Applying IFRS in Power & Utilities

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Applying IFRS in Power & Utilities

The revised revenue recognition proposal — power and utilities

March 2012

IASB — proposed standard

What you need to know

• The IASB and the FASB have issued a second exposure draft of their converged revenue model that is closer to current IFRS and US GAAP than their 2010 proposal.

• The proposed model would apply to revenue from contracts with customers and would replace all the revenue standards and interpretations in IFRS, including IFRIC 18 Transfers of Assets from Customers

• Although the proposed model is not expected to have a significant impact on many transactions within the industry, the effect on certain arrangements that are common for P&U entities is still unclear.

• The proposal will significantly increase the volume of financial statement disclosures.

• The IASB and FASB will hold outreach events to gather feedback. P&U entities should review the proposal and share any concerns with the IASB and FASB.

The revised revenue recognition proposal issued by the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) (collectively, the Boards) could result in changes in current practice for the timing and amount of revenue recognition for power and utilities (P&U) entities. In particular, we focus on the following key areas in this publication:

• Accounting for contract modifications

• Assessing whether goods and services are distinct and identifying separate performance obligations

• Allocating the transaction price for power purchase arrangements and other long-term utility contracts

• Take-or-pay arrangements

The issues discussed here are intended to provoke thought and to assist entities in formulating ongoing feedback to the Boards that can help in the development of a high-quality final standard. Nevertheless, these discussions do not represent our final or formal views as the elements of the Exposure Draft (ED) are subject to change and additional issues may be identified on further deliberations by the Boards before a final standard is issued.

This publication supplements the more comprehensive analysis of the revised revenue recognition proposal, which is discussed in our publication entitled Revenue from contracts with customers – the revised proposal (general Applying IFRS). Our general Applying IFRS also highlights some issues for entities to consider in evaluating the impact of the ED and some of the expected changes to current IFRS.

Introduction

3 Applying IFRS in Power & Utilities — The revised revenue recognition proposal — power and utilities

Contents

Overview and scope 3

• Contracts in the scope of multiple IFRSs 3

• Collaborative arrangements 4

Step 1: Identify the contract(s) with a customer 4

• Existence of a contract 4

• Contract modifications 5

Step 2: Identify the separate performance obligations 8

• Green or renewable certificates 8

• Long-term service arrangements 9

Step 3: Determine the transaction price 9

• Variable consideration 9

• Contributions from customers and upfront fees 10

• Time value of money 11

Step 4: Allocate the transaction price to separate performance obligations 11

• Determining the standalone selling price 11

• Contingent consideration 14

Step 5: Recognise revenue when the entity satisfies each performance obligation 15

• Performance obligations satisfied over time 15

• Constraining the cumulative amount of revenue recognised 16

Other recognition and measurement concerns 16

• Take or pay arrangements 16

• Onerous performance obligations 18

Disclosures 18

Next steps 18

Applying IFRS in Power & Utilities — The revised revenue recognition proposal — power and utilities3

Overview and scopeThe Boards’ proposal specifies the accounting for all revenue arising from contracts with customers and affects all entities that enter into contracts to provide goods or services to their customers, unless those contracts are in the scope of other IFRS requirements.

The principles in the proposed standard would be applied using the following five steps:

1. Identify the contract(s) with a customer

2. Identify the separate performance obligations in the contract(s)

3. Determine the transaction price

4. Allocate the transaction price to the separate performance obligations

5. Recognise revenue when the entity satisfies each performance obligation

The proposed standard would also apply to the measurement and timing of the recognition of gains and losses on the sale of certain non-financial assets, such as property, plant and equipment.

Under the proposal, entities would need to exercise judgement when considering specific facts and circumstances reflected in the written and implied terms of contracts with customers. Entities would also have to apply the requirements of the proposal consistently to contracts with similar characteristics and in similar circumstances. A complete discussion of the proposed standard related to accounting for contract(s) with a customer can be found in Applying IFRS: Revenue from contracts with customers — the revised proposal (January 2012) (general Applying IFRS).1

The Boards are proposing that entities adopt the new standard retrospectively for all periods presented in the period of adoption, although the ED provides some limited relief from full retrospective adoption. We expect the effective date would be no earlier than annual periods beginning on or after 1 January 2015. The Boards will determine the exact date of adoption during further redeliberations.

