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20.3 Fair value of regulated assets and liabilities
Publication date: 19 Jan 2024
us Utilities guide
Assets acquired and liabilities assumed in a business combination should be recorded at their acquisition-date fair values, except as specifically stated in ASC 805. Regulation can impact the fair value of utility plant assets and it may be appropriate to offset certain fair value adjustments with regulatory assets and liabilities (i.e., record a regulatory offset). However, regulation does not override US GAAP. ASC 805 and ASC 820 should be applied when accounting for a business combination. The interaction of regulation and fair value in a business combination is summarized in Figure UP 20-1.
Figure UP 20-1
Accounting for a regulated utility business combination
Accounting for a regulated utility business combination
Component |
Fair value considerations |
Regulatory considerations |
|---|---|---|
Utility plant assets
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No separate regulatory accounting
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Regulatory assets and liabilities
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Not applicable; the asset or liability being recorded is the regulatory asset or liability itself
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Intangible assets and liabilities, including contractual rights and obligations
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Regulatory offset may be appropriate in certain circumstances, depending on ratemaking and specific pass-through mechanisms
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Regulatory offset may be appropriate in certain circumstances
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In addition, ASC 805-20-25-28C and ASC 805-20-30 includes specific guidance for accounting for contract assets and contract liabilities from contracts with customers acquired in a business combination. While we would not expect a regulated utility to have contract assets and/or contract liabilities associated with its regulated customers, such assets and liabilities should be accounted for following this guidance. (see BCG 2.5.16).
The following sections address accounting considerations specific to regulated utility acquisitions.
Question UP 20-1
Is it appropriate for a reporting entity to record a regulatory asset or liability as an offset to working capital assets acquired and liabilities assumed in a business combination?
Is it appropriate for a reporting entity to record a regulatory asset or liability as an offset to working capital assets acquired and liabilities assumed in a business combination?
PwC response
Generally, no. In accordance with ASC 805, generally working capital assets and liabilities are required to be measured at fair value in a business combination. Typically, a regulated utility recovers working capital items through its general cost of service. As a result, we would not expect a reporting entity to record a regulatory asset or liability to offset fair value adjustments to working capital items. Amounts included in a utility’s general cost of service would not have the direct cause and effect relationship between rates and costs to qualify for regulatory offset.
See UP 20.3.3.1 for further information on recording an offsetting regulatory asset or liability. See BCG 2.6.3.4 and FV 7.3.3.1 for further information on the valuation of working capital items when applying the acquisition method.
20.3.1 Utility plant assets
Utility plant assets are assets that are included in “rate base,” that is, assets on which the regulated utility is permitted to earn a return that is included in rates charged to customers. The environment in which a utility’s plant assets are managed, as well as the impact of regulation on future cash flows, has a significant effect on the fair value. ASC 820 requires the use of market participant perspectives in measuring fair value and the resulting valuation should exclude any characteristics of an asset arising from its association with a specific entity. However, ASC 820-10-35-2B acknowledges that the use of an asset may be limited by restrictions to which it is subject.
A fair value measurement is for a particular asset or liability. Therefore, when measuring fair value a reporting entity shall take into account the characteristics of the asset or liability if market participants would take those characteristics into account when pricing the asset or liability at the measurement date. Such characteristics include, for example, the following:
a. The condition and location of the asset
b. Restrictions, if any, on the sale or use of the asset.
Regulation is viewed as being a characteristic (restriction) of the asset and the impact of regulation is considered a fundamental input to measuring the fair value of utility plant assets in a business combination as further discussed in this section. See also UP 20.3.1.3 for other factors that should be considered in measuring the fair value of utility plant assets.
20.3.1.1 Regulation is a characteristic of utility plant assets
ASC 820-10-35-10B describes factors that should be considered in measuring the fair value of a nonfinancial asset, indicating that the highest and best use of the asset should be based on potential uses that are “physically possible,” “legally permissible,” and “financially feasible.” The currently-accepted framework for utility plant asset valuations is based on the conclusion that use of utility property outside of regulation is neither legally permissible nor financially feasible because of the public interest in the assets.
