Question

In: Accounting

Metropolitan Hydro (MH) is a private company that owns and operates all of the province's electricity...

Metropolitan Hydro (MH) is a private company that owns and operates all of the province's electricity generation and transmission systems. It is deciding whether it should follow IFRS or ASPE in the upcoming year. The company must choose now and is looking to analyze the impact of following IFRS or ASPE. Each year, MH must prepare and submit audited financial statements to the government. The company generates and sells electricity to residential and commercial customers. It is committed to the following: Identifying and providing innovative solutions that will improve the reliability and efficiency of electrical delivery Sustainability (including not only profitability but also environmental sustainability)—in this regard, MH has a publicly available environmental policy against which the company is measured by the government The company has just finished a new project to install smart meters in all residential houses. The meters allow residents to track usage and power supply and demand. Each meter is very expensive and will likely become technologically obsolete in three years. MH decided to pursue this strategy nonetheless due to its commitment to sustainability. The company wants all customers to think about using electricity wisely and the meters help with this. The company generally requires a security deposit (amounting to the cost of the meter) when a customer signs up to receive electricity or when the meter is first installed. The value of the meter declines over time and after three years it is worthless. If customers cancel their electricity delivery contract early, they get the full amount back once they return their meters. Otherwise, at the end of three years, MH retains the security deposit and has no obligation to return the cash. MH is rate-regulated. This means that it must ask for government approval whenever it wants to raise the rates that it charges for electricity. Generally, the government allows the company to recover all costs incurred in generating the electricity plus a reasonable profit margin. Therefore, rates are set as being equal to “cost plus reasonable profit margin.” This means that, once approved, the company is able to charge revenues equal to all costs incurred plus a reasonable profit. Under ASPE, special “rate-regulated accounting” exists. One of the features of this special accounting is that companies following rate-regulated accounting are able to defer any losses that are incurred on disposition of assets, on the basis that they can recover these losses from future revenues. IFRS does not allow this. Sometimes MH signs supply contract agreements with other suppliers of electricity to ensure that power supplies to MH customers are not disrupted. Under the terms of these contracts, MH locks in the quantity and price of electricity. However, the contracts do not explicitly include net settlement provisions. Because electricity is a commodity, the contracts may be bought and sold on the regional commodities exchange. MH is concerned about maintaining a consistent supply of electricity to its customers, since many of its generating stations are getting very old and the incidence of breakdown and generating station closures due to the age of the equipment is increasing. There is no market for these old generating stations (and MH would probably replace the capacity with newer, greener forms of electricity, such as wind or solar). Often the land that these stations are sitting on is polluted with chemicals. Technically, since this pollution occurred many years ago in most cases, there are no laws in place to force cleanup. Currently, the company is doing a voluntary land assessment and remediation program to identify the extent of this pollution. The company expects that it would recover all of the cleanup costs it might incur from future revenues through increased customer rates. However, there is always the chance that future governments might change the ability to build these costs into the rates charged to customers. Some of the generating stations are located on lands held by First Nations. The company is negotiating to obtain legal title to the lands but understands that it may have to relocate the assets. The assets in question are material. MH obtains much of its financing through bonds and commercial paper issuances. Therefore, it is important that it retain its good credit ratings. Currently, it has a very good credit rating, awarded by both S&P and Moody's credit rating agencies. This good rating helps keep costs (and therefore customer rates) down. There are debt covenants in the debt agreements that limit the amount of debt as a percentage of total capitalization (total assets). Debt may not exceed 75% of total assets under these covenants. (Currently, the actual debt to total assets ratio is 65%.) Instructions Assume the role of an accounting consultant hired to determine which set of accounting standards to follow. Discuss the financial reporting issues relating to the above. Use the case analysis framework presented in the Case Primer, including an overview, analysis, and recommendations.

Solutions

Expert Solution

SOLUTION

Overview

-     Rate regulated by the government so must show accountability and justify costs

-     GAAP is a constraint due to the fact that government likely wants GAAP statements (also audit required) and may choose ASPE or IFRS – ASPE may provide more relief in terms of requiring less disclosures and complex accounting. In addition, ASPE is more flexible which may allow for unique business model. IFRS may be more appropriate since accountable and need to access capital markets (banks) for capital.

-     Company is a monopoly (owns and operates Ontario’s electricity transmission systems – therefore must show that they are not taking advantage. In addition, regulated industry – must get approval for rate increases but basically allowed to recover costs plus a reasonable profit. May be some bias to show that they are not making an unreasonable profit and that they are controlling costs. May also be a bias to show that they value sustainability since they are evaluated by the government on this.

