The International Accounting Standards Board (Board) recently published the Exposure Draft Regulatory Assets and Regulatory Liabilities. In this spotlight article, we provide a brief overview of the proposals and discuss how investors may find the new information useful in analysing the financial performance of rate-regulated companies.
Few sectors would be affected by the proposals. Rate regulation that falls within the scope of the proposals will most likely affect companies that operate in the utilities sector (power generation and transmission, gas transmission and distribution, water supply, sewage) and in the public transport industry (toll roads, air traffic control, airport services). Nonetheless, it is worth highlighting that the proposals have not been developed for a specific sector and may apply to companies in any sector.
A company would be affected by the proposals if:
Differences in timing arise when a regulatory agreement requires a company to include in the regulated rate for one period compensation for goods or services supplied in a different period. As a result, differences in timing give rise to rights or obligations to add or deduct amounts to or from future regulated rates.
A simplified example
WaterUtil plc (a fictitious company) is party to a regulatory agreement that entitles the company to recover the input costs it incurs in supplying goods to customers. The regulated rates for Year 1 are set to recover estimated input costs of currency units (CU) 100. However, actual input costs for Year 1 amount to CU120. The regulatory agreement gives WaterUtil plc the right to add that under-recovery of input costs (CU20) in the rates to be charged to customers in Year 2.
Currently, IFRS Standards do not require companies to recognise the rights and obligations resulting from such differences in timing in the financial statements nor to report how these rights and obligations affect financial performance. As a result, companies currently either do not report such information in the financial statements, or do not report it in a consistent and comparable manner.
For a non-regulated company, the information currently provided in the financial statements enables investors to understand the relationship between the company’s revenue and expenses. An understanding of this relationship allows investors to assess the financial performance and future cash flows of the company.
However, when a company is a party to a regulatory agreement that creates differences in timing, the company’s reported financial performance in a period may not provide investors with sufficient information to help them better understand the relationship between revenue and expenses. This is because the reported financial performance in a period may not reflect the compensation to which the company is entitled for the goods or services it supplied in that same period. Without information about differences in timing, it is difficult for investors to understand what portion of the fluctuation in the revenue-expense relationship is due to differences in timing. Without this information, it is also difficult for investors to identify the company’s rights to increase and obligations to decrease regulated rates in the future. To resolve these difficulties, the proposals require that companies provide information about differences in timing by recognising regulatory assets, regulatory liabilities, regulatory income and regulatory expense.
Let us use the example to examine the problem and the solution proposed by the Board.
To recap, WaterUtil plc can recover CU20 for goods supplied in Year 1 by increasing regulated rates in Year 2. Let us assume the regulated rates for Year 2 are set to recover estimated input costs of CU100 plus the input costs under-recovered in Year 1 of CU20—that is, a total of CU120. Actual input costs for Year 2 amount to CU100. For simplicity, the example assumes that the regulated rates allow WaterUtil plc to recover only input costs and no profit.
Table 1: Simplified profit and loss statement of WaterUtil plc
||Year 1||Year 2|
Profits in Year 1 do not reflect the full compensation the company is entitled to for goods supplied in that year. Profits in Year 2 include compensation for goods supplied in Year 1.
Investors might conclude that WaterUtil plc underperformed in Year 1 and overperformed in Year 2.
Table 1A: Simplified profit and loss statement applying the proposals
|In CU||Year 1||Year 2|
|Regulatory income (regulatory expense)||20||(20)|
Profits in Year 1 and Year 2 reflect the full compensation the company is entitled to for goods supplied in each of those years.
Investors would have a better understanding of the performance of the company in each reporting year.
Table 2: Simplified balance sheet of WaterUtil plc
|In CU||Year 1||Year 2|
In Year 1, the balance sheet does not capture WaterUtil plc’s right to increase rates in Year 2 for goods supplied in Year 1.
Investors lack information to assess how the company’s right to increase rates in the future will affect its future cash flows.
Table 2A: Simplified balance sheet applying the proposals
|In CU||Year 1||Year 2|
In Year 1, the balance sheet captures WaterUtil plc’s right to increase rates in Year 2 for goods supplied in Year 1.
The information about the regulatory asset would provide investors better insight into how that asset would affect the company’s future cash flows.
As with any accounting change, the proposals would not result in changes to the company’s cash flows. In addition, the net of regulatory income and regulatory expense would appear as non-cash adjustments in the statement of cash flows.
