Evaluation of the second criterion requires additional judgment if the regulated utility is subject to any form of ratemaking that introduces uncertainty about the cause-and-effect relationship between costs and rates. Prior to the codification, paragraph 65 of
FAS 71 elaborated on this point as follows:
Excerpt from FAS 71, paragraph 65
If rates are based on industry costs or some other measure that is not directly related to the specific enterprise’s costs, there is no cause-and-effect relationship between the enterprise’s costs and its revenues. In that case, costs would not be expected to result in revenues approximately equal to the costs; thus, the basis for the accounting specified in this Statement is not present under that type of regulation.
Consistent with this guidance, adoption by a regulator of any alternative forms of ratemaking, such as rate freezes, performance or incentive rates, price caps, or discounting, would call into question whether
ASC 980 applies. If alternative or nontraditional forms of ratemaking are implemented, a reporting entity should carefully evaluate whether it meets or continues to meet the
ASC 980-10-15-2(b) criterion.
Deferred recovery plans
In some jurisdictions, regulators have adopted deferred recovery plans in response to significant increases in costs. These plans vary, but typically provide for rates to remain fixed or increase moderately with a tracking mechanism to capture costs in excess of the level allowed in current rates. This is different from a standard tracker that is meant to capture amounts in excess of or below an estimate of current costs, with adjustment of rates to compensate over the short-term.
Costs subject to a deferred recovery plan may include purchased power costs, operations and maintenance costs, depreciation, or interest. A regulated utility subject to these types of rate arrangements should consider not only whether the uncollected costs qualify for deferral as a regulatory asset but whether it continues to meet the
ASC 980-10-15-2(b) criterion. The fact that a regulator is unwilling to approve current rates based on the current cost of service calls into question the ability to meet this basic premise of regulatory accounting.
Rate freezes
Regulators may issue rate orders that freeze rates over a period of time, providing a regulated utility with limited ability to adjust its prices. Although regulatory oversight typically remains in place and a return to cost-based ratemaking may be expected, rate freezes and similar programs create uncertainty about whether an entity continues to meet the scope criteria for application of
ASC 980. Factors to consider in evaluating the potential impact of a rate freeze include:
- Length of the rate freeze
- Expected stability of costs during the rate freeze period
- Rate adjustments for specific events (e.g., tax law changes, significant changes in fuel costs, unusual storm damage)
A rate freeze extending over a period of several years, lack of regulator rate action or formal rate proceeding after a period of unchanged rates, or an inflexible rate program that fails to adjust for volatile costs, such as fuel, result in a presumption that the reporting entity does not meet the
ASC 980-10-15-2(b) criterion. Relevant factors to consider in assessing whether this presumption can be overcome may include predictability of costs during the rate freeze period, the nature of ongoing cost filings (if any), involvement or participation of interveners in evaluating cost filings, and periodic regulatory oversight of the level of costs and earnings.
Rate discounts
In some situations, a regulated utility may provide rate discounts to all customers or to a particular customer class. Sustained rate discounts also create uncertainty about whether the
ASC 980-10-15-2(b) criterion is met. Subsidization of discounts for one customer class by other customer classes may be an indication that rates are cost-based on an entity-wide basis. If, however, the level of discounting becomes significant, it may indicate that the criteria for application of
ASC 980 are not met for the portion of the business in which customers receive the discount.
Index-based rates
In some jurisdictions, the regulator may develop rates for fuel or other costs based on a market index, instead of the reporting entity’s specific costs for providing the service. In other instances, all or a portion of base rates may include provisions for an automatic rate change based on changes in a specified index. These mechanisms may not be directly tied to the reporting entity’s cost of providing service. We do not believe adoption of an index-based mechanism automatically precludes application of
ASC 980 to that portion of the business. However, regulated utilities should evaluate any index or market-based mechanism with skepticism. In evaluating this type of mechanism, regulated utilities should consider how closely the index mirrors actual costs and whether it will continue to reflect underlying costs over the entire period it is in effect.