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IFRS and You

How the new standards affect utility balance sheets.

Fortnightly Magazine - December 2010

a mismatch between the traditional original cost based regulation that is common in North America and in financial reporting.

Similarly, U.S. electric utilities report asset retirement obligations of approximately $20 billion to $22 billion, corresponding to 4 to 5 percent of their net utility plant. 12, 13 Both IFRS and U.S. GAAP provide for the recognition of costs of dismantling an asset and restoring its site as a liability, with an offsetting amount included in the capitalized cost of the asset. However, the implementation of the two approaches differs. While U.S. GAAP uses an adjusted risk-free rate to discount the liability, IFRS relies on a discount rate that corresponds to the risk of the liability. In addition, IFRS revalues the liability each accounting period.

Impairment and Revaluations

Utility companies are capital intensive and differences between GAAP and IFRS likely will have a significant impact on utilities. The two key differences pertain to asset impairment testing and asset revaluation.

Both IFRS and GAAP require periodic tests of whether assets or liabilities are impaired and thus required to be written down. However, the test for impairment differs. Under current GAAP, asset impairment occurs in a two-step procedure.

In step one, the sum of the undiscounted cash flows that the asset or liability cause is calculated. If this sum is larger than the current book value of the asset or liability, there’s no impairment. If the sum is less than the book value of the asset or liability, then the asset or liability is impaired.

In step two, an impaired asset or liability is written down to the undiscounted sum of the cash flows or net realizable value.

Under IFRS, impairment testing relies on the discounted sum of cash flows that the asset or liability earns or incurs. Since IFRS uses discounted cash flows in the impairment test, it becomes more difficult for an asset (or liability) to pass the test. 14 If the asset or liability is impaired, then it’s written down to the discounted sum of the cash flows or its net selling price.

To understand the difference, consider a utility with a plant on its books at $190 million. The utility expects to generate $20 million in cash flows over the next 10 years. Under GAAP, because the total expected cash flows exceed the book value of the plant, no impairment to the asset is needed. Under IFRS, however, one must consider the discounted value of these cash flows. Using a conservative after-tax discount rate of 7 percent, the present value of the plant’s cash flows are approximately $140 million. Consequently, the utility would have to write-down the value of its plant by $50 million ( see Figure 3 ). The likelihood of impairment is positively related to the amount of long-term assets on the balance sheet, as well as the life of these assets. In particular, for firms with longer-lived assets, discounting has a more pronounced effect. That is, discounting cash flows on an asset with 40 years of useful life will have much more of an impact on the net