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

For rate-regulated water, gas and electricity networks, major accounting changes are coming. The IASB’s exposure draft – Regulatory Assets and Regulatory Liabilities – was published at the beginning of this year and a consultation closed in the summer. Next year, the standard setter will continue to consult on and refine its proposals with a new standard likely in early 2023.

This is no minor accounting tweak. The proposals are expected to have a significant impact on financial reporting and key financial metrics for UK utilities. Some of the changes could impact on credit ratings and bank covenants, and companies will need to ensure that ratings agencies, lenders, investors, analysts and regulators understand what they are seeing. Beyond the numbers, the changes could create substantial implementation challenges: based on current drafting, much of the data that would be needed is not captured at a granular level.

Addressing the performance/income time-lag

Why the change? At the heart of the matter is the time-lag that currently exists between regulated businesses’ performance and income. As part of the regulatory framework, prices are typically agreed 2-5 years in advance (and in some cases longer still) based on a set of estimates and assumptions. A catch-up is then performed to reconcile the estimates with actual costs or revenue.

Because of this lag, financial results based on current accounting standards don’t accurately capture in-year performance. The new standard aims to remove the time-lag element and align profit and loss more closely with actual regulatory performance. Investors would then be more able to observe regulatory performance as it happens rather than a picture complicated by revenue received or costs incurred from previous years, or which will be adjusted in future years. Currently, investors often look elsewhere to get a meaningful picture of a regulated business’ performance – such as regulatory financial statements and performance reporting. Under the new standard, the statutory accounts would become more transparent for users and more comparable across entities.

Complexity in the detail

So far, so good. Most UK utilities that responded to the IASB’s exposure draft were supportive of the high level aims of the overhaul. The difficult part comes in the detail of applying the exposure draft to regulatory frameworks for UK utilities. The performance metrics and accounting issues involved are highly complex, and the exposure draft may be refined in some areas to reflect feedback from the industry to date.

Take three examples:

  • Regulatory versus accounting asset bases. The regulatory framework assumes a certain depreciation of assets (which is based on economic principles), but this may not currently match the statutory accounting basis of depreciation, which is based on the concept of useful life. Say for example you have £20 of overspend on assets in the year. Under the regulatory framework, this overspend may be recovered over 20 years at £1 per year. But under IFRS accounting, it may be recovered over 10 years instead – so £2 per year. Moving to this new accounting basis (instead of the current approach based on the regulatory asset base) means there would be more income coming in faster. The accounting would say you have £2 per year as deemed income rather than £1 of cash recovery implied by the regulatory framework. This has to be accounted for: an asset would be recognised in the early years for the difference of £1 per year, which would be ‘unwound’ in later years, to correct the accounting position in relation to the actual cash position. Critically in this instance the exposure draft could introduce a new timing difference between the regulatory framework and accounting standards.
  • Assets under construction. The exposure draft doesn’t allow income to be recognised on assets that aren’t yet deployed. However, UK utilities typically earn a return on assets under construction. This would create a new timing difference relative to the regulatory framework that would need to be accounted for: the cash received before the asset is ready for use would create a liability which is unwound in later years.
  • The inputs and judgements that regulated businesses make. Currently, the amounts that regulated businesses are able to recover against prior investments or expenditure are increased according to calculations made with reference to certain indices such as inflation. Some of these indices are not certain at the time the calculation is made, meaning that businesses have to make estimates and from those judge how much they will be able to recover and when. Currently, none of this is recorded for accounting purposes – it’s ‘invisible’. Under the new proposals, it would be recorded in the financial statements and based on a ‘weighted average’ or ‘most likely’ estimate. This could be complex and require judgment to estimate, and supporting evidence will need to be presented to the auditors for them to agree and sign off on the accounts.

A ‘whole of business’ project

Whatever the final requirements of the standard, implementation is going to be a significant undertaking. It will be a ‘whole of business’ change, not just an accounting matter. New models, governance arrangements and internal controls may be needed. Many different parts of the business will need to pull together to make the project a success.

In our experience, key success factors are having senior sponsorship, buy-in from across the business, early stakeholder engagement and very tight project management.

Get involved

The good news is that there’s still plenty of opportunity to input and influence the final outcome: there will be further consultations on specific points during 2022.

At KPMG, we will be running a series of webinars to take organisations through the key issues and points of debate. We hope you’ll join us – it’s in everyone’s interests to understand the implications of key proposals and form a considered view.