As outlined in ASC 980-10-15-2, a reporting entity is required to apply ASC 980 if it meets three specified criteria:
  • Rates are established by an independent third-party regulator or the entity’s own governing board (UP 17.2.1)
  • Rates are designed to recover costs of service (UP 17.2.2)
  • Rates designed to recover costs can be charged to and collected from customers (UP 17.2.3)
A reporting entity should assess and document whether it continues to meet each of the criteria, setting forth the significant factors considered, at least annually or any time rate structures change or significant regulatory developments occur. The unit of account for the application of ASC 980 may be a transaction, a group of transactions, a separable operation of the reporting entity, or the reporting entity in its entirety, depending on the level at which the criteria in ASC 980-10-15-2 are met. The documentation should address whether separable portions of the business qualify for application of ASC 980 if there are specific or different factors impacting various parts of the business (e.g., service territories, customer classes, or functional activity such as generation).
The determination of whether a reporting entity’s rate structure continues to meet the criteria of ASC 980 should consider the totality of the evidence and all relevant facts. The following discussion highlights considerations in making this assessment. The discussion is framed in the context of the entire business; however, similar factors would be considered in assessing a separable portion of the business (see UP 17.2.4).

17.2.1 Rates are established by an independent third-party regulator or the entity’s own governing board

The first criterion for determining whether rate-regulated accounting applies to a reporting entity is that its rates for regulated services are established by an independent, third-party regulator or its own governing board.

ASC 980-10-15-2(a)

The entity’s rates for regulated services or products provided to its customers are established by or are subject to approval by an independent, third-party regulator or by its own governing board empowered by statute or contract to establish rates that bind customers.

This criterion is straightforward and has not generated much controversy in application. If a third-party regulator sets the rates for a reporting entity, this criterion is usually met. This requirement is also met by self-regulated enterprises, such as governmental or quasi-governmental entities with a governing board responsible for setting customer rates (e.g., municipal water authorities and rural electric cooperatives).

17.2.2 Rates are designed to recover costs of service

The second criterion for determining whether rate-regulated accounting applies to a reporting entity is that its regulated rates are designed to recover its costs of providing the regulated services or products.

ASC 980-10-15-2(b)

The regulated rates are designed to recover the specific entity’s costs of providing the regulated services or products. This criterion is intended to be applied to the substance of the regulation, rather than its form. If an entity’s regulated rates are based on the costs of a group of entities and the entity is so large in relation to the group of entities that its costs are, in essence, the group’s costs, the regulation would meet this criterion for that entity.

