Adoption of IFRS (International Financial Reporting Standards) in the United States undoubtedly will mark a significant change for many U.S. companies. It will require a shift to a more principles-based approach, place far greater reliance on management (and auditor) judgment, and spur major changes in company processes and systems.
But this change should not be feared. The move to IFRS also presents a tremendous opportunity. Moving to an entirely new accounting structure ultimately might enable companies to streamline reporting processes and reduce compliance costs.
IFRS has fewer bright lines and less interpretive and application guidance than does U.S. GAAP (Generally Accepted Accounting Principles). Companies will need to consider carefully the economic substance of their transactions and then apply the principles embodied in IFRS to that substance. Arguably, doing so might enable a closer alignment with underlying business objectives.
Many financial professionals in the power and utility industries today are aware of IFRS, which presently is used or under consideration in every major financial market around the world. There is a growing recognition, both in the United States and internationally, that a single set of high-quality global accounting standards offers real benefits. IFRS seems increasingly likely to provide that single set of standards.
The Securities and Exchange Commission (SEC) is aware of the growing global acceptance of IFRS and has taken comments from listed companies, audit firms, investment groups, rating agencies, the legal community and government agencies in an effort to create a comprehensive plan for a smooth transition to using IFRS in the United States. These discussions take into consideration issues like whether to allow U.S. filers the option of either adopting IFRS or setting an effective date for implementation by all U.S. registrants.
The SEC hosted a roundtable meeting in August 2008 that focused on the performance of IFRS during the market turmoil that already was churning earlier this year. While panelists shared a general consensus that IFRS performed quite well, they acknowledged that challenges exist in the application of both IFRS and U.S. GAAP in areas such as fair-value accounting. In addition, the roundtable focused on accounting for off-balance sheet arrangements and commodity pricing, both topics of particular interest for the power and utility industries. Panelists also expressed the view that IFRS could benefit from additional application guidance to reduce certain inconsistencies as presently applied.
In late August, the SEC approved for public comment its long-awaited “Roadmap” to the eventual use of IFRS by U.S. companies. The proposed Roadmap anticipates mandatory reporting under IFRS beginning in 2014, 2015 or 2016, depending on the size of the issuer, and provides for early adoption in 2009 by a small number of very large companies that meet certain criteria. The SEC later might decide to allow other companies to adopt IFRS early, before the mandatory date of conversion. The roadmap also identifies several milestones that the SEC will consider in making its decision in 2011 about whether to proceed with mandatory adoption of IFRS.
While there are differences between U.S. GAAP and IFRS, the general principles, conceptual framework and accounting results between them are often the same, or similar, for most commonly-encountered transactions.
In general, IFRS standards are broader than their U.S. counterparts, with limited interpretive guidance. While U.S. standards contain underlying principles as well, the strong regulatory and legal environment in U.S. markets has resulted in a more prescriptive approach—with far more “bright lines,” comprehensive implementation guidance and industry interpretations.
The International Accounting Standards Board (IASB) generally has avoided issuing interpretations of its own standards, preferring instead to leave implementation of the principles embodied in its standards to preparers and auditors, and its official interpretive body, the International Financial Reporting Interpretations Committee (IFRIC).
The more principles-based approach offered by IFRS will present some unique challenges for the regulated utility industry. With IFRS likely to arrive in the near—rather than distant—future, affected utilities should consider the implications of IFRS and start planning now.
• Accounting by regulated entities: Under U.S. GAAP, FASB Statement No. 71, Accounting for the Effects of Certain Types of Regulation, regulated entities are allowed to account for certain incurred costs that will be able to be recovered through future rates as regulatory assets. Conversely, amounts previously collected but owed back to ratepayers are accounted for as regulatory liabilities. There is no comparable provision under IFRS, which means that, from the regulatory-asset perspective, certain costs (including stranded costs from deregulation, fuel recoveries, storm damage, environmental remediation, and losses on refinancing to a name a few) will need to be written-off (despite the regulatory provision to recover such costs from ratepayers in the future). This would result in the recording of future revenues with no corresponding cost recognition.
• Property, plant and equipment: Accounting for items such as property, plant and equipment may be more granular under IFRS than under U.S. GAAP. IFRS requires companies to account for fixed assets at the component level, which is defined as the unit of measurement to separately identify an asset, or part thereof, with a separately identifiable estimated useful life. Although most utilities account for assets using a retirement-unit level, reviewing current fixed-asset accounting records will help utilities determine which components should be depreciated over what estimated useful lives.
Lack of a parallel standard to Statement No. 71 in IFRS will mean that the treatment of gains and losses arising from disposal of assets belonging to regulated entities also will require review, as will the treatment of impairments and decommissioning obligations for current operating assets—particularly as the trend toward new nuclear generation and expansion into alternative energy sources continues. Policies that bear reviewing include those relating to allowable capitalized costs and accounting for subsequent replacement of components to make sure amounts are not overcapitalized on a company’s balance sheet.