Physically possible
Legal restrictions on the physical use of utility plant assets created by regulation (see below) may be viewed as similar to an easement or zoning restriction. Although the asset is within the jurisdiction of a regulator, it is essentially zoned for the single purpose of serving customers of regulated utilities and yields a regulated return. As with an easement, the regulated utility may pay to have the public-use requirement removed (i.e., by return of all or a portion of any gain to customers), but that obligation impacts the realizable value of the asset. Similar to an easement, this leads to a conclusion that a market participant would consider the impact of regulation when valuing the asset.
Legally permissible
State utility commissions and regulators grant a type of monopolistic status to regulated utilities, while retaining some legal control over utility operations to protect the public interest. Under this regulatory compact, regulated utilities agree to rate regulation and accept a “duty to serve,” which includes agreement to serve all who seek service in the territory and to provide safe and reliable service at fair and reasonable rates. Further, the utility’s shareholders receive a stable return, which lowers the return on investment necessary to attract capital. However, in exchange, the shareholders are subject to the requirement that the regulated assets of the regulated utility must be operated for the benefit of the ratepayers and the regulator’s approval is required for significant transactions.
The unique relationship between a public utility, its regulator, and its customers was first established in 1877 in connection with the Munn v. Illinois case. Munn and Scott, owners of a grain elevator, challenged the right of the state of Illinois to regulate their business. The US Supreme Court found that “when private property is devoted to a public use, it is subject to public regulation.” Further, the court ruled that:
When, therefore, one devotes his property to a use in which the public has an interest, he, in effect, grants to the public an interest in that use, and must submit to be controlled by the public for the common good, to the extent of the interest he has thus created.
This decision highlights the public interest in the individual property of the regulated utility and indicates that use of that property is controlled for the common good. Regulated utility assets are limited to use for public purposes, and the legal obligation arising from regulation directly restricts the use of an asset as “utility property.” In addition, regulated utilities often are required to obtain certificates of convenience for significant asset acquisitions, which serve to formally notify a regulator of intent to construct or purchase assets and to gain approval as to the need for the asset and intended use. These requirements further support direct linkage of regulation to the individual asset.
Financially feasible
In the context of a public-use asset that cannot be sold without the regulator’s approval, it is not feasible to realize the potential value of the asset outside of the rate-regulated environment. The regulator would either deny the sale or require the regulated utility to refund the gain to the ratepayers. As such, a market participant would be expected to determine the fair value of a utility asset based on retaining the asset for regulated operations and earning a regulated rate of return.
Other considerations
The FASB’s approach to accounting by regulated entities provides helpful guidance when considering the fair value of utility plant assets in a business combination. The FASB previously recognized that regulation may impact the economics of transactions such that it should affect the application of US GAAP. Rate-regulated accounting guidance was issued in recognition of the potentially pervasive impact of regulation on a regulated utility. Prior to the Codification, in the Basis for Conclusions to FAS 71, the FASB provided the following context.
FAS 71, paragraph 75
The Board concluded that, for general-purpose financial reporting, the principal economic effect of the regulatory process is to provide assurance of the existence of an asset or evidence of the diminution or elimination of the recoverability of an asset. The regulator’s rate actions affect the regulated enterprise’s probable future benefits or lack thereof. Thus, an enterprise should capitalize a cost if it is probable that future revenue approximately equal to the cost will result through the rate-making process. (emphasis added)
The FASB acknowledged that regulation may result in a benefit or detriment to a regulated utility and that rate actions of the regulator may change the value of an asset to an enterprise. Incorporating the effects of regulation in the valuation of the individual assets of a regulated utility is thus consistent with the FASB’s conclusion.
Question UP 20-2
Is there an acceptable alternative view that regulation is an attribute of the reporting entity and should be excluded when measuring the fair value of utility plant assets?
Is there an acceptable alternative view that regulation is an attribute of the reporting entity and should be excluded when measuring the fair value of utility plant assets?
PwC response
Generally, no. At the time the guidance in ASC 805 was initially promulgated by the FASB, there was significant industry debate as to whether regulation should be considered an attribute of the reporting entity owning the asset or a characteristic of the asset itself. Because ASC 820 requires a market participant view of fair value, a conclusion that regulation is an attribute of the reporting entity and not a characteristic of the individual assets would lead to the conclusion that the effects of regulation generally should not be incorporated in the valuation of utility plant assets. However, there is strong support for the view that regulation is a characteristic of the asset and that its effects should be incorporated in the valuation of utility plant assets. This conclusion is consistent with industry practice since the adoption of ASC 805 which has followed the view that regulation is a characteristic of the asset and should be incorporated into the valuation of utility plant assets.
