Over the next year (or years), companies in Canada and the U.S. will make the transition towards adopting International Financial Reporting Standards (IFRS). These standards will have a...
IFRS and You
How the new standards affect utility balance sheets.
may subject utilities reporting under IFRS to volatility not previously experienced under U.S. GAAP. 8
The International Accounting Standards Board (IASB) is considering a proposal that will allow for regulatory assets but in a more limited sense than SFAS 71. 9 If the IASB decides to not recognize regulatory assets and liabilities, the impact on utilities’ balance sheets would be substantial, based on an analysis of 92 electric, gas, and water utilities (see Figure 1) . In 2009, decreases in total assets and total equity would have measured approximately $1.4 billion and $800 million, respectively. In percentage terms, total assets would be reduced on average by 12 percent, total liabilities by 9 percent, and total equity by 17 percent (see Figure 2) .
Given the reliance of many parties on balance sheet metrics, it’s important to recognize that regulatory assets and liabilities will result in future cash flows. Therefore, investors and analysts will have to adjust forecasted cash flow as well as credit metrics to account for the potential de-recognition of regulatory assets and liabilities. Further, regulatory recognition of utilities’ ability to recover items in future revenues as regulatory assets and be turned into cash sends an important signal to investors; without this information, investors will have to infer it from sources other than the balance sheet.
Depreciation and Asset Retirement
Utilities generally have a large amount of fixed assets that can be divided into many components. The IFRS requirement that assets be depreciated by components likely will create substantial costs for utilities. Currently, most utilities depreciate their assets by classes rather than components, and U.S. and Canadian GAAP allow componentization but don’t require it. Given the age and composition of utility assets, it will be costly to satisfy IFRS’ current requirements and determine a depreciation schedule for components. For example, electric utilities often have large and dispersed generation, transmission and distribution assets, and many such assets last 40 years. Depreciation by components might require a physical inspection and subsequent tracking of components of these assets, which will increase the reporting burden. Similarly, gas distribution and water utilities often have large in-ground distribution systems that would be difficult to depreciate using IFRS’ componentization method. Regulators, such as the Federal Energy Regulatory Commission (FERC), 10 and GAAP allow for depreciation by class, so the required analysis of asset components and their useful lives will likely be more detailed than what’s currently required under either GAAP or FERC reporting. As a result, a transition to componentization would impose additional costs on regulated entities and likely on their customers.
The transition to componentization under IFRS might have several consequences affecting regulation. First, it’s possible that the componentization would lead to depreciation rates that differ from those approved by the regulator. Depreciation constitutes a large component of regulated entities’ revenue requirement and provides a large portion of the utilities’ cash flow from operations. 11 Therefore, the change could create controversy in rate proceedings. Second, IFRS allows the company to measure a component of its PP&E at fair value upon transition to IFRS, which would result in