Under the proposals, investors could expect to receive more useful information from companies that would:
The proposed disclosure requirements aim to provide a better understanding of the relationship between a company’s revenue and expenses, thus helping investors obtain insight into a company’s prospects for future cash flows. The disclosures investors might find most helpful include those on:
If you are keen to discuss the proposals with the project staff, please feel free to connect with the Investor Team at the IFRS Foundation by emailing firstname.lastname@example.org. We look forward to hearing from you.
Jeremy: I am a global equity analyst at Newton Investment Management where I am responsible for valuation and accounting across the whole investment team. Prior to this, I covered sectors such as aerospace, engineering, autos and technology.
I believe that the market is very efficient or, if you prefer an analogy, the market is very good at guessing how many smarties are in the jar, because it relies on the collective wisdom of all participants. Similarly, at Newton, we believe that the collective wisdom of the team is greater than the insights of any individual. We have a thematic framework which describes the cross-sector tailwinds and headwinds that we believe are material over the medium to long term. We have an investments team that considers environmental, social and governance (ESG) perspectives, and our sector specialists have a deep understanding of company fundamentals.
My team provides an unbiased and independent perspective on equity recommendations that is grounded in financial statement analysis. These valuation and accounting reviews highlight risks and opportunities which may be overlooked by the market, because sometimes the numbers in the accounts tell a different story from the narrative of the investment case.
All of these perspectives are integrated and expressed in valuation models. For example, the thematic framework may inform the growth rates used in a discounted cash flow model, the ESG review may inform our view of the timing of cash costs in relation to a decommissioning provision, and my valuation and accounting review may inform our view of recurring restructuring expenses.
Jeremy: A key difference between the covid-19-induced crisis and prior crises is that the root cause is the spread of the virus itself. As a result, short-term forecasts of economic activity—such as whether a recovery is ‘v’-, ‘u’- or ‘w’-shaped—are effectively forecasts of the number of new cases, which is something outside the expertise of most analysts. When I think of the Telecom-Media-Technology (TMT) bubble of the late 1990s or the Great Financial Crisis (GFC) of 2007–08, the root causes were economic: asset price bubbles and asset valuations respectively. Another difference that comes to mind is that previous crises originated from certain sectors (for example, TMT and banking), whereas in this crisis, all sectors have been impacted at the same time.
What we observed in early 2020 was that companies particularly sensitive to covid-19 restrictions, such as those in the travel and leisure sector, were the first to feel the pain. In these areas, our analysis focused on the ability to survive the lockdowns and on liquidity. We looked at the levels of cash and the levels of debt and the ability to service it. In previous crises the focus was different: after the TMT bubble burst, analysts were looking to understand whether earnings and growth expectations were reasonable. During the GFC, the focus was on trying to understand the exposure of entities to the incorrectly priced mortgage-backed securities that were at the heart of the crisis.
A crisis is a stress test which results in discontinuities, meaning that for many companies the future will look very different from the past. Modelling discontinuities is easier for active fundamental investment strategies than for many passive strategies, which often assume that the future looks like the past.
Jeremy: One challenge for investors over the past year has been screening for new investment ideas. Many company results in 2020 and 2021 have been distorted by the impact of the virus, which creates challenges for analysts who want to normalise performance for their forecasts. As a result, investors have had to rely on information about prior years to screen for investment ideas.
Let me discuss my approach to company analysis, by considering the short, medium and long terms.
Over the short term, the key question is liquidity: will the company survive the crisis? Timely cash flow disclosure is essential for such analysis.
Over the medium term, the key question is timing: how long will it take for profits to get back to normal? Estimating the impact of covid-19 to understand underlying performance and company guidance is very important in this analysis.
Over the long term, the key question is change: how will the ‘new normal’ compare to the ‘old normal’? Many commentators are referring to covid-19 as the ‘Great Reset’, meaning that the ‘new normal’ may be materially different from the ‘old normal’. For example, we have already seen an acceleration of the move from in-store purchases to online deliveries. There also seems to be a societal shift towards more sustainable products and companies. Better segmental disclosure and information about expenses are important for long-term analyses.
Jeremy: Let me start with the short term and discuss cash flow disclosure.
Cash flow disclosure has been helpful where covid-19 restrictions have resulted in liquidity concerns. In such circumstances, even quarterly reports are not frequent enough because cash burn rates can be as high as in many start-up businesses. There have been quite a few examples of good disclosure. For example, some hotels provided monthly like-for-like sales numbers and other companies disclosed more detailed covenant information. In one case, a company published monthly cash burn rates which allowed investors to assess how long the company could survive, based on their own judgement of the duration of restrictions.