Contracts in the scope of multiple IFRSsP&U entities often enter into transactions that would be partially within the scope of the proposed revenue recognition standard and partially within the scope of another standard (i.e., embedded derivatives, leases and service concessions).

Generally, entities entering into transactions that fall within the scope of multiple accounting standards currently separate those transactions into the individual elements to account for them under the respective standard(s). The ED does not propose to change this practice. However, the ED does clarify that any separation and measurement guidance in other applicable IFRSs takes precedence over the model in this ED. Accordingly, if the other standard does not specify how to separate and/or initially measure any parts of the contract, the entity would apply the proposed standard to separate and/or initially measure those parts of the contract.

A further consideration is the interaction between the proposed revenue recognition model and the proposed lease model. Although the criteria for determining what is or is not a lease are not expected to change significantly under the proposed leasing ED, this assessment will take on increased importance as operating leases are moved onto the balance sheet.

The current accounting for operating leases and service contracts is often similar. Therefore, entities may not have differentiated arrangements which were service contracts and operating leases. Consequently, it is possible that not all embedded leases that exist within arrangements have been identified, extracted and/or accounted for as such.

Given the proposed accounting for operating leases is expected to be completely different from current standards, the assessment of whether an arrangement is a service contract or an operating lease will have significantly different accounting implications. As a result, P&U entities may need to evaluate current and future contracts more closely.

How we see it

1 Available at ey.com/ifrs.

Applying IFRS in Power & Utilities — The revised revenue recognition proposal — power and utilities Applying IFRS in Power & Utilities — The revised revenue recognition proposal — power and utilities 4

Collaborative arrangementsThe ED also explains that a counterparty to a contract may not always be a customer. Instead, the counterparty may be a collaborator or partner that shares in the risks and benefits of developing a product to be sold. Contracts with collaborators or partners are sometimes observed in the P&U industry. For example, where two parties collaborate in the development and operation of a power plant and one of the parties in the arrangement purchases an amount of the power produced.

The Boards indicated that revenue could be recognised from transactions with partners or participants in a collaborative arrangement only if the other party to the arrangement meets the definition of a customer. However, the Boards decided not to provide further guidance to clarify whether parties to these arrangements would meet the definition of a customer.

In the Basis for Conclusions to the ED, the Boards explain that it would not be possible to provide application guidance that applies to all collaborative arrangements. Therefore, the parties to the arrangement would need to consider all of the facts and circumstances to determine whether a supplier/customer relationship exists that would be subject to the proposed standard.

Step 1: Identify the contract(s) with a customerTo apply the proposed model, an entity must first identify the contract, or contracts, to provide goods and services to its customer. Any contracts that create enforceable rights and obligations would fall within the scope of the proposed standard. The enforceable rights and obligations may be written, oral or implied by the entity’s customary business practice.

Generally, the step for identifying the contract with the customer would not differ significantly from current practice in the P&U industry. For example, the proposed requirement for combining two or more contracts entered into with the same customer at, or near, the same point in time into a single contract for accounting purposes is consistent with existing standards.

However, there could be differences for P&U entities in determining whether a contract exists, as well as the accounting for contract modifications.

Existence of a contractTermination clauses are an important consideration when determining whether a contract exists for the P&U industry. Any arrangement in which the vendor has not provided any of the contracted goods or services and has not received, or is not entitled to receive, any of the contracted consideration is considered to be a “wholly unperformed” contract. If each party has the unilateral right to terminate a wholly unperformed contract without compensating the counterparty, then the ED states that a contract does not exist and its accounting and disclosure requirements would not apply.

The proposed standard is clear that contracts amongst collaborators in which the counterparty is not a customer are out of the scope of the proposed standard. As no new application guidance is being provided for these arrangements, we believe that entities will likely reach similar conclusions as today about whether a contract is a revenue-generating transaction or an arrangement with a collaborator or a partner. Many entities account for those transactions in accordance with, or by analogy to, the current revenue recognition standards. However, it is not clear if the removal of these transactions from the scope of the revenue standard would prohibit companies from using the revenue standard by analogy.

How we see it

If each party has the unilateral right to terminate a wholly unperformed contract without compensating the counterparty,

then the proposed standard states that a contract does not exist and its accounting and disclosure requirements would not apply.


Contract modificationsContract modifications are a common occurrence in the P&U industry. In many cases, the modification will extend the period of the contract combined with changing the contract price. For example, a P&U entity might decide to extend the period of a contract and create a blended price for the remaining units of the extended contract period. In some cases, this blended price would reflect the pricing for the remaining undelivered units in the original contract combined with a separate price for the additional units added to the contract. In other cases, there may be additional factors used in determining the modified contract price.