This criterion requires a cause-and-effect relationship between a reporting entity’s costs and its rate base revenues. As a result, entities whose rates are regulated on a group or regional basis generally would not meet this criterion. Furthermore, the timing of cost recovery and the related frequency of ratemaking is important. A reporting entity should consider its rate case experience, including the design of its rates and timing of recovery, when determining whether this criterion is met. These factors are summarized in Figure UP 17-1.
Figure UP 17-1
Evaluating whether rates are designed to recover costs of service
Indicators that rates are cost-based
Indicators that rates are other than cost-based
Rate case activity
  • General rate cases occur at regular intervals or more frequently as necessary
  • Regulatory lag periods are not extensive and are comparable to peers
  • Sustained period of no rate cases
  • Unusually long lag periods, causing the reporting entity to under-earn or over-earn
Rate design
  • Rates are designed to recover incurred costs plus a reasonable return on rate base
  • Rate process incorporates actual or estimated costs (or both) in developing the revenue requirement and customer rates
  • Rates are based on market or average industry costs or based on reporting entity performance (incentive-based rates)
  • The revenue requirement has little or no connection to the reporting entity’s cost of service
Periods of alternative ratemaking (e.g., rate freezes) (UP
  • A return to cost-based regulation may be elected by the utility if the results of the alternative form of rate regulation do not provide cost recovery
  • Alternative rate structure is temporary or for a short period, and cause and effect is still present
  • Regulator determines if and when the utility may return to cost-based regulation
  • Alternative rate making is in effect permanently, for a long period, or without a stated timeframe
Cost uncertainty
  • Highly volatile costs (such as fuel) are recovered via a tracker or other similar recovery mechanism
  • Special rate cases are provided for nonrecurring, unusual, significant costs or gains (e.g., major storm damage, sale of a facility)
  • The utility is required to manage volatile costs to a target; shareholders are subject to the risks and rewards of deviation from that target
  • No interim adjustments to rates to compensate for potentially significant losses or gains; no true-up to actual costs if amounts deviate from expected
  • Disallowances may occur on occasion but are limited in frequency and amount
  • Regulator demonstrates willingness to allow recovery of incurred costs plus a return
  • Frequent or recurring disallowances occur, impacting the utility’s ability to recover its costs
  • Implementation of phase-in plans
Whether a reporting entity meets this criterion is a matter of judgment that should be based on all relevant factors. Cost-based ratemaking does not necessarily result in a dollar-for-dollar pass-through of costs. Ratemaking involves projections and assumptions, and actual costs will differ from estimated amounts used in developing rates.
Further, changes in cost structure may not be captured immediately in rates. Some delay in the timing between when a cost is incurred and when recovery begins (referred to as regulatory lag) is generally expected and would not normally impact the conclusion that this criterion is met. In addition, as described in Figure 17-1, occasional regulatory disallowances likely would not impact the assessment. However, a regulated utility should consider whether it continues to comply with this criterion if it is receiving frequent or recurring negative rate decisions or disallowances.
Question UP 17-1
Does the term “entity’s costs” used in the second and third criteria of ASC 980-10-15-2 mean all costs or only allowable costs?
PwC response
We interpret the term “entity’s costs” to mean allowable costs.

Definition from ASC 980-10-20

Allowable Costs: All costs for which revenue is intended to provide recovery. Those costs can be actual or estimated. In that context, allowable costs include interest cost and amounts provided for earnings on shareholders’ investments.

The inclusion of a return (earnings on shareholders’ investments) in the definition of allowable costs means that for a reporting entity to qualify as a regulated utility, rates should be set to recover its cost of service and a reasonable rate of return. However, except in the case of equity return on allowance for funds used during construction, the return portion of a reporting entity’s costs does not qualify as an incurred cost that would otherwise be charged to expense and, therefore, cannot be capitalized as a regulatory asset (see also Question UP 17-5).
When considering whether the second and third criteria of ASC 980-10-15-2 are met, a reporting entity should perform its evaluation by considering only those costs that are allowable by the regulator. The utility should not consider or account for costs not associated with the regulated portion of the business using rate-regulated accounting.
See UP 17.3.1 for further information on allowable costs and how they compare to incurred costs. Also, see Question 17-5 as it relates to treatment of the equity return component for regulatory assets. Impact of alternative ratemaking

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.

17.2.3 Rates designed to recover costs can be charged to and collected from customers

The third criterion that must be met to apply ASC 980 is that a regulated utility will be able to charge to and collect from its customers rates that will recover its costs.

Excerpt from ASC 980-10-15-2(c)

In view of the demand for the regulated services or products and the level of competition, direct and indirect, it is reasonable to assume that rates set at levels that will recover the entity’s costs can be charged to and collected from customers. This criterion requires consideration of anticipated changes in levels of demand or competition during the recovery period for any capitalized costs. This last criterion is not intended as a requirement that the entity earn a fair return on shareholders’ investment under all conditions; an entity can earn less than a fair return for many reasons unrelated to the ability to bill and collect rates that will recover allowable costs. For example, mild weather might reduce demand for energy utility services. . . . The resulting decreased earnings do not demonstrate an inability to charge and collect rates that would recover the entity’s costs; rather, they demonstrate the uncertainty inherent in estimating weather conditions.