Where cash flow benefits have been received due to covid-19, and to the extent they are material, an analysis by source and type is very helpful. Sources included government, suppliers and landlords, and types included cash received, costs waived and costs deferred, including repayment schedules.
If cash flow benefits have not been received, this sort of information is also useful because it gives investors confidence in the resilience of the business. For example, one UK company disclosed that it did not receive government loans or furlough payments.
Working capital analysis has been vital for companies that experienced large cash outflows. A challenge on this front has been the limited transparency of factoring arrangements such as reverse factoring.
For the medium term, I’d like to mention non-GAAP disclosure and company guidance.
In most cases, companies have done a reasonable job of separating the impact of covid-19 on revenues and costs. For revenues, investors would ideally like to see estimates both for positive changes (for example, channel shifts like online sales) and negative changes (for example, event cancellations). Likewise, for costs, investors would like to see estimates for positive changes (for example, government support) and negative changes (for example, the cost of additional PPE for staff).
An example of company information that has not been so helpful is non-GAAP performance measures or adjusted profit measures with little explanation of the adjustments or reconciliation to GAAP results. I believe that the proposals for management performance measures in the IASB’s Primary Financial Statements project will be useful in this regard.
Management guidance is even more important during this abnormal period to help analysts forecast performance, growth and risks. A range of guidance is always more helpful than a point estimate, and can be provided using scenarios with clear assumptions. Extreme counterfactuals can serve as upper and lower bounds: for example, what would profits be without covid-19, and what would profits be with the current covid-19 restrictions, but without any government support? Sensitivity tables are also helpful for showing key variables, such as the level and duration of government support.
For the long term, I would like to mention segmental disclosure and expense analysis.
Within companies, some divisions have fared better under covid-19 than others. For example, a leisure company disclosed that the impact of covid-19 on operating profit varied a great deal between divisions. Live attractions were most adversely impacted, while the home entertainment division actually benefited to some extent.
Looking further ahead, covid-19 has accelerated existing trends which means that, now more than ever, better information is needed to identify and value winning and losing segments. Often, what is immaterial for financial reporting may be material to valuation. For example, one software company has two divisions: a cloud-based business and a CD-ROM based business. The cloud-based business is quite small, but fast-growing, and makes up the bulk of the company’s market value. Investors want more detailed information about the cloud-based business, such as its cost structure. Disclosure of new segments or re-segmentation create an issue for the time series of data, but provide useful information about a business that has or is expected to materially change.
Understanding the cost structure of a business is always important, but in a crisis it is absolutely critical. If revenues collapse, which costs are really variable? For a traditional manufacturing businesses, cost of goods sold can be assumed to be mostly variable, while selling, general and administrative expenses are mostly fixed. For a modern software company, the majority of costs are often lumped into selling, general and administrative expenses, without much additional detail being provided. Investors would like to know more about, for example, how these costs are split into fixed versus variable expenses, how are they split by segment, and what is outsourced versus internally generated.
The need for better expenses analysis goes beyond understanding the shock from covid-19. Many expenses are growth-oriented, in that they are investments relating to future periods. In this sense, investments in information technology, research and development, and advertising represent unrecognised intangible assets. Without better information about these expenses, analysts are unable to value these intangibles appropriately.
Jeremy: For 2021, I would really like to see companies provide a range of guidance for what will be another abnormal year. If liquidity is a concern, then provide clear cash flow details. If the impacts from covid-19 are material, then estimate the impact on revenue, costs and cash flow.
For 2022 and beyond, investors need to imagine a ‘new normal’ and identify winners and losers. A more detailed understanding of the segments and their cost structures would help with their analyses.
A crisis is not only a challenge, but also an opportunity to demonstrate resilience and adaptability.
Jeremy Stuber is a global equity analyst at Newton Investment Management, leading on valuation and accounting issues across all sectors. His responsibilities include reviewing recommendations, challenging existing holdings and developing the valuation framework. Over the last 18 years he has covered various global sectors, including aerospace & defence, automotive, engineering and IT services. He previously worked as a management consultant with Cap Gemini.
Jeremy chairs the Corporate Reporting Users’ Forum (CRUF) and is a Fellow of the Institute of Chartered Accountants in England and Wales (FCA), qualifying with Ernst & Young. Jeremy holds MA and MEng degrees from Cambridge University.
