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IND-AS: Impact On Power & Utility Companies

Published on Tue, Jun 16,2015 | 20:37, Updated at Tue, Jun 16 at 20:37Source : 

By: Vishal Bansal, senior professional in a member firm of EY Global

Power and utility industry is highly regulated and capital intensive. Also, some of the activities in this industry are very unique. These aspects give rise to peculiar Ind-AS issues for companies operating in the power and utility industry. This article describes some key issues that are expected to arise.

Power Purchase Agreements
Power producing companies often enter into long-term power purchase agreements with the prospective buyers to ensure a continuous demand for power produced. Such contracts are typically accounted for as normal sale/purchase contracts under the Indian GAAP. On transition to Ind-AS, accounting for such arrangements may undergo significant changes. To decide appropriate accounting, companies will need to carefully examine detailed terms and conditions of the agreement and the fact whether the agreement is with a private party or with a government body.

For agreements with a government body, the first assessment is whether the contract should be accounted for as service concession arrangement under Appendix C to Ind-AS 115 on the subject Service Concession Arrangements (SCAs). Appendix C to Ind-AS 115 applies to public-to-private SCAs if they satisfy both the following conditions:
(a)    Grantor controls or regulates what services the operator must provide with the infrastructure, to whom it must provide them and at what price.
(b)    Grantor controls, through ownership, beneficial entitlement or otherwise, any significant residual interest in infrastructure at the end of the arrangement period.

If these criteria are met, a power producing company will not be able to recognize the power plant as fixed asset in its financial statements. Rather, it is presumed that the company is providing services to the government. Accordingly, it will recognize revenue at the fair value while construction is in progress. The company will recognize the corresponding amount either as an intangible asset or financial asset or both, depending on exact terms and conditions. Subsequent accounting under the intangible asset model and financial asset model is substantially different. Under the intangible asset model, amount received on sale of power during operation phase is recognized as revenue. Simultaneously, the company amortizes intangible asset to profit or loss. The financial asset model works similar to accounting for finance lease receivables, where amounts received are allocated between capital recovery and interest using effective interest method.

Apart from impact on the financial statements, upfront recognition of revenue may have potential income-tax impact as well. Considering this treatment, even indirect tax authorities may contend that the company needs to pay service/ works contract tax on the construction revenue.

For agreements with a private party as well agreements with government bodies not covered under Appendix C to Ind-AS 115, the company will assess whether the arrangement is or contains a lease under Appendix C to Ind-AS 17 Determining whether an arrangement contain a lease. Appendix C to Ind-AS 17 lays down the following two criteria:
(a)          The fulfilment of the arrangement is dependent on the use of a specific asset or assets (the asset).
(b)         The arrangement conveys a right to use the asset.

If it is determined that the arrangement contains a lease, the lease element is separated from the underlying service element and classified as an operating or finance lease. Such accounting may have significant impact on the financial statements of power producing companies. If the arrangement is finance lease, the company will derecognize the entire power plant from its financial statements. The same will get recognized in the financial statements of the customer.

Lease accounting may also have significant business implications such as compliance with debt covenants, measurement of EBITDA, presentation of revenue and cost numbers and ability to raise further finance, for the power producing company.

Impact Of Rate Regulation
In India, regulators often set prices of electricity and other utilities in advance, based on the estimated volumes, cost and a target rate of return. At the end of the period, the regulator and the company determine the actual volume, cost and return. This may give rise to either a surplus that needs to be refunded to the customer or a deficit that needs to be recovered from the customer. This is done through future price adjustments.

Under Indian GAAP, notified accounting standards do not deal with recognition and measurement of rate regulatory assets and liabilities/ regulatory deferral accounts. However, there are few Expert Advisory Committee (EAC) opinions which support recognition of such assets and liabilities in specific cases, e.g., opinion 38, published in volume 25 (opinion no. 25.38). Recently, the ICAI has issued second edition of the Guidance Note on Accounting for Rate Regulated Activities (GN). The GN defines regulatory assets and regulatory liabilities, set out criteria for their recognition, specify how they should be measured and require disclosures about their financial effects. The GN is applicable for financial years beginning on or after 1 April 2015.

Ind-AS 114 Regulatory Deferral Accounts specifies financial reporting requirements for regulatory deferral account balances. Ind-AS 114 is an optional standard made available to first-time adopters of Ind AS. Ind-AS 114 is interim standard intended to provide relief from derecognizing rate-regulated assets and liabilities on adoption of Ind-AS. Ind-AS 114 allows but does not require a company whose activities are subject to rate regulation to continue applying most of its existing accounting policies for regulatory deferral account balances upon first-time adoption of Ind-AS.