As noted in the excerpt, the FASB recognized that a regulated utility may not earn a fair return in all circumstances, such as when there are changes in consumption due to weather or economic circumstances. In such cases, the utility should consider a number of factors related to the regulatory, legal, and market environment to support whether it will be able collect revenue sufficient to recover its costs. Key factors to consider in making this assessment are included in Figure UP 17-2.
Figure UP 17-2
Assessing whether rates  designed to recover costs can be charged to and collected from customers
Indicators: able to charge and collect cost-based rates
Indicators: unable to charge and collect cost-based rates
Regulation/ legislation
  • Monopolistic operating environment in which rates are regulated
  • Few choices of suppliers for the portion of the business being evaluated
  • Deregulation legislation has been or will soon be enacted
  • Unbundling of services that enables existing customers to bypass the utility, creating stranded or unrecoverable investment
Competitive environment
  • No issues in charging and collecting rates designed to recover incurred costs plus a reasonable return
  • Rates for customer classes are consistent with a cost recovery model (i.e., certain classes do not subsidize others)
  • Rates are consistent with neighboring utilities
  • Prices discounted below what is authorized by the regulator due to competition (thereby preventing the reporting entity from recovering its costs and collecting them from customers)
  • Significant disparity among the rates charged to different customer classes (i.e., one customer class significantly subsidizes another)
  • Rates are higher than those of neighboring utilities or alternative competitive sources
  • Excess capacity or significant loss of customers
The utility should consider a number of factors related to the regulatory, legal, and market environment to support whether it will be able collect revenue sufficient to recover its costs. As noted in Figure 17-2, the guidance provides that existence of an exclusive franchise with minimal competition from other services or products would provide a reasonable expectation that this criterion is met. However, this criterion would not be met if market or other structural factors exist (e.g., competition in the regulated utility’s service territory or a dramatic decline in demand) that would prevent the utility from charging rates to recover its costs, regardless of the actions of the regulator.
This criterion also requires that the regulated utility be able to continue charging rates sufficient to recover costs, considering the potential impact of competition or changes in demand during the recovery period for any capitalized costs. For example, the introduction of competition into the service territory could have a significant effect on a regulated utility’s ability to charge and collect rates from customers set at levels to recover its cost of service. The shift in the landscape from a cost-based monopolistic environment to a competitive, market-based structure may occur over a period of time; reporting entities will need to apply judgment when considering changes in the environment (see UP 17.6).

17.2.4 Application to a portion of a reporting entity’s operations

In accordance with ASC 980-10-15-4, if only some of a reporting entity’s operations are subject to regulation, and those operations meet the criteria in ASC 980-10-15-2, rate-regulated accounting should be applied only to that portion of its operations. Although there is no specific guidance on what constitutes “some of an entity’s operations,” the guidance on discontinuation in ASC 980 may be helpful in making this determination (see UP 17.8.1 for further information on how to define a separable portion of a business).
Question UP 17-2
Would a group of costs (e.g., natural gas costs) qualify as a separable portion of the business?
PwC response
It depends. ASC 980 applies to a separable portion of the business if the operations qualify. This analysis may be straightforward when a reporting entity has a distinct business unit or has operations within a customer jurisdiction that clearly meet the criteria for application of ASC 980. However, analyzing whether a specific asset or group of costs are subject to regulation and recovery may be complex. Determining whether the asset or group of costs is clearly specified in a rate order or other evidence that would support regulatory accounting, including the means and timing of cost recovery, is key to this analysis.
For example, assuming all of the criteria in ASC 980 are met, a pipeline expansion for which capital and operating expenses will be recovered through rates imposed by a regulator may qualify for regulatory accounting if the related capital and operating costs are segregated such that it is clear which costs are being recovered through a cost-of-service mechanism. Similarly, if a reporting entity does not qualify for application of ASC 980 to its entire business but has cost-of-service regulation for one aspect of its costs (e.g., fuel costs), it may qualify for rate-regulated accounting for those costs, assuming the other criteria of ASC 980 are met.
The application of ASC 980 to a group of costs is highly judgmental and may not be appropriate in many circumstances. All facts and circumstances should be carefully evaluated against the criteria in ASC 980 in reaching an accounting conclusion.
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