The Board is asking for views on:
The feedback received will help the Board determine its activities and work plan for 2022 to 2026. This is the third time the Board has consulted the public via an agenda consultation to help create its five-year plan.
It is essential that investors provide feedback to inform the Board’s work—they are the final customers for the product of IFRS Standards, the financial statements. In this brief publication, Board Member Zach Gast highlights the vital role that investors can play in shaping the work of the Board.
For further information about the Agenda Consultation, watch three short videos by our Chair Hans Hoogervorst; Board Member Nick Anderson; and Executive Technical Director Nili Shah.
The consultation period ends on 27 September 2021. Investors can submit a comment letter here. Alternatively, if you are unable to submit a full comment letter, you can instead complete a survey. We would also like to meet with investors to explore feedback in detail. If you would be interested in participating in this way, please contact the Investor Engagement team at email@example.com.
In March 2021 the Board published the Exposure Draft Disclosure Requirements in IFRS Standards—A Pilot Approach. The Exposure Draft seeks feedback on a proposed approach to developing disclosure requirements in IFRS Standards and on proposed disclosure requirements for IFRS 13 Fair Value Measurement and IAS 19 Employee Benefits (test Standards).
Disclosure requirements developed using the proposed approach are intended to enable companies, auditors and others to make more effective materiality judgements and thus provide disclosures that are more useful to investors. Applying the proposed approach, the Board aims to enhance investor engagement to ensure that the Board has an in-depth understanding of investors’ information needs and clearly explains those needs in the Standards. The proposals require companies to comply with disclosure objectives rather than to prescriptive requirements, which means companies are required to apply judgement and focus on disclosing material information only.
The Board has applied this approach to the two test Standards and is now seeking feedback on whether the proposals accurately reflect investor needs and would enable companies to enhance the effectiveness of their judgements.
In this short video, Board Member Nick Anderson introduces the proposals. We have also published a snapshot, which provides a more detailed summary of the Exposure Draft. The full text of the Exposure Draft is available. The Board communicated with stakeholders when developing the proposals and will conduct further outreach with investors during the second half of the consultation period, which ends on 21 October 2021. Please contact firstname.lastname@example.org if you would like to participate.
In the December 2020 Update, we introduced the Board’s Discussion Paper Business Combinations under Common Control, which addresses mergers and acquisitions (M&As) between companies under common control (transfers of businesses from one company within a group to another).
We have now published a webcast for investors summarising the Board’s views as set out in the Discussion Paper, and explaining how the Board’s approach would apply in common scenarios. To help the Board decide whether to confirm its approach, we invite investors to complete a short survey or participate in a one-to-one interview to share their views. If you would like to share your feedback please contact email@example.com.
M&As under common control are widespread globally and IFRS Standards do not currently specify how companies should report them. As a result, companies report these transactions in various ways and often provide little information about them. The webcast presents suggestions for how the Board could amend IFRS Standards to make reporting more comparable and more transparent.
Management commentary is a report that complements financial statements. It is aimed at investors and provides management’s insights into factors that affect the company’s ability to create value and generate cash flows. Management commentary is known by various names around the world, for example management’s discussion and analysis or strategic report.
The Board heard that management commentaries do not always provide investors with the information they need. For example, they sometimes fail to focus on matters that are important for the company’s long-term prospects or fail to provide sufficient information about intangible resources and relationships or environmental and social matters that affect the company. To help companies prepare better management commentaries, the Board is developing a comprehensive new framework that focuses on information needs of investors.
The Board intends that companies will be able to apply that new framework alongside national laws or regulations as well as in conjunction with topic-specific narrative reporting requirements or guidelines, for example on sustainability reporting.
As noted below, the Trustees of the IFRS Foundation are developing a plan that could lead the Foundation to establish a new board for setting sustainability reporting standards. In the future, companies may be able to apply those standards in conjunction with the new framework on management commentary.
The Board expects to publish its proposals on management commentary in May 2021 and to conduct outreach from June to October 2021. The Board invites investor views on whether its forthcoming proposals appropriately cover the information that investors need. For more information visit the Management Commentary project page.
