(The National Advisory Committee on Accounting Standards (NACAS) constituted under the Companies Act, 1956, by the Ministry of Corporate Affairs, while considering Indian Accounting Standards converged with IFRS, suggested that the Institute of Chartered Accountants of India (ICAI) may issue a Guidance Note to address accounting issues for rate regulated entities. Since, accounting for rate regulated activities would be relevant in the context of the existing notified Accounting Standards also, the following text of the Guidance Note has been formulated by the Council of ICAI in that context. The Guidance Note will be considered by the NACAS as it may require modification in the relevant Accounting Standards where and to extent the accounting treatment of such activities is affected by this
Guidance Note. Accordingly, the Guidance Note will be effective from a date to be announced later.)
Introduction
Background
1. Regulation of different economic activities through bodies established under statute or otherwise can be found in many countries. The object of regulation is typically to promote the orderly growth and development of the regulated industry, protect the interests of consumers, regulate competition, monitor social and environmental issues within the industry etc. Regulation of utilities like telecommunication, electricity and water often aims to control prices, ensure service quality, protect the environment and establish an investment environment capable of attracting capital at reasonable cost. In India we have different bodies such as the Reserve Bank of India, Securities and Exchange Board of India, Insurance Regulatory and Development Authority, Central Electricity Regulatory Commission, State Electricity Regulatory Commissions, Directorate General of Hydrocarbons (DGH), Telecom Regulatory Authority of India etc. for regulating different sectors. 2. Regulation can take many forms depending upon the industry and objectives to be achieved. Rate regulation is one of the main forms of regulation often found in the utility sector or in sectors dealing with ‘public goods’ or other important goods and services. For example, in India, electricity prices are regulated by the CERC/SERCs, fertilizer prices and highway tolls are regulated by the Government
.
Framework for Rate Regulation
3. A key aspect of rate regulation is that the regulator is empowered to
determine prices that bind the entity’s customers under a statute or
otherwise. Regulatory authorities are usually set up under a legislation which
stipulates their constitution, functions, powers etc. While such legislation may
provide the general guidelines and considerations for determination of tariffs,
the regulatory authority decides the particular methodology to be adopted for
tariff setting which is notified through regulations or rules. The regulator from
time to time issues orders for tariff setting in individual cases which provide
further guidance on the implementation of the notified regulations and rules.
The legislation, regulations, rules and tariff orders provide the entity with the
framework for charging the customers for the regulated goods and services.
4. Entities subject to price regulation are not allowed to charge prices for
regulated goods or services other than those approved by the regulatory
authority. In those circumstances, the regulator acts on behalf of the
customers who individually would have no bargaining power with the entity.
The regulator also acts on behalf of the entity. Agreements between a rateregulated
entity and its customers cannot be understood without reference to
the regulation in place. Therefore, it can be said that such agreements are
different from the agreements between an entity and its customers in a nonregulated
environment.
Methods and Process of Rate Regulation
5. There are several basic methods for rate regulation and in each case,
the application of a particular methodology may vary with the regulator, the
entity being regulated and the circumstances faced. Some of the forms of
rate regulation are cost of service regulation, price-cap mechanisms or a
hybrid methodology featuring combinations of price cap and cost-of-service
approaches.
6. Under the cost-of-service regulation (also referred to as return-on-ratebase
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.
7. The regulators may adopt several approaches for cost-of-service
regulation. The regulator may stipulate the various costs which can be
covered under the tariff, the admissible rate of return and the mechanism for
recovery of the tariffs. Alternatively, the regulator establishes the revenues
required to cover the expected cost of providing the regulated service,
including a fair return on the investment in the regulated operations. This
amount is called the "revenue requirement." The regulator then sets rates
that will provide the entity with a reasonable opportunity to recover its
revenue requirement.
8. Not all costs that an entity incurs are automatically recoverable from
its customers. Regulators typically review entities’ costs to ensure that they
were appropriately incurred to provide the regulated service and were
‘prudent’. When a regulator decides that a cost was not prudently incurred, it
may disallow all or part of the cost, thereby reducing (or eliminating) any
future recovery of that cost. Consequently, a cost must be permitted by the
regulator to be included in the determination of rates. In cost-of-service
regulation, such costs are the actual or estimated costs for which revenue is
intended to provide recovery and include costs of debt and a reasonable
return on shareholders’ investments.