• Financial instruments: This area poses probably the biggest conversion challenge. Commodity contracts and hedging activity play a significant part in the operations of utilities. Although the two relevant accounting standards, FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities (as amended for U.S. GAAP purposes), and IAS 39, Financial Instruments: Recognition and Measurement, generally are comparable, some fundamental differences merit utilities’ consideration. Review of contractual language and details will be key: Reevaluating contracts will allow utilities to determine the proper accounting treatment in accordance with IFRS.
IFRS uses the “own-use” definition to exempt contracts that were entered into and continue to be held for the purpose of receipt or delivery of a non-financial item in accordance with the entity’s expected purchase, sale or usage requirements. Certain hedging relationships—or the concept of normal purchases and normal sales—might be treated differently under U.S. GAAP than they are under IFRS and its related own-use determination. Under IFRS, it’s also possible to hedge components (portions) of risk that give rise to changes in fair value. The overall valuation of financial instruments (specifically, considering the definition of fair value as set forth in the literature) and the accounting for day-one gains also may result in differing accounting results under the two standards.
• Accounting for joint ventures: Currently, IFRS states that investments in associated companies are accounted for using the equity method, and investments in jointly controlled entities are accounted for under the equity method or proportionate consolidation. However, the treatment of joint ventures, including jointly-controlled assets, operations and entities, and the use of pro rata consolidation currently allowed under IFRS, are under review. This is another challenging area that likely will affect certain operating structures in place in the U.S. power and utilities industries. While varying structures allow companies to account for such joint ownership in the United States, some companies also have used the pro rata consolidation concept in U.S. GAAP-based financial statements to account for ownership interests in plants and related assets.
• Emissions: Due to a worldwide focus on climate change, emissions generated by power and utility companies have received a lot of attention, and this also has raised accounting awareness. In addition, the recent District of Columbia Circuit Court of Appeals ruling in July 2008 striking down the U.S. Environmental Protection Agency’s Clean Air Interstate Rule raised valuation and potential impairment issues related to nitrogen oxide and sulphur dioxide trading programs. This ruling has affected companies that began installing certain emissions-reduction control equipment at their plants. While both the Financial Accounting Standards Board (FASB) and IASB have accounting for emission allowances as current projects, neither U.S. GAAP nor IFRS currently sheds much light on any specific method of accounting for these allowances, resulting in at least two different methods of accounting. The two methods primarily focus on whether the emission allowances should be recorded as inventory or intangibles with the valuation question focused on whether to carry the allowances at historical cost or fair value. A related question arises as to whether an obligation should be recorded, and as of what date, related to a company’s emissions.
IFRIC previously issued Interpretation 3 related to accounting in this area, but that interpretation was withdrawn, leaving unanswered questions about accounting for emissions. However, IASB recently added an Emission Trading Schemes project onto its agenda. The board tentatively decided that the scope of the project will address accounting for all tradable emission rights and obligations, and for activities to receive tradable rights in the future. Accounting commentary and literature increasingly address IFRS issues, so conversion likely will lend additional guidance in this area.
Investor-owned U.S. power and utility companies are regulated by the SEC as well as other entities, such as the Federal Energy Regulatory Commission (FERC) and local agencies of the states in which they operate. The accounting rules of FERC and other regulatory agencies heavily have influenced the accounting policies guiding U.S. utilities. To date, IFRS makes no allowance for other regulators, and this is not likely to be covered by the continuing SEC roundtable and other planning discussions.
At this point, FERC isn’t expected to change its Uniform System of Accounts simply because of a proposed U.S. conversion to IFRS. Even if a change eventually would be forthcoming, it wouldn’t happen until after U.S. issuers convert to IFRS.
For most industries, IFRS ultimately might enable companies to streamline reporting processes and reduce the cost of compliance. However, for U.S. power and utility companies, if the concepts of Statement No. 71 are not adopted or embraced by IFRS rule makers, accounting practices mandated by FERC and other regulatory bodies might result in the requirement to maintain a separate set of financial records, similar to the process for current statutory reporting in certain international jurisdictions. The need to generate the required accounting information could have significant implications for a company’s information-technology system. As a result, these companies would need to continue evaluating accounting for industry-specific issues and how it affects their IFRS planning.
In any case, momentum is building for U.S. adoption of IFRS, and conversion no longer appears to be a matter of “if,” but more a matter of “when” and “how.” For companies that report in multiple jurisdictions, the adoption of a single global set of accounting standards can be a benefit in terms of process standardization and related efficiency gains. Multiple approaches to financial reporting continue to be inefficient and troublesome, and many affected companies strongly support the SEC’s continued efforts in the U.S. transition to IFRS.
The question that power and utility executives and directors need to tackle—sooner, rather than later—is how they can maximize the opportunities presented by IFRS and effectively and efficiently deal with any challenges as a result of the conversion. The straightforward answer is to start planning now, dedicate the appropriate management focus and create a project team across all aspects of the company—including the financial accounting and reporting, tax and IT departments—to assess the effort and work toward transition activities. Also, it’s never too early to begin educating analysts and investors on how a conversion to IFRS might impact the company’s financial results.
Now is the time to begin planning for conversion from GAAP to IFRS. The resources needed and the impact on the organization will be far-reaching. But with proper strategic planning, benefits can be substantial.