A peer reviewer of one of DHInfrastructure’s tariff studies (an accountant at a large international financial institution) once made the following comment: “Modern double-entry accounting as a profession has developed over the last seven centuries, with highly advanced standards that are clearly explained in the International Financial Reporting Standards…. We see no reason for [country X] to be an exception that uses some peculiar ‘regulatory accounting’ that is divorced from conventional accounting.”
The peer reviewer was not alone in his suspicions. Having worked in more than 90 countries, we have undertaken tariff and cost-of-service studies in exceptionally different legal and regulatory environments. When we do these studies, we often encounter skepticism about the concept of “regulatory accounting,” especially from accountants steeped in their own national or international financial accounting standards.
But regulatory accounting serves a purpose, and it is critically important to the transparency of tariff setting for regulated infrastructure services, especially electricity, water & sanitation, gas and heating.
What It Is
Regulatory accounting refers to the specialized accounting rules and practices used by regulators to monitor and analyze the financial performance of regulated utilities. It has a long history—especially in the United States—dating back to the early days of utility regulation in the late 19th century.
Regulatory accounting is not meant to replace or supersede standard financial accounting practices. Rather, it’s an additional layer of accounting requirements specifically designed to meet the needs of utility regulators.
The Controversy
Suspicions of “regulatory accounting” date back to the earliest days of the evolution of regulatory accounting in the United States. See, for example, the dissenting opinions in Accounting Research Bulletin No. 44 (Revised), about declining-balance depreciation and the impact of alternative treatments of depreciation on deferred taxes. In the U.S., these debates were largely settled with the issuance of Financial Accounting Standards Board (FASB) Statement No. 71 in 1982, “Accounting for the Effects of Certain Types of Regulation.” This standard formalized regulatory accounting practices within U.S. GAAP, providing a framework for regulated entities to account for deferrals and other regulatory adjustments.
While IFRS (International Financial Reporting Standards) has become the global benchmark for financial reporting, its approach to regulatory accounting is more recent. Regulatory accounting was not part of IFRS’s foundational principles, as it was initially designed to provide general-purpose financial reporting for international markets. However, recognizing the need for regulatory-specific treatments, IFRS introduced IFRS 14 Regulatory Deferral Accounts in 2014, primarily as a transitional standard for first-time IFRS adopters.
This timeline underscores that regulatory accounting principles originated and were formalized under GAAP. Today, these principles have been adapted and applied alongside IFRS in many regulatory environments. Utility regulators worldwide have embraced regulatory accounting practices tailored to their economic and legal contexts, demonstrating their importance in addressing the unique needs of regulated industries.
The Purpose of Regulatory Accounting
While financial accounting aims to provide a standardized view of a company’s financial position for investors and creditors, regulatory accounting serves a different purpose. Its primary goal is to help regulators set fair rates and ensure that utilities can recover their costs while providing reliable service to customers.
Regulatory accounting differs from financial accounting in the following ways:
- Treatment of costs: Regulatory accounting may allow utilities to defer certain costs as assets that would normally be expensed immediately under GAAP, IFRS, or IPSAS. This helps match costs with the periods in which they are allowed in rates.
- Revenue recognition: Regulators may allow utilities to recognize revenue in periods different from when it would be recognized under standard accounting principles.
- Asset valuation: The regulatory asset base, a crucial concept in setting rates, may be valued differently than assets on a company’s financial statements.
- Depreciation: Regulatory accounting may use different depreciation methods or asset lives than those used in financial statements to better reflect the economic reality of utility operations.
- Detailed cost allocation: Regulatory accounting requires much more granular cost allocation to specific utility services and customer classes.
The Purpose of Regulatory Accounting
Again, regulatory accounting isn’t a deviation from sound accounting principles; rather, it’s a specialized application of accounting concepts to the unique economic circumstances created by regulation. It gives regulators the tools to ensure the following:
- Utilities can recover their prudently incurred costs over time, promoting financial stability and continued investment in infrastructure.
- Rates remain stable and predictable for consumers, avoiding sharp fluctuations that could result from strict adherence to GAAP, IFRS, or IPSAS principles.
- Regulators have the information they need to make informed decisions about rate-setting and utility performance.
- Intergenerational equity is maintained by matching costs with the periods in which customers receive benefits.
How and When to Use It
For utility managers and regulators in countries which do not have a strong tradition of regulatory accounting, it’s important to understand the following:
- Regulatory accounting requirements don’t replace the need for utilities to produce standard financial statements. Both are necessary.
- Regulatory accounting practices should be clearly defined and consistently applied.
- There should be a clear process for reconciling regulatory accounting statements with standard financial statements.
- Accountants and auditors working with utilities should have specialized training in regulatory accounting principles.
Implementing robust regulatory accounting practices is essential for effective utility regulation. But it need not conflict with adherence to national or international financial accounting standards. The two can and should coexist, each serving its own important purpose.