In the first quarter of 2021 the Trustees have continued their consideration of the IFRS Foundation’s potential role in the remit of sustainability reporting. The Trustees received 577 responses to their Consultation Paper on Sustainability Reporting and in February announced their next steps in response to broad demand for global sustainability standards. The Trustees explained that the responses indicate growing and urgent demand to improve the global consistency and comparability in sustainability reporting, as well as strong recognition that urgent steps need to be taken and broad demand for the IFRS Foundation to play a role in this. Following further analysis of the comments received, in March the Trustees announced the strategic direction and further steps based on feedback to sustainability reporting consultation. Later in March, the Trustees announced the establishment of a working group to accelerate convergence in global sustainability reporting standards focused on enterprise value and to undertake technical preparation for a potential international sustainability reporting standards board under the governance of the IFRS Foundation.
The Trustees intend to publish a feedback statement that summarises the responses received to their 2020 Consultation, and how that feedback informed the above decisions. Together with the feedback statement, the Trustees will publish for public comment the proposed changes to the Foundation’s Constitution necessary to formalise establishment of a new board, including its composition. Any changes to the Constitution are subject to a public consultation with a 90-day comment period.
Stakeholders are encouraged to continue to monitor developments with the project on the IFRS Foundation website.
This year’s report showcases the resilience and responsiveness of the International Accounting Standards Board, the Foundation’s staff and the Trustees in their efforts to deliver on the mission to bring transparency, efficiency and accountability to the world’s capital markets.
2020 was shaped by the covid-19 pandemic and the report highlights how the Foundation adapted to the circumstances, moving its entire staff to remote working, embracing virtual meetings and outreach, and adjusting its standard-setting work plan to accommodate stakeholders. It also features reports by Trustee Chair Erkki Liikanen—including a discussion of the Trustees’ 2020 consultation on sustainability reporting—and International Accounting Standards Board Chair Hans Hoogervorst—in which he reflects on a decade of standard-setting as his tenure comes to an end in June 2021.
Board Chair Hans Hoogervorst delivered a speech at a meeting of the International Accounting Forum for Accounting Standards Setter, reflecting on his 10-year tenure, which comes to an end in June 2021.
The Board is seeking public comments on a proposed approach to developing disclosure requirements in IFRS Standards and on proposed disclosure requirements for the Standards on fair value measurement and employee benefits. These proposals would enable companies to enhance their judgement and reduce ‘boilerplate’ information, giving investors more useful information.
The amendments will help companies to improve accounting policy disclosures so that they provide more useful information to investors and other primary users of the financial statements, and to distinguish changes in accounting estimates from changes in accounting policies.
In response to calls from stakeholders and because the covid-19 pandemic is still at its height, the Board has extended by one year the application period of the practical expedient in IFRS 16 Leases to help lessees accounting for covid-19-related rent concessions.
The Board met on 23 March 2021 and decided to extend by 30 days the comment period for the Exposure Draft published in January 2021.
The IFRS Foundation recently announced plans to join its three websites in a single platform. The new platform will launch in April 2021, alongside several new features including an innovative Standards navigator and enhanced search capabilities.
The workshop was moderated by EAA President Thorsten Sellhorn and included a presentation of the Discussion Paper by the IASB technical staff; a reflection by Martin Hoogendoorn, financial accounting professor at the Erasmus University Rotterdam; an overview of EFRAG’s developing views by Patricia McBride; and a Q&A session with Board Member Ann Tarca and staff.
In this podcast, Hans Hoogervorst and Sue Lloyd, Board Chair and Vice-Chair, talk about the Board’s discussions at both its supplementary meeting on 10 March and its regular meeting on 23 and 24 March 2021. Topics covered include IFRS 16 Leases and covid-19-related rent concessions, feedback on the Goodwill and Impairment consultation, decisions taken in the Primary Financial Statements project and next steps on the Comprehensive Review of the IFRS for SMEs Standard. You can also read the IASB Updates for the supplementary meeting and the regular March meeting.
Board Chair Hans Hoogervorst and Vice-Chair Sue Lloyd talk about the supplementary meeting held on 4 February to discuss IFRS 16 Leases as well as about topics discussed at the regular monthly meeting, which included Financial Instruments with Characteristics of Equity and Extractive Activities. You can read the February IASB Update.
Listen to Vice-Chair Sue Lloyd talk about feedback on the consultation paper General Presentation and Disclosures; decisions made in the Disclosure Initiative—Subsidiaries that are SMEs project; an overview of the Board's current work plan; the recently published Exposure Draft Regulatory Assets and Regulatory Liabilities; and the upcoming consultation on the project Disclosure Initiative—Targeted Standards-level Review of Disclosures. The IASB Update is also available.