9. Cost-of-service rate-making does not necessarily equals a one-for-one
pass-through of all costs. Regulations enable for rate fixation which provides
that the entity will recover its costs using reasonable assumptions regarding
demand as well as normal expenditures. The regulator to promote
efficiencies may stipulate performance norms for recovery of some costs or
may provide recovery of some elements of cost as per norms while other
elements are recovered at actuals. For example, tariff regulations issued by
many of the SERCs in the electricity sector in India classify costs into
‘controllable’ and ‘uncontrollable’ costs and provide for adjustment of tariffs
for the ‘uncontrollable costs’ during ‘truing up’ process while variations in the
‘controllable costs’ are to be borne by the entity. In some cases, the
regulators also prescribe a formula for sharing efficiency gains between the
entity and the customers, such as the gains on account of reduction in
distribution losses etc.
10. 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. For ‘truing
up’ of the initially determined rates, the entity provides the regulator with
details of actual costs, capital expenditure etc., based on audited accounts
and other supporting evidence. The regulator reviews the details of actual
costs provided by the entity and may also provide opportunity to other
stakeholders to submit their comments on the entity’s application for rate
review. Upon such review, the regulator determines the additional costs
which can be recovered by the entity or amounts which need to be refunded
to the customers.
11. Following the truing up exercise, the regulator usually adjusts the rates
to be charged from customers so as to ensure recovery of additional costs or
refund of amounts, as the case may be. The regulators may also decide not
to immediately adjust the rates due to various considerations, for example, to
avoid rate fluctuations or to smooth out an increase in rates, and require the
regulated entity to defer the recovery or refund of the difference between the
expected and actual amount of those costs. This results in a portion of the
costs (or cost savings) of one period being included or adjusted in the
revenue of another period.
Objectives
12. This Guidance Note deals with the effects on an entity’s financial
statements of its operating activities that provide goods or services whose
prices are subject to cost-of-service regulation.
13. The objectives of this Guidance Note are to recommend:
(i) the recognition of a regulatory asset or regulatory liability if the
regulator permits the entity to recover specific previously incurred costs or
requires it to refund previously collected amounts and to earn a specified
return on its regulated activities by adjusting the prices it charges to its
customers;
(ii) the measurement basis of a regulatory asset or regulatory liability both
on initial recognition and at the end of each subsequent reporting period; and
(iii) the disclosures that identify and explain the amounts recognised in the
entity’s financial statements arising from a regulatory asset or regulatory
liability and assist users of those financial statements to understand the
nature and financial effects of its rate-regulated activities.
Scope
14. An entity should apply this ‘Guidance Note’ to its operating activities
that meet the following criteria:
i. 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
ii. the price established by regulation (the ‘rate’) 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.
15. If regulation establishes different rates for different categories, such as
different classes of customers or volumes purchased, the related operating
activities of an entity are within the scope of this ‘Guidance Note’ provided
that the regulator approves the definition and the rate for each of those
categories and that all customers of the same category are bound by the
same rate.
16. Activities of an entity which are subject to other forms of regulation are
not covered by this Guidance Note. For example, the telecom sector in India,
though regulated by the Telecom Regulatory Authority of India (TRAI), is not
subject to price regulation which provides for recovery of entity specific costs
plus a specified return. Similarly, some regulations determine rates based on
targeted or assumed costs, for example industry averages, rather than the
actual costs incurred or expected to be incurred by the entity. Activities
regulated in this way are not within the scope of this Guidance Note.
17. Where the prices an entity charges its customers for the goods or
services it provides are regulated according to a ‘price cap’, the entity cannot
charge more than the set prices. Under such regulation the buyer is assured
of the result while the supplier takes the risk and receives the rewards from
additional effort or from the implementation of cost-reducing innovations.
Though the prices are regulated and bind customers, this Guidance Note
does not cover such activities because prices are not designed to recover the
entity’s specific costs to provide the goods or services.
18. Regulators may require a regulated entity to maintain its accounts in a
form that permits the regulator to obtain the information needed for
regulatory purposes. This Guidance Note does not address an entity’s
accounting for reporting to regulators (regulatory accounting).
19. Rate regulation may be applied to all or only a portion of an entity’s
activities. In some cases, an entity may have both regulated and nonregulated
activities. In others, the entity may be permitted to negotiate rates
individually with some customers. This Guidance Note applies only to the
activities of an entity that meet the criteria set out in paragraph 14.
20. The entity should determine at the end of each reporting period
whether its operating activities during the reporting period meet the criteria in
paragraph 14 for application of this Guidance Note.
Definitions
21. The following terms are used in this Guidance Note with the meanings
specified:
i. A regulator is an authorised body empowered by statute or by
any government or any authorised agency of a government to
set rates that binds an entity’s customers.
ii. Cost of Service regulation is 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.
iii. A regulatory asset is an entity’s right to recover fixed or
determinable amounts of money towards incurred costs as a
result of the actual or expected actions of its regulator under the
applicable regulatory framework.
iv. A regulatory liability is an entity’s obligation to refund or adjust
fixed or determinable amounts of money as a result of actual or
expected action of its regulator under the applicable regulatory
framework.