There may be circumstances when a reporting entity’s measurement of the fair value of utility plant assets should also incorporate potential uses outside of the regulated environment (see UP 20.3.1.2).
20.3.1.2 Highest and best use for utility plant assets acquired in a business combination
ASC 820 requires reporting entities to determine fair value from the perspective of a market participant. In most cases, the “expected use” of regulated assets will be in a regulated environment. However, in certain cases, a market participant may determine that using the assets outside of a regulated environment achieves its highest and best use. In those circumstances, the regulated utility should evaluate potential alternative uses by a market participant when determining the asset’s fair value.
For example, a business combination may include the acquisition of a regulated power plant located near a liquid trading point. The plant may be strategically suited to merchant operations and there may be interested buyers outside of the regulated environment. In such cases, when measuring the plant’s fair value, the reporting entity should consider the highest and best use for the asset and the expected regulatory treatment of gains resulting from sales of assets in that jurisdiction. If the acquirer may reasonably expect to retain a portion of any gain on sale, the alternative use as well as a reasonable estimate of expected outcome should be considered in the valuation.
20.3.1.3 Considerations in valuing utility plant assets
As discussed in UP 20.3.1.1, the impact of regulation should be incorporated in the valuation of utility plant assets. The acquirer should also consider whether there are other factors that would impact fair value in accordance with ASC 820. For example, a market participant’s required rate of return is a key input in the determination of fair value. Regulated utilities should also incorporate differences in the risk-adjusted rate required by market participants and the current earned return on the assets in the valuation.
Utility plant assets are typically valued using an income approach. Factors that reporting entities should consider in performing the valuation include:
- The nature and use of the utility plant assets
- How the regulated utility’s earned return compares to the rate of return for similar assets subject to regulation in the exit market
- Whether the regulated entity is over- or under-earning on its utility plant assets and the timing for any potential catch-up through the ratemaking process (i.e., regulatory lag)
A market participant may be willing to pay more for the utility plant assets if the regulated utility is earning a higher than market rate for similar regulated assets. Conversely, it may require a lower purchase price if the regulated utility is under-earning or earning a return that is below market. Further, any mechanism for the utility to be “trued-up,” or expectation that the regulated return will be adjusted to a rate based on current market conditions in a near-term rate case, may reduce the impact of the purchase price adjustment that the market participant would otherwise require.
The valuation of utility plant assets may also be impacted by any uncertainty inherent in the cash flows (e.g., construction in progress that is still subject to regulatory review may not be assured of recovery). See UP 20.3.2.2 and UP 20.3.2.3 for further information on the determination of an appropriate risk-adjusted discount rate and incorporation of uncertainty risk in a fair value measurement, respectively. Although this discussion is in the context of fair value measurements of regulatory assets, the guidance also applies to the valuation of utility plant assets.
20.3.2 Regulatory assets and liabilities
Existing regulatory assets and liabilities should be measured at fair value in a business combination following the concepts in ASC 820. That is, fair value is the price that would be (1) received to sell an asset or (2) paid to transfer a liability between market participants (i.e., an exit price). Figure UP 20-2 summarizes key considerations in measuring the fair value of regulatory assets and liabilities.
Figure UP 20-2
Fair value measurement of regulatory assets and liabilities
Fair value measurement of regulatory assets and liabilities
Determine unit of account
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The unit of account is the individual regulatory asset or liability.
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Evaluate valuation premise
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We would expect valuation at the individual asset or liability level.
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Assess principal market
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There is no principal market for the sale of regulatory assets or transfer of regulatory liabilities. There have been some limited sales of regulatory assets (e.g., stranded costs, storm costs) through securitization transactions; however, this type of transaction involves additional legal and other requirements that are not characteristics of typical regulatory assets.
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In the absence of a principal market, determine the most advantageous market
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Reporting entities generally need to develop a hypothetical market to measure the fair value of regulatory assets and liabilities.
