?

This decision has been welcomed by many preparers, particularly in the UK. However, the focus is now shifting to understanding the full implications of this decision and whether there are unintended consequences.

For example, suppose revenue in Year 1 is 1,000 lower than permitted by the regulator. The entity is permitted to recover the deficit through regulated rates in the future. 200 will be recovered through revenues in Year 3, i.e. ‘fast money’; 800 will be recovered by increasing the regulatory asset base, i.e. ‘slow money’. Under the ED, this would have resulted in recognition of regulatory income of 1,000 in Year 1, balanced by a regulatory asset of 1,000 at the end of Year 1.

Under the indirect approach, there is now a question for the 800 that will be added to the regulatory asset base whether this amount:

  1. should be recognised as a regulatory asset, since under the principles of the ED the entity has earned regulatory income of 800; or
  2. should not be recognised as a regulatory asset, on the basis that under the indirect approach the entity is not permitted to do so where amounts are recovered through the regulatory asset base. 

In practice, more details about exactly how the regulator tracks the 800 may be needed to answer this question.

A further question: what the unit of account is for the direct/indirect assessment? For example, if the regulator decides to implement a ‘direct’ approach in future periods, would the direct approach apply only to assets added to the regulatory asset base in future? How would assets under construction at the cut-over date be treated? For global businesses operating under multiple regulatory regimes, would it provide useful information to investors and analysts for an entity to apply the direct approach in some jurisdictions and the indirect approach in other jurisdictions?

Another question is how extensive the additional note disclosures will be for the indirect approach. Significant additional work may be required depending on the detail and complexity of the required disclosures.

And perhaps the biggest question is how clear it will be whether a given case qualifies for the direct or the indirect approach. We’ve seen in other accounting change projects that once a ‘bright line’ of this kind is drawn, questions immediately start piling up at the boundary.

Assets under construction

Another key decision made by the IASB concerns assets under construction. In another welcome change from the proposals in the ED, the IASB has decided that if the regulator permits an entity to earn a regulatory return on assets under the course of construction, then the entity will recognise regulatory income during the construction period. However, the interaction between these two decisions may create complexity. If the indirect approach applies, returns on assets under construction can simply be booked during the construction period. But if the direct approach applies, additional (quite complex) analysis will be required to determine the appropriate accounting entries. In this case, a portion of the return relating to capitalised borrowing costs may need to be deferred and recognised as borrowing costs are depreciated. 

Differing treatments of inflation vs interest rates

A third key decision is in relation to a key economic driver of regulatory returns – inflation. This has become particularly relevant in recent months. The question considered by the IASB was whether, if the r indexation of the regulatory asset base should result in recognition of a regulatory asset. In its discussions, the IASB noted that recognition of an asset would be consistent with the overall accounting model in the ED. However, the IASB decided on cost-benefit grounds that an entity should not recognise a regulatory asset for inflation adjustments to the regulatory asset base. The impacts of this decision could be material. For example, if returns are 5% nominal, and inflation is 2%, returns booked could reduce by 40% (2% / 5%).

This contrasts with the agreed approach for another key economic driver: interest rates. Here, the ED proposes that interest rate rises are booked in the year the rate rise occurs. We believe this would more clearly demonstrate the relationship between revenue and expenses in a given period, in line with the IASB’s intention. Income will be aligned with the related expense, which in this case is interest. It will also lead to more intuitive impacts on covenants and profit after tax, reducing volatility.

Caught between an accounting rock and an economic hard place?

All of this raises a question as to whether the standard is destined to get caught between an accounting rock and an economic hard place. So much depends on which side of the direct/indirect line companies land on. There is also a risk of inconsistency in the treatment of different economic drivers, for example in the treatment of inflation vs interest, which could make it hard for users of accounts to build a full picture. Today’s accounting may not be perfect – it doesn’t capture in-year regulatory performance – but it is widely understood.

The IASB deserves credit for the way it has been listening to feedback and is striving to accommodate concerns and reach the best possible outcomes. But the fear is that we will end up caught between an accounting rock and an economic hard place!

Transition and tax

In addition, the transition adjustment on implementation of the new standard could result in an immediate tax payable amount – a ‘dry tax charge’ – which makes tax planning essential. Transition is itself another major question, because the ED proposed that the new requirements would need to be applied on a fully retrospective basis with very limited transition relief – a significant difference to other recent big accounting changes. This will be discussed in future Board meetings so stay tuned! 

Still time to influence

There is much further to go in the process and many key decisions that remain to be taken. The final ‘product’ could yet look different. This is why it’s important to continue to engage and get your views heard.

As always, we’d be delighted to hear from you and discuss any aspect of this key accounting standard for rate regulated businesses.