Accounting issues arising from Rate Regulation
22. Rate regulation of an entity’s business activities creates operational
and accounting situations that would not have arisen in the absence of such
regulation. With cost-of-service regulation, there is a direct link between the
costs that an entity is expected to incur and its expected revenue as the
rates are set to allow the entity to recover its expected costs. However, there
could be a significant time lag between incurrence of costs by the entity and
their recovery through tariffs. Recovery of certain costs may be provided for
by regulation either before or after the costs are incurred. Rate regulations
are enforceable and can create legal rights and obligations for the entity.
23. An issue therefore arises as to whether an entity should recognise in
its financial statements the right to recover incurred costs or the obligation to
refund amounts received for which costs have not been incurred through
future tariff adjustments. Recognition of the right to recover incurred costs in
the future or the obligation to refund amounts received in the financial
statements of the entity would arise if they meet the definition of assets and
liabilities as provided in the Framework for the Preparation and Presentation
of Financial Statements issued by the Institute of Chartered Accountants of
India.
Regulatory assets
24. The Framework, defines an ‘asset’ as follows:
“An asset is a resource controlled by the enterprise as a result of past
events from which future economic benefits are expected to flow to the
enterprise.”
In a cost-of-service regulation, the resource is the right conferred by
the regulator whereby the costs incurred by the entity result in future
cash flows. In such cases, incurrance of costs creates an enforceable
right to set rates at a level that permits the entity to recover those
costs, plus a specified return, from an aggregate customer base. For
example, if the regulator has approved certain additions to be made by
the entity in its assets base during the tariff period, which would be
added to the asset base for tariff setting, the entity upon making such
additions obtains the right to recover the costs and return as provided
in the regulatory framework though the actual recovery through rates
may take place in the future. While adjustment of future rates is the
mechanism the regulator uses to implement its regulation, the right in
itself is a resource arising as a result of past events and from which
future cash inflows are expected.
25. 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 as per the Framework since the entity’s right (to
recover amounts through future rate adjustments) constitutes a resource
arising as a result of past events (incurrence of costs permitted by the
regulator for recovery from customers) from which future economic benefits
are expected to flow (increased cash flows through rate adjustments).
26. As regards the ‘control’ criterion in the definition of an asset as per the
Framework, it may be argued that though the entity has a right to recover the
costs incurred, it does not control the same since it cannot force individual
customers to purchase goods or services in future. In this regard, it may be
mentioned that the rate regulation governs the entity’s relationship with its
customer base as a whole and therefore creates a present right to recover
the costs incurred from an aggregate customer base. Although the individual
members of that group may change over time, the relationship the regulator
oversees is between the entity and the group. The regulator has the authority
to permit the entity to set rates at a level that will ensure that the entity
receives the expected cash flows from the customers’ base as a whole.
Further, the Framework states that control over the future economic benefits
is sufficient for an asset to exist, even in the absence of legal rights. The key
notion is that the entity has access to a resource and can limit others’ access
to that resource which is satisfied in case of the right provided by the
regulator to recover incurred costs through future rate adjustments. Any
issues regarding recoverability of the amounts should not affect the
recognition of the right in the financial statements though they certainly merit
consideration in its measurement.
Regulatory liabilities
27. The Framework defines a liability as ‘a present obligation of the
enterprise arising from past events, the settlement of which is expected to
result in an outflow from the entity of resources embodying economic
benefits.’ In cost-of-service regulation, an obligation arises because of a
requirement to refund to customers excess amounts collected in previous
periods. In such cases, collecting amounts in excess of costs and the
allowed return creates an obligation to return the excess collection to the
aggregate customer base. For example, if the tariffs initially set assume a
certain level of costs towards energy purchased but the actual costs incurred
by the entity are less than such assumed levels, the entity would be obliged
to make a refund following the ‘truing up’ exercise by the regulator. Such
obligation is a present obligation relating to amounts the entity has already
collected from customers owed to the entity’s customer base as a whole, not
to individual customers. It is not a possible future obligation because the
regulator has the authority to ensure that future cash flows from the customer
base as a whole would be reduced to refund amounts previously collected.
The obligation exists even though its amount may be uncertain. An economic
obligation is something that results in reduced cash inflows, directly or
indirectly, as well as something that results in increased cash outflows.
Obligations link the entity with what it has to do because obligations are
enforceable against the entity by legal or equivalent means.