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Determine valuation technique
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Reporting entities should consider the appropriate valuation technique based on the facts and circumstances:
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Determine key inputs
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In general, we would expect regulated utilities to measure the fair value of individual regulatory assets and liabilities using an income approach. This is also the approach typically used for utility plant assets. ASC 820-10-55-3F through 55-20 provides further guidance on the application of this approach, including the factors that should be incorporated in the valuation.
20.3.2.1 Amount and timing of cash flows
A key component of the measurement of fair value when using an income approach is the expectation about possible variations in the amount and timing of cash flows. Although some regulatory assets and liabilities may have minimal or no uncertainty about the timing or amount expected to be paid or received, others may involve significant inherent uncertainty. For example, the timing of collection may vary for a regulatory asset collected through a rate surcharge dependent on the level of sales. In other cases, such as revenue subject to refund, there may be uncertainty about the amount that ultimately will be paid or received prior to the time of the final rate order. Depending on the amount and range of uncertainty, it may be appropriate to develop various probability-weighted scenarios using an expected present value technique. See ASC 820-10-55-13 and FV 4.4.3 for further information.
20.3.2.2 Risk-adjusted discount rate
In measuring the fair value of regulatory or utility plant balances, a reporting entity should select an appropriate risk-adjusted discount rate. In developing the appropriate rate, the reporting entity should consider the nature of the regulated cash flows and the rates demanded by market participants as of the measurement date. The specific facts and circumstances will influence whether an adjustment to the rate being earned is required.
When no return is currently allowed or the earned rate differs from the risk-adjusted discount rate, the reporting entity should adjust the carrying value of the regulatory asset or liability when applying the acquisition method.
20.3.2.3 Regulatory assets: uncertainty risk
The measurement of the fair value of an asset should incorporate consideration of the uncertainty inherent in its future cash flows (a risk adjustment). In evaluating the uncertainty risk for a regulatory or utility plant asset, the reporting entity should assess the overall probability of the asset’s recovery. A market participant would demand a discount for the uncertainty related to the recovery of the asset. The level of uncertainty in the future cash flows — and thus the related adjustment — may vary, depending on the nature of the specific asset and its inherent collection risk. For example, if a regulated utility has a specific rate order for a regulatory asset and the amounts are either “collected” through amortization against the utility’s revenue requirement or through a rate surcharge or specified rate, the reporting entity may be able to support recording no adjustment for uncertainty risk. However, other regulatory assets may have more collection uncertainty. For example, a regulatory asset for which recovery is deemed to be probable, but for which an order has not yet been received, may require an additional risk premium in measuring fair value at the acquisition date.
20.3.2.4 Regulatory liabilities: uncertainty risk
ASC 820 also provides guidance for the fair value measurement of liabilities and the incorporation of adjustments for risk. The types of risk adjustments to include vary depending on whether the liability is held by another party as an asset. Regulatory liabilities are not held by other parties as an asset; therefore, the guidance in ASC 820-10-35-16H through 35-16L should be applied.
Excerpt from ASC 820-10-35-16J
When using a present value technique to measure the fair value of a liability that is not held by another party as an asset…, a reporting entity shall, among other things, estimate the future cash outflows that market participants would expect to incur in fulfilling the obligation. Those future cash outflows shall include market participants’ expectations about the costs of fulfilling the obligation and the compensation that a market participant would require for taking on the obligation. Such compensation includes the return that a market participant would require for the following:
a. Undertaking the activity (that is, the value of fulfilling the obligation-for example, by using resources that could be used for other activities)
b. Assuming the risk associated with the obligation (that is, a risk premium that reflects the risk that the actual cash outflows might differ from the expected cash outflows; see paragraph 820-10-35-16L).
Similar to the uncertainty adjustment discussed in UP 20.3.2.3, an adjustment for uncertainty risk related to a regulatory liability can be incorporated either by adjusting the cash flows or by adjusting the discount rate. As with regulatory assets, when developing the risk premium for regulatory liabilities, regulated utilities should consider what a market participant would demand as compensation for the risk being assumed to fulfill that regulatory liability. For example, this could include a probability-weighted estimate of the amounts ultimately required to be returned to ratepayers.
