Rate regulation involves setting tariffs for utilities like water and energy, determined by sector regulators such as Ofwat and Ofgem in the UK. These tariffs are based on estimated costs required to deliver goods or services over a specific period, resulting in ‘allowed revenue’ or, in accounting terms, ‘total allowed compensation’.

The current problem 

Regulated rates are calculated using estimates, which may differ from actual costs and quantities. This difference leads to over- or under-recovery of compensation, referred to as timing differences. Performance incentives also impact the calculation of regulated rates as entities can earn bonuses or face penalties based on their efficiency, eg, penalties imposed by Ofwat for excessive sewage spills into UK rivers.

Adjustments for these timing differences are made in the regulated rates of future periods and can significantly impact an entity’s revenue, profit, and cash flows. Regulators can choose to make these adjustments in allowed revenue in the current price control period (‘revenue adjustments’) or by adjusting the entity’s regulatory capital base (RCB). The RCB is the value of the asset base that the entity will recover in the future through regulatory depreciation and represents the present value of the future revenues that the business expects to earn. 

Current IFRS Accounting Standards do not permit entities to reflect these timing differences however, resulting in the widespread use of alternative performance measures by rate-regulated entities keen to ensure the revenue and asset base are understandable to users of their accounts.

Types of regulatory schemes

At this point, it is important to note that there are generally two types of regulation, namely cost-based and incentive-based regulation. In a cost-based regulatory environment, the financial accounting and regulatory accounting are similar, leading to a close relationship between the entity’s property, plant and equipment (PPE) and its RCB. In an incentive-based regulatory environment, as is the case in the UK, the financial accounting and regulatory accounting are not aligned.

Another important issue is the way regulators determine the return on capital calculated on the value of the RCB, which is included in an entity’s allowed revenue (and therefore the regulated rate) for each year. Some regulators use a nominal interest rate approach while others use a real interest rate approach. The real interest rate is lower than the nominal interest rate because it does not include a component for inflation. All UK entities operate under a real interest rate model and are compensated for inflation through an adjustment to the RCB. This adjustment flows through into allowed revenue as part of the regulatory depreciation of the RCB. In the nominal model the RCB is analogous to a historic cost model for PPE while in the real model, the RCB is comparable to a current cost model for PPE.

The IASB’s proposals

The IASB’s 2021 Exposure Draft Regulatory Assets and Liabilities (ED) was aimed at addressing this issue by setting principles for recognising, measuring, presenting and disclosing regulatory assets and liabilities (RARL). The objective was to provide relevant information that accurately represents the impact of regulatory income and expense on an entity’s financial performance, the impact of RARL on an entity’s financial position, and the expectations of future cash flows.

The ED requires entities to recognise regulatory assets for enforceable rights to add amounts to future regulated rates and regulatory liabilities for enforceable obligations to deduct amounts from future regulated rates. These would be measured on a modified historical cost basis, reflecting updated future cash flow estimates.

The recognition of RARL gives rise to regulatory income and regulatory expense respectively, achieving the objective of reflecting the full amount of total allowed compensation in the period it relates to.

The IASB’s direct (no direct) relationship concept

After extensive deliberation, in December 2022 the IASB tentatively decided to base some of the accounting requirements on whether an entity’s PPE and its RCB have a direct or no direct relationship.

The direct (no direct) relationship concept will have implications for the extent to which rate-regulated entities within scope will be able to recognise RARL. The approach currently proposed by the IASB means that:

• all entities will be required to recognise RARL arising from timing differences that are ‘revenue adjustments’;
• entities whose PPE and RCB have a direct relationship will also be required to recognise RARL arising from timing differences included in the RCB;
• entities whose PPE and RCB do not have a direct relationship will be prohibited from recognising RARL arising from timing differences included in the RCB; and
• all entities will be prohibited from recognising RARL arising from timing differences relating to inflation included in the RCB.

The IASB’s rationale for these proposals is that, based upon feedback received from stakeholders, it would be difficult and costly for entities whose PPE and RCB have no direct relationship to track the movement of individual items included in the RCB. The proposed standard will prohibit recognition of any inflation adjustment to the RCB as the IASB considers that the costs of recognising that asset will outweigh the benefits of the information provided to users.

The UKEB’s concerns

The UK Endorsement Board (UKEB) has raised significant concerns about the IASB’s proposals. In particular, given all UK entities within the scope of the future accounting standard have no direct relationship between PPE and RCB due to the nature of UK regulation, the UKEB is concerned about the lack of completeness, and therefore understandability, of their accounts. The UKEB Secretariat’s work has highlighted that currently, depending on the sector, as much as 60% of the timing differences of UK entities may not be recognised.

Applying the IASB’s proposals will not enable entities to report the full extent of their financial performance and financial position. Examples of potential RARL that would not be recognised on the statement of financial position of such entities include:

• The difference between accounting and regulatory capitalisation of expenditure, including the capitalisation of interest;
• The difference between accounting and regulatory depreciation; 
• Inflation adjustments included in the RCB; and
• Any other incentive mechanism adjusted in the RCB.

Although the IASB proposes to prohibit the recognition of the inflation adjustment for all entities, it is really only entities operating under a real interest model that are affected by this proposal. Entities operating under a nominal interest model automatically recognise inflation when they charge customers the regulated rate.

The UKEB’s suggested alternative

The UKEB asked its Secretariat to explore potential alternatives to the IASB proposals. As a result, the Secretariat has developed a top-down approach to track and monitor timing differences at a higher unit of account. This would be more aligned with regulatory practices.

This approach considers how enforceable rights and obligations arising from timing differences included in the RCB of entities whose PPE and RCB have no direct relationship could be tracked and monitored. The approach would be supplementary to the IASB’s current proposals rather than a replacement.

In July 2024, the UKEB wrote a letter to the IASB setting out its concerns with the IASB’s current proposals. This letter was accompanied by a Consolidated report on the UKEB Secretariat’s proposed top-down approach, which the UKEB believes is worth exploring further. The report sets out a summary of the development work to-date and the areas in which additional work is required to fully develop it into a possible standard-setting solution.

Next steps

Further work is necessary to fully develop the top-down approach and field test it with entities in the UK and in other jurisdictions. A successful outcome to this work would enable all rate-regulated entities to provide a complete picture of their financial performance, financial position and expectations of future cash flows in their IFRS accounts, without extensive reliance on alternative performance measures.

Seema Jamil-O’Neill, UK Endorsement Board Technical Director