Nature of regulatory assets and regulatory
liabilities
28. Regulatory assets and regulatory liabilities that would be recognised
as a result of application of this Guidance Note are not financial instruments
since the entity does not have the right to request reimbursement from, or
the obligation to make payments to, individual customers for fixed or
determinable amounts under a contract.
29. The regulatory assets are also not intangible assets as per AS 26,
Intangible Assets since they are not identifiable non-monetary asset, without
physical substance, held for use in the production or supply of goods or
services, for rental to others, or for administrative purposes. Accordingly, it
would be appropriate to classify the assets and liabilities arising out of rate
regulation separately from other assets and liabilities.
Recognition
30. A regulatory asset should be recognised when it is probable that the
future economic benefits associated with it will flow to the entity as a result of
the actual or expected actions of the regulator under the applicable
regulatory framework and the amount can be measured reliably.
31. Probability refers to the degree of uncertainty that future economic
benefits associated with the regulatory asset will flow to the entity. Therefore,
the probability criterion is said to be met when there is a reasonable
assurance that future economic benefits will flow from the regulatory asset to
the entity. A regulatory asset can be recognised when the regulatory
framework provides for the recovery of the incurred costs and the entity has
incurred such costs. If the recovery of the incurred costs is at the discretion
of the regulator, the right can at best be said to be a contingent asset as per
Accounting Standard (AS) 29, Provisions, Contingent Liabilities and
Contingent Assets. In such case it would not be appropriate to recognise an
asset till the approval of the regulator is received. For example, if any
additions to the rate base are subject to the approval of the regulator, the
entity should not recognise a regulatory asset on account of costs incurred
on capital additions before approval of the regulator since the recovery of
additional amounts through tariffs is contingent upon approval by the
regulator.
32. In some cases, a regulator permits an entity to include in the rate
base, as part of the cost of self-constructed property, plant and equipment or
internally generated intangible assets, amounts that would otherwise be
recognised as expense in the statement of profit and loss in accordance with
Accounting Standards. After the construction or generation is completed, the
resulting cost is the basis for depreciation or amortisation and unrecovered
investment for rate determination. A regulatory asset should be recognised
by the entity in respect of such costs since the same is recoverable from the
customers in future through tariffs.
33. As regards the criterion for reliable measurement, since the
recoverable amount is linked to the specific costs incurred which are
permitted to be recovered by the regulatory framework, meeting the same
may not present much difficulty for regulatory assets.
34. A regulatory liability should be recognised
(i) when an entity has a present obligation as a result of a past
event;
(ii) it is probable that an outflow of resources embodying economic
benefits will be required to settle the obligation; and
(iii) a reliable estimate can be made of the amount of the obligation.
35. Since in a cost-of-service regulation, the tariffs are subjected to ‘truing
up’ based on actual costs incurred and prudence checks by the regulator, if
the costs incurred by the entity are lower than those initially considered for
rate determination, the entity has no realistic alternative to making a refund
to the customers. Similarly, if the tariffs are set assuming certain level of
additions to the asset base and the actual additions by the entity are lower,
the entity would be required to refund a portion of the tariffs collected due to
the lower additions to the asset base. The regulatory framework may also
provide for other circumstances which would warrant a refund of the amounts
collected to the customers directly or indirectly through a downward
adjustment of rates. For example a electricity distribution entity may have an
obligation to share gains from reduction of distribution losses with the
consumers in a specified ratio which would be passed on to consumers
through an adjustment in future tariffs. Such amounts should be recognised
as a liability if on the balance sheet date it is probable that the entity would
be required to make refund upon review by the regulator and a reliable
estimate can be made of the amount of refund.
36. Regulated entities should comply with the requirements of the
Accounting Standards in the same way as other entities.1 Therefore, if the
criteria in paragraph 14 are satisfied, the entity should recognise regulatory
assets and regulatory liabilities in accordance with this Guidance Note in
1 For rate regulated acitivities, the relevant Accounting Standards will be modified where
and to extent the accounting treatment of such activities would be affected by this
Guidance Note.
addition to the assets and liabilities recognised in accordance with the
Accounting Standards in the normal course.
Measurement
37. 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.
38. Estimates of the amount expected to be recovered, refunded or
adjusted are determined by the judgment of the management of the entity
considering various factors such as:
i. statutes or regulations that specifically provide for the recovery
of the cost in rates;
ii. formal approvals from the regulator specifically authorising
recovery of the cost in rates;
iii. previous formal approvals from the regulator allowing recovery
for substantially similar costs (precedents) for a specific entity or
other entities in the same jurisdiction;
iv. written approval from the regulator (although not a formal
approval) approving future recovery in rates;
v. uniform regulatory guidance providing for the treatment of
various costs that the regulator typically follows in setting rates;
vi. opinions of independent experts regarding recoverability of the
cost on the basis of regulations and past practice.
vii. any additional evidence provided by events after the balance
sheet date, where appropriate as per the applicable Accounting
Standard.