20.3.2.5 Regulatory liabilities: nonperformance risk
ASC 820 also requires incorporation of nonperformance risk in the fair value measurement of a liability.
Excerpt from ASC 820-10-35-18
When measuring the fair value of a liability, a reporting entity shall take into account the effect of its credit risk (credit standing) and any other factors that might influence the likelihood that the obligation will or will not be fulfilled. That effect may differ depending on the liability, for example:
a. Whether the liability is an obligation to deliver cash (a financial liability) or an obligation to deliver goods or services (a nonfinancial liability)
b. The terms of credit enhancements related to the liability, if any.
Credit risk is often the largest component of nonperformance risk. The nonperformance risk associated with a regulatory liability is based on the regulated utility’s own credit and any other factors that may impact repayment. Many argue that there is no risk of nonperformance because the regulator requires full repayment of all regulatory liabilities. However, nonperformance risk, by definition, includes the market price an investor will demand as compensation for the risk of default. Risk of default is equally applicable to regulatory liabilities as it is to conventional debt obligations. Therefore, in measuring the fair value of regulatory liabilities, the reporting entity should incorporate its own risk of nonperformance. See FV 8 for information about how to measure nonperformance risk.
20.3.3 Intangible assets and liabilities
ASC 805 requires recognition of all identifiable assets acquired and liabilities assumed in a business combination, including contractual rights and obligations. This would include items such as (1) power purchase agreements or fuel supply agreements accounted for as executory contracts (e.g., contracts accounted for as normal purchases and normal sales, contracts that do not qualify as derivatives); (2) power plant operating licenses; and, (3) rights of way or other rights agreements. An intangible asset or liability would be recognized for contract terms that are favorable or unfavorable compared to current market transactions or related to identifiable economic benefits for contract terms that are at market.
Accounting for such items in a regulatory environment typically includes addressing certain issues involving the valuation of intangibles in a business combination, as further discussed in this section.
20.3.3.1 Recognition of offsetting regulatory assets and liabilities
The effects of regulation are typically not incorporated in the initial fair value measurement of intangible assets such as contractual rights or obligations, including power purchase contracts, emission allowances, and similar items. However, similar to utility plant assets, regulated customers often have a specific interest in contract rights and obligations or other intangible assets held by a regulated utility. Therefore, a question arises as to when it is appropriate to record an offsetting regulatory asset or regulatory liability (regulatory offset) when applying the acquisition method. Figure UP 20-3 illustrates the considerations in determining whether regulatory offset should be recorded when applying the acquisition method.
Figure UP 20-3
Determining when regulatory offset should be recorded in a business combination
Determining when regulatory offset should be recorded in a business combination
Certain contractual rights and obligations or other intangible assets that were not previously recorded in the acquiree’s financial statements may be recorded as a result of a business combination. These rights and obligations may include an associated customer “interest” or “obligation” that was not previously reflected as a regulatory asset or liability (e.g., an out-of-the money power purchase agreement that does not meet the definition of a derivative, but was executed for the benefit of customers and will be collected through rates).
Although the customer interest or obligation existed prior to the business combination (from transactions that the predecessor initiated as part of providing service to its customer base), a regulatory asset or liability would not have been recognized if the related asset or liability was not recognized on the balance sheet in accordance with applicable US GAAP.
In determining whether a previously-unrecognized regulatory asset or liability should be recorded on the acquisition date, considerations include:
- Would the predecessor entity have recorded a regulatory asset or liability (regulatory offset) if the related asset or liability had been recorded on the balance sheet?
For example, does the regulated utility have a direct cost pass-through or other specific recovery mechanism associated with the asset or liability? If there is direct cause and effect between assets or liabilities recorded and regulatory recovery from, or return to, customers, it would be appropriate to record the impact of regulation. However, if there is no direct linkage between cost and recovery (e.g., amounts are recovered through the general rate case process or are not recoverable at all), we would not expect a reporting entity to recognize the impact of regulation when applying the acquisition method.
- Did the business combination affect the regulated utility’s obligation to return gains, or its right to recover losses from customers? Are the ASC 980 requirements still met?