On transition to Ind-AS, companies, which are subject to rate regulation, will need to decide whether they intend to use Ind-AS 114. This decision may have long lasting impact on them. Particularly, a company which decides not to use this standard on the date of first-time adoption of Ind-AS will not be able to adopt it subsequently.

Long-Term Fuel Purchase
Power and utility companies often enter into long-term purchase contracts for oil, gas, coal and/or power to meet contractual obligations to supply their customers. Generally, these contracts are meant for receipt of a commodity in accordance with the company’s expected purchase, sale or usage requirements. However, in few cases, it may use these contracts for generating profit from short-term price fluctuations in one or more of the following ways:

•              Contractual volume purchased exceeds forecast customer usage demand. In such cases, the company may sell these excess purchases to the market.
•              A power and utility company may have signed a long-term contract at a price lower than market price. If excess volumes are purchased under the contract to be sold in the market, this would be considered as profit generation from short-term price fluctuations.

Under the Indian GAAP, such contracts are considered executory, even if the company may use some of those to make short-term profit. Thus, no specific accounting is applied to the same until the company actually realizes the underlying profit or loss. The application of Ind-AS will require the company to examine whether these contracts meet the criteria for “own use exemption” under Ind-AS 109 Financial Instruments. If the company is net settling these contracts or using the same for generating a profit from short-term price fluctuations or broker-dealers’ margin, this exemption will not be available and the company may need to apply derivative accounting either for the whole or a part of the contract. Any such accounting is expected to bring significant volatility in the statement of profit and loss.

Customer Discounts And Incentives
Power and utility companies sometimes offer customers a cash incentive to change their utility provider, or to renew their supply agreement. If the benefit that the company receives from the customer by providing the cash incentive is the ‘right’ to perform under a contract (e.g., right to provide electricity in the future), then the cash payment would qualify as a cash incentive. Under Ind-AS, a cash incentive to customer is reduced in the measurement of revenue.

Some power and utility companies offer an early settlement discount to their customers. Under Indian GAAP, cash discount is treated as expense and does not impact measurement of revenue. Under Ind-AS, management needs to make an estimate of the consideration it expects to be entitled to as a result of offering such incentives, considering past experience with similar customers and similar transactions. Generally, for customers that are expected to avail such incentives, early settlement discounts may have to be recognized as a reduction of revenue as the sales are recognized.

Connection Fees And Transfers Of Assets From Customers
Before a power and utility company can deliver power, gas or water to a household, the household needs to be connected to the grid. The cost of connection may be met by the grid operator, or the grid operator may charge these costs (in full or in part) as a one-time nonrefundable connection fee. In such cases, the issues that arise are:

•              How should the connection fees charged to customers be recognized (should they be recognized immediately or deferred over a certain period)?
•              How should the costs incurred by the grid operator be treated (should they be expensed immediately or capitalized as part of the cost of the grid)?

Indian GAAP does not provide any specific guidance on these issues. It is expected that companies may be following varying practices on the matter. Under Ind-AS, appropriate accounting for such contribution shall depend on the following factors:

(i)           Does the company control the item of PPE received from the customer? If yes, it will recognize the transferred asset as an item of PPE and measure its cost on the initial recognition at fair value.
(ii)         When the cash is transferred, the company assesses whether the asset to be constructed meets the definition of an asset, i.e., it will be within the company’s control when it is completed.
(iii)        Once the asset meets the condition to be recognized at fair value, it is accounted for as an “exchange transaction.” This means that the company is considered to have delivered a service in exchange for receiving the asset. Accordingly, the company will recognize the corresponding amount as revenue over the period it renders concerned services. If only one service is identified, the company will recognize revenue when the service is performed. However, if ongoing service is provided as a part of the agreement, the period over which the revenue will be recognized for that service is generally determined by the terms of the agreement with the customer.

On transition to Ind-AS, companies will need to carefully assess all conditions surrounding the use of the asset to make this determination, which will involve a thorough understanding of the agreement and the laws pertaining to the operations of the business.

In providing the customer with ongoing access to goods/services, companies may have difficulties in assessing the period over which the revenue should be recognized. It will be necessary for companies to make detailed assessments of their customers’ agreements and asset usage in order to determine the appropriate period. In some cases, information systems may need to be enhanced to capture relevant data for this assessment, and to amortize the revenue over the period this service is provided.

In addition, when converting to Ind AS, power and utility companies will need to deal with many other accounting differences, such as those related to accounting for emission rights, property, plant and equipment, business combinations, financial instruments, joint ventures, financial liabilities and equity, amortization of intangible assets, employee compensation, stock option and many more.

The conversion to Ind-AS is not only an accounting exercise. Rather, it is an exercise in change management, which impacts various other aspects of business. It is imperative that power and utility companies start preparing themselves for Ind-AS in time so that they can address all the issues in an effective manner. The benefits of a timely start and a robust plan are substantial.


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