Impairment
39. An entity should review the estimates of the amount expected to be
recovered, refunded or adjusted at least at the end of each reporting period
to reflect the current best estimate. If expectation differs from previous
estimates, the changes should be accounted for as a change in an
accounting estimate in accordance with relevant requirements of the
applicable Accounting Standard. If an 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, this is an indication that the cashgenerating
unit in which the regulatory assets and regulatory liabilities are
included may be impaired. Accordingly, the entity shall test that cashgenerating
unit for impairment in accordance with AS 28 Impairment of
Assets.
De-recognition
40. An entity should derecognise the entire carrying amount of regulatory
assets and regulatory liabilities when the underlying activities fail to meet the
criteria in paragraph 14 and any resulting loss/gain should be recognised in
the statement of profit and loss.
41. If it is no longer probable that the future economic benefits associated
with a regulatory asset will flow to the entity or an outflow of resources
embodying economic benefits will be required to settle a regulatory liability,
the regulatory asset or liability, as the case may be, should be de-recognised
and any resulting loss/gain should be recognised in the statement of profit
and loss.
Presentation
42. An entity should present regulatory assets and regulatory liabilities as
current/non-current, as the case may be, in the balance sheet, separately
from other assets and liabilities.
43. An entity should offset rate regulated assets and liabilities pertaining to
the same regulator.
Disclosures
44. An entity should disclose information that:
i. enables users of the financial statements to understand the
nature and the financial effects of rate regulation on its
activities; and
ii. identifies and explains the amounts of regulatory assets and
regulatory liabilities, and related income and expenses,
recognised in its financial statements.
45. An entity should disclose the fact that some or all of its operating
activities are subject to rate regulation, including a description of their nature
and extent.
46. An entity should disclose the break-up of regulated assets and
regulated liabilities into major components of the respective balances in the
notes to accounts.
47. For each set of operating activities subject to a different regulator, an
entity should disclose the following information:
i. an explanation of the approval process for the rate subject to
regulation (including the rate of return), including information
about how that process affects both the underlying operating
activities and the specified rate of return;
ii. the indicators that management considered in concluding that
such operating activities are within the scope of this ‘Guidance
Note’, if that conclusion requires significant judgement;
iii. significant assumptions used in measurement of regulatory
assets and regulatory liabilities including:
(a) the supporting regulatory action, for example, the issue of
a formal approval for costs to be recovered pending a
final ruling at a later date and that date, when known, or
(b) the entity’s assessment of the expected future regulatory
actions.
An entity should disclose the above information for each category of
regulatory asset and regulatory liability that is subject to a different regulator.
48. A disclosure should be made of reconciliation from the beginning to
the end of the period, in tabular format unless another format is more
appropriate, of the carrying amount in the balance sheet of the regulatory
asset and regulatory liability, including at least the following elements:
i. the amount recognised in the statement of profit and loss
relating to balances from prior periods collected or refunded in
the current period.
ii. the amount of costs incurred in the current period that were
recognised in the balance sheet as regulatory assets and
regulatory liabilities to be recovered or refunded in future
periods.
iii. other amounts that affected the regulatory asset and regulatory
liability, such as items acquired or assumed in amalgamation
etc., or the effects of changes in foreign exchange rates or
estimated cash flows. If a single cause has a significant effect
on the regulatory asset and regulatory liability, the entity should
disclose it separately.
49. When an entity derecognises regulatory assets and regulatory
liabilities in accordance with paragraphs 41 and 42 because the related
operating activities fail to meet the criteria in paragraph 14, it should disclose
a statement to that effect, the reasons for the conclusion that the criteria in
paragraph 14 are not met, a description of the operating activities affected
and the amount of regulatory assets and regulatory liabilities derecognised.
50. If the disclosures required by paragraphs 46–49 of this Guidance Note
do not meet the objectives set out in paragraph 45, the entity should disclose
whatever additional information is necessary to meet those objectives.
Effective date
51. An entity shall apply this Guidance Note for accounting periods
beginning on or after the date (to be announced separately).
Transition
52. On the first occasion this Guidance Note is applied, the entity should
recognise in the financial statements regulatory assets and liabilities as on
that date with corresponding credit/charge to opening balance of revenue
reserves.
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