For example, as part of the business combination, the acquirer may have agreed not to seek customer recovery of certain “off-market” contracts. As such, it would not be appropriate to record a regulatory asset to offset the contractual liability recorded when applying the acquisition method. The regulated utility should review the rate order approving the acquisition to ensure the impacts of the agreement are properly reflected in recording the business combination.
The regulated utility should record a regulatory asset or liability if the right to recovery or obligation to refund existed with the predecessor entity, and the predecessor would have recorded a regulatory asset or liability if the related contractual right or obligation had been recognized on the balance sheet.
EXAMPLE UP 20-1
Recognition of regulatory offset when applying the acquisition method
Recognition of regulatory offset when applying the acquisition method
M&H Holding Company (M&H) acquires all of the stock of Rosemary Electric & Gas Company (REG) on April 2, 20X1. In accordance with the requirements of ASC 805, the acquired assets and liabilities assumed in the business combination are measured at fair value as of the acquisition date.
REG has an “in-the-money” power purchase agreement with a third-party power generator fair valued at $40 million as of the acquisition date. Prior to the acquisition, REG concluded that the power purchase agreement was not a lease and designated the contract under the normal purchases and normal sales scope exception. As such, the agreement was accounted for as an executory contract and was not recognized at fair value in the accounting records. As part of its accounting for the acquisition of REG, M&H will record a contract intangible asset related to this agreement for $40 million (i.e., it would record the fair value of the contract at the acquisition date). REG has a power cost adjustment mechanism and recovers all prudent power costs from customers. Prior to the acquisition, a regulatory liability was not applied to this contract asset because it was not recognized on the balance sheet. Ongoing payments under the power contract were recovered as part of the power cost adjustment mechanism.
Should M&H record a regulatory liability to offset the contract intangible asset recorded as part of its acquisition of REG?
Analysis
Yes, M&H should record a regulatory liability because the benefit from this contract must be returned to customers. Further, REG would have recorded a regulatory liability if the power contract had been recorded on the balance sheet prior to the acquisition. Therefore, in applying the acquisition method, M&H will also recognize a related regulatory liability.
20.3.3.2 Contracts with specific prohibition against transfer or resale
Contractual rights or licenses held by a regulated utility may have specific prohibitions against transfer to a third party. For example, a regulated utility may have a right to receive power from a hydroelectric project operated by a government entity, but is prohibited from transferring these rights to another party. The fair value for this type of contract may be measured by comparing the cost of the power from the facility to the cost of market power. However, if the contract cannot be transferred, the fair value cannot be monetized. Similarly, regulated utilities may hold Federal Energy Regulatory Commission or other operating licenses that are not legally transferrable. Therefore, a question arises as to whether these transfer restrictions affect the recognition of the rights or licenses in acquisition accounting.
ASC 805 concludes that transfer restrictions do not impact the requirement to record such contractual rights or obligations.
Excerpt from ASC 805-20-55-2
Paragraph 805-20-25-10 establishes that an intangible asset is identifiable if it meets either the separability criterion or the contractual-legal criterion described in the definition of identifiable. An intangible asset that meets the contractual-legal criterion is identifiable even if the asset is not transferable or separable from the acquiree or from other rights and obligations. For example: (a) An acquiree leases a manufacturing facility under an operating lease that has terms that are favorable relative to market terms. The lease terms explicitly prohibit transfer of the lease (through either sale or sublease). The amount by which the lease terms are favorable compared with the pricing of current market transactions for the same or similar items is an intangible asset that meets the contractual-legal criterion for recognition separately from goodwill, even though the acquirer cannot sell or otherwise transfer the lease contract.
20.3.4 Liabilities
Regulated utilities typically have numerous long-term liabilities, such as long-term debt, asset retirement obligations, and environmental accruals. Generally, liabilities should be measured at fair value on the measurement date, with certain exceptions. Refer to BCG 2.5 for a summary of exceptions to the recognition and fair value measurement principles in ASC 805.
Similar to contractual rights or other intangibles, the impact of regulation should not be directly incorporated into the valuation of long-term liabilities. However, it may be appropriate to recognize an offsetting regulatory asset for certain liabilities in a business combination if certain criteria are met. See UP 20.3.3.1 for information on recognizing regulatory offset.
