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IFRS and You

How the new standards affect utility balance sheets.

Fortnightly Magazine - December 2010

present value than discounting cash flows on an asset with five years of useful life. Infrastructures for electric, natural gas, and water facilities have very long asset lives; therefore impairment of companies in the utilities industry likely will be more significant than impairment of companies in other industries. Further, the utility sector is subject to regulatory and legislative oversight and the useful life of assets might depend on regulatory and legislative developments.

A second consideration is that IFRS allows for upward revaluations of assets, which increases the book value of these assets so they’re more in line with their fair value. In this regard, it’s important to note that carbon legislation could make renewable investments much more valuable. This is an important aspect of regulation as, for example, power plants, pipelines, etc., are only useful if they have regulatory approval to operate. It has been increasingly common for regulators to extend the lives of some long-lived assets, thereby increasing the market value of these assets while the book value remains the same. Companies following IFRS could potentially take advantage of this by adjusting the book value of these assets upwards. Such an option isn’t available for firms following GAAP.

Fair Value for Contracts

Many utilities procure commodities ( e.g., electricity) through contracts. If, for example, the contract involves procuring electricity for customers, utilities will often rely on the so-called normal purchases and sale exemption under U.S. GAAP. This allows them to reflect the results of the transaction in income only when the contract has settled— i.e., they can opt out of fair value accounting for these contracts. 15 During times of fluctuating commodity prices, opting out of fair value accounting for the procurement of electricity or other commodities is likely to make the utility’s income and assets less volatile. While IFRS has an “own use” exemption, the limitations of own use accounting are stricter than those pertaining to normal purchase and sale. As a result, some utilities that currently rely on the normal purchase and sales exemption likely will need to switch to fair value accounting for some commodities contracts. 16 Many power purchase contracts that currently are treated as off balance-sheet operating leases will become on balance-sheet leases, and both the power company and the utility will have to disclose lease related revenues and expenses.

This treatment will result in a “bulking up” of the balance sheet and, because some gains and losses in the fair value of contracts are recognized in income, income might become more volatile.

It’s therefore important that regulators, utilities and other stakeholders consider the potential impact on ratemaking initiatives that involve periodical reviews of realized return on equity. Specifically, it might be necessary to change the determination of whether a utility has earned substantially more or less than intended under an incentive-based mechanism or under any other mechanism that calls for the utility to share earnings in excess of a preset amount with customers. Among the ways to make this determination, utilities can: 1) recognize the increased volatility and therefore increase the band around