-     Debt to total assets ratio is important since debt covenants state that debt cannot exceed 75% of total assets. If it does, the loans may be called. In addition, higher debt will cause cost of capital to rise and this will cause rates to increase (undesirable). Important to keep their good credit ratings.

-     Special rate regulated accounting under ASPE – allows them to defer losses on assets that have been disposed – may be a bias to use this to show lower costs in the year.

-     Role is that of accounting consultant – therefore must focus on transparency.

Analysis and recommendations

Smart meters

MH asset

Customer asset/not an asset on MH books

- Legal title with MH (must return the meter if customer cancels contract) – therefore risks with MH

- Rewards also with MH since they benefit by renting out the equipment

- Require security deposit up front equal to cost to protect against risk of loss

- Like a lease contract – should recognize income over life of asset (three years)

- Should depreciate the asset – which method? May depreciate more upfront since meters become obsolete over time. Or – use straight line since the meters last 3 years and likely the customer uses similar amounts of electricity over time.

- Choice under IFRS to value at FV under revaluation method

- Located on customer property and therefore possession = rewards of ownership

- Meters technologically obsolete within three years and therefore useless (likely that most owners keep the assets for most of their useful lives

- Is this like a sale of the equipment and service (MEA) – issue is how to allocate the total amount of the contract including the security deposit over the life of the asset – relative FV method or residual method

Conclude – note that special IFRS guidance (no guidance under ASPE) – IFRIC18. Could argue to treat as an asset since this is the most transparent.

Supply contracts

Purchase contracts

Derivatives

- These are normal purchase contracts to lock in a supply of electricity

- The entity plans to use the electricity = expected use

- No net settlement provisions

- Concern about ensuring supply to customers (given old equipment)

- Meets the definition of a derivative since no funds upfront, settled in future and value of contract depends on value of electricity

- Essentially net settleable since a commodity and markets exists which allow them to trade out of the position (regional commodities exchange)

- May want to use hedge accounting since price is locked in and therefore no volatility (should not impact NI) – gains and losses to OCI under IFRS since cash flow hedge (future transaction)

- Under ASPE – if considered to be an exchange traded contract – covered by 3856 would not recognize contract until maturity.

- If hedge accounting used (voluntary) – must meet criteria and test for effectiveness

Conclude and why – essentially ASPE is the same as IFRS except as noted. If recognized and hedge accounting not used – makes net income look more volatile – however not transparent since price risk removed.

Asset impairment

Impair

Do not

- Since these are likely a significant portion of assets, must assess for impairment frequently

- Also technology changing and old technology out of synch with new objective re sustainability

- IFRS – recoverable amount is higher of value in use and FV less cost to sell

- May be easier to calculate VIU since they have a stable customer base and allowed to recover all costs (rate regulated)

- ASPE – compare to fair value less cost to sell – generally discount future cash flows only if carrying value is greater than undiscounted cash flows

- May be an issue due to equipment being on lands held by Aboriginals – may not be able to access

- May be difficult to come up with the FV number since no market

- They know that they can recover all costs so technically never impaired

Conclude and why – different tests under IFRS and ASPE. IFRS may result in earlier recognition of any impairments – negatively affects debt ratio

ARO

Recognize

Do not

- IFRS requires legal and constructive obligations to be recognized and provides more guidance (IAS 37) as to how to measure

- Given sustainability objectives, likely constructive obligation

- Old non-green technology likely means should accrue

- Likely able to get increased rates to cover

- If recognized must decide as to whether to capitalize or expense (capitalize only if meets definition of asset – would have to argue that part of cost of getting asset ready for use i.e. cannot use asset unless also provide for cleanup – like a product cost). Recoverable through increased rates.

- ASPE only requires legal obligations – none exist

- May be too difficult to measure

Conclude and why – different recognition and measurement under IFRS – may result in greater liabilities being recognized – could negatively affect ratio (increased debt)

Assets on aboriginal land

W/O

Do not

- Must decide whether to impair or write off since do not have legal title to land and may not be able to move it (may not want to since old technology and significant costs)

- Currently still own the assets even if not the land.

- Value still recoverable from future revenues assuming can increase prices to recover costs)

- Still in negotiations – outcome uncertain at this stage – not far enough along

Conclude

Other issues:

-     Relocation costs – capitalize or expense and why

-     Other


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