EXAMPLE UP 20-2
Recognition of regulatory assets to offset fair value adjustments for liabilities
Recognition of regulatory assets to offset fair value adjustments for liabilities
Pine Tree Electric Company (PTE) owns all of the stock of Rosemary Electric & Gas Company (REG) and Cypress Water & Power Company (CW&P). REG and CW&P are regulated utilities located in different states and are subject to different utility commissions. PTE is acquired by M&H Holding Company (M&H) on April 2, 20X1. In accordance with the requirements of ASC 805, all of the assets and liabilities acquired in the business combination are measured at fair value as of the acquisition date.
Both REG and CW&P have significant environmental remediation liabilities; however, they have different forms of regulatory recovery:
- REG has an environmental cost recovery mechanism in place whereby it recovers the cost of remediating specified environmental sites previously reviewed and approved by its regulator. Its existing environmental liability is offset by a related regulatory asset.
- CW&P recovers its environmental costs through its general rate cases. The amount included in the periodic rate cases is based on an average of actual cash expenditures for environmental remediation over the preceding three years.
M&H plans to measure the environmental liabilities at fair value as part of applying the acquisition method.
Should M&H also record regulatory assets to offset the remeasurement of the environmental liabilities?
Analysis
In recording the acquisition of PTE, M&H’s accounting for regulatory assets associated with environmental liabilities should reflect differences in the REG and CW&P recovery mechanisms:
- REG has a specific mechanism to recover its environmental costs and, prior to the acquisition, had recorded a regulatory asset to reflect the unrecovered portion of the costs incurred to date. Management of M&H therefore concludes that it is appropriate to adjust REG’s environmental-related regulatory asset when applying the acquisition method.
- CW&P recovers its environmental costs through the general rate case process, with no specific recovery mechanism. Therefore, the ASC 980-340-25-1 criteria are not met and any adjustments to the environmental liabilities recorded when applying the acquisition method should not be offset by recording a regulatory asset.
20.3.5 Long-term debt
This section discusses the considerations related to the accounting for long-term debt in the acquisition of a regulated utility.
20.3.5.1 Recognition of an offsetting regulatory asset or liability
Long-term debt presents unique considerations in evaluating whether regulatory offset should be recorded, as a direct cause-and-effect relationship between recovery of debt costs and rates is often difficult to establish. Regulated utilities generally recover the cost of long-term debt as part of a general rate case or other proceeding that establishes the utility’s authorized rate of return. The authorized rate of return may be established annually or as part of the general rate cycle, depending on the jurisdiction and the individual regulated utility. The determination of the authorized rate of return may incorporate the actual cost of the utility’s borrowings and capital structure or may be based on a hypothetical capital structure.
In evaluating whether regulatory offset is appropriate, the regulated utility should consider the rate treatment of debt costs and how interest and other costs are recovered. Factors that would support regulatory offset include:
- Interest and other debt-related costs are considered as a direct input in the ratemaking process
- Regulatory mechanisms directly incorporate interest cost or other debt-related expenses/benefits
- The jurisdiction has a history of direct recovery of gains and losses on debt, amounts related to interest rate swaps, or other debt-related costs
The regulated utility should consider all available evidence in determining whether it is appropriate to record a regulatory asset or liability to offset any debt related fair value adjustments. It may be difficult to support recognizing a regulatory asset or liability if the regulated utility’s cost of capital is determined based on a hypothetical structure, or if there is limited correlation between the cost of debt and amounts recovered through rates.
20.3.5.2 Accounting for other debt-related amounts
Long-term debt, should be measured at fair value as of the acquisition date (See FV 7.3.3.5 for further discussion of the measurement of debt at fair value).
In accordance with ASC 835-30 debt issuance costs, premiums, and discounts are recorded in the balance sheet as adjustments to the carrying amount of the related debt. Therefore, for reporting entities, the fair value measurement should replace all amounts on the balance sheet related to long-term debt.
For regulated utilities, however, a question arises as to whether certain debt-related amounts may be recorded on the balance sheet by the acquirer as regulatory assets. We believe that it would be appropriate to record regulatory assets associated with certain debt-related costs if the recognition criteria in ASC 980 are met. Further, we would generally expect the treatment of the debt-related costs to be consistent with the accounting for assumed debt (i.e., if an offsetting regulatory asset or liability is recorded for the fair value of debt based on considerations described in UP 20.3.5.1, it is likely it will also apply to the related debt costs). However, reporting entities should separately evaluate the accounting for debt-related costs. Absent an appropriate basis for their recovery, the regulated utility should not record any regulatory assets or liabilities.
Regulated utilities may also have previously-deferred amounts related to reacquired debt. Gains and losses on reacquired debt are recognized at the time of a debt extinguishment by reporting entities in general, but such amounts are deferred for collection or payment through the rate process by regulated utilities if probable of recovery or return. Because these amounts represent regulatory assets or liabilities that were previously deferred as a result of their regulatory treatment, we believe it would generally be appropriate to continue to defer these amounts when applying the acquisition method. Reporting entities should consider the guidance in UP 20.3.2 when measuring and recording the fair value of such amounts.
20.3.6 Preexisting relationships between the acquirer and the acquiree
ASC 805-10-55-20 and 55-21 discuss relationships between the acquirer and the acquiree that existed prior to the business combination (referred to as preexisting relationships). The acquirer should identify any preexisting relationships to determine which ones have been effectively settled. Typically, a preexisting relationship will be effectively settled, since such a relationship becomes an “intercompany” relationship upon the acquisition and is eliminated in the postcombination financial statements. The acquirer should recognize a gain or loss if a preexisting relationship is effectively settled as part of the business combination.
There may be circumstances when a regulated utility acquired in a business combination has a preexisting relationship with an unregulated component of the acquiring entity (e.g., the acquiree, a regulated utility, has a long-term electric supply agreement with an unregulated generation subsidiary of the acquirer). In such cases, the reporting entity should consider whether the relationship has been “effectively settled” or whether the regulated entity’s asset (or liability) continues to exist. If the contract costs are otherwise recoverable as a component of rates, and the regulator through approval of the business combination has not addressed termination of the contract, the regulated utility would typically conclude that the relationship has not been effectively settled. Therefore, the preexisting relationship established by this long-term contract would continue to be recoverable by the regulated utility through rates. This conclusion is similar to the concept in ASC 980-810-45 whereby intercompany profit between unregulated entities and regulated affiliates is not eliminated in consolidation (see UP 17.7). Consequently, the reporting entity would record an asset or liability for the fair value of the contract on the acquisition date, and would follow the guidance in UP 20.3.3.1 to assess whether an offsetting regulatory asset or liability should be recorded. Similar considerations apply in evaluating existing relationships between regulated and unregulated subsidiaries of an acquiree.
EXAMPLE UP 20-3
Accounting for preexisting relationships in a business combination
Accounting for preexisting relationships in a business combination
M&H Holding Company acquires all of the stock of Rosemary Electric & Gas Company on April 2, 20X4. Prior to the acquisition, REG had contracted with M&H’s unregulated generation subsidiary to purchase energy under a 20-year power purchase agreement. REG is permitted to recover 100% of its purchased power costs from ratepayers. At the date of the acquisition, the contract is $30 million “out-of-the-money” for REG, and $30 million “in-the-money” for M&H. The business combination does not result in a change to REG’s rate agreement and it will continue to recover 100% of its purchased power costs. Because the contract is “out of the money” for REG at the acquisition date, M&H will record a contract liability as part of its accounting for the acquisition.
As part of its accounting for the acquisition, should M&H record a regulatory asset to offset the contract liability recognized as part of acquisition accounting?
Analysis
Yes. M&H should record a regulatory asset because the costs of the power purchase agreement continue to be recoverable from ratepayers. Further, REG would have recorded a regulatory asset if the power purchase agreement had been recorded on the balance sheet prior to the acquisition. Therefore, M&H would record the following journal entry when applying the acquisition method (amounts in millions):
Dr Regulatory asset
|
$30
|
|
Cr Contract intangible liability
|
$30
|
This accounting is predicated on consistent regulatory treatment before and after the merger. A regulator’s requirement to cancel the contract or change the contractual terms as a condition of the merger transaction would impact the accounting conclusion. Any such changes should be evaluated to determine the appropriate accounting.
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