When a contract is modified, entities would first need to determine if the contract modification represents a separate contract or a modification of the existing contract when additional goods or services are to be provided. A contract modification is deemed to be a separate contract if both of the following criteria are met:

• The additional goods or services are distinct

And

• The price of the additional goods or services reflects the standalone selling price and any appropriate adjustments to that price to reflect the circumstances of the particular contract

If it is determined that the modification is not a separate contract, an entity would account for the effects of these modifications differently, depending on which of the following scenarios is most applicable:

1. The goods and services not yet provided are distinct from the goods and services provided before the modification of the contract.

2. The goods and services not yet provided are not distinct from the goods and services provided before the modification of the contract (i.e., all promised goods are part of a single performance obligation).

3. The goods and services not yet provided are a combination of 1 and 2 above.

Contract modifications that modify or remove previously agreed to goods and services would not be treated as separate contracts. However, as long as the modified goods and services are distinct from the goods and services provided before the modification, the entity would treat the contract modification as the termination of the old contract and the creation of a new contract for all remaining unsatisfied performance obligations.

Although this may sound straight forward, the assessment of modifications could require the application of judgement, particularly in determining whether the additional consideration reflects the standalone selling price of the additional goods or services. This is illustrated in the example on the following page.

Illustration 1 — Wholly unperformed supply contractEntity A enters into a one-year contract to supply electricity to Customer B at a monthly fixed price per megawatt hour (MWh). If the contract does not include a minimum contracted volume that Customer B is required to purchase, and there is no penalty within the contract for non-delivery by Entity A or non-purchase from Customer B, then the contract would be considered to be a "wholly unperformed" contract.

Illustration 2 — Supply contract with obligation to performEntity A enters into a one year contract to supply electricity to Customer B at a monthly fixed price per MWh. Entity A is obligated to provide electricity to Customer B if it should request these volumes. However, Customer B is obligated to pay a significant penalty if it changes electricity providers. As Entity A does not have the unilateral right to terminate the contract and Customer B is required to pay compensation for termination, the contract would be in scope of the ED.


Entity C has a contract to supply 100,000 MWh of energy per year to Customer D for the next 10 years at a fixed price of CU 55/MWh. After 5 years have elapsed, Entity C and Customer D agree to extend the contract by an additional 5 years. The price per unit for the remaining 10 years of the modified contract will now be CU 65/MWh.

Entity C has determined that each individual MWh is a distinct performance obligation under the original contract and the current spot price represents the separate standalone selling price for each unit delivered (see Steps 2 and 4 below for further discussion).

Scenario 1: The modified price was based on blending the original contract price for the remaining years 6 to 10 (CU 55/MWh) with the market price for the additional volumes from years 11 to 15 (CU75/MWh).

Years 6-10 pricing: 100,000 MWh x 5 years x CU 55/MWh CU 2,750,000

Years 11-15 pricing: 100,000 MWh x 5 years x CU 75/MWh CU 3,750,000

CU 6,500,000

The remaining contract consideration of CU6,500,000 is divided by the undelivered volumes in the modified contract of 1,000,000 MWh (100,000 x 10 years) resulting in the revised contract price of 65/MWh.

In this scenario, the modification results in additional volumes of 500,000 MWh (100,000 x 5 years) for the added period of years 11-15 and additional consideration of CU 3,750,000. The additional consideration resulting from the modification reflects the market price of the additional goods to be delivered. As such, the entity could view this additional consideration to represent the standalone selling price of the additional 500,000 MWh to be delivered as a result of the modification. Under this view, the modification would be accounted for as a separate contract.

This would result in the following revenue recognition profile (ignoring the impact of the time value of money discussed in Step 3 below):

Contract period

Volumes (10,000 x 5 years)

Allocated price (CU/MWh)

Revenue recognised (CU)

Contract cash flow (CU)

Accrued (deferred) revenue (CU)

Years 1-5 500,000 55 27,500,000 27,500,000 —

Years 6-10 500,000 55 27,500,000 32,500,000 (5,000,000)

Years 11-15 500,000 75 37,500,000 32,500,000 —

1,500,000 92,500,000 92,500,000

Scenario 2: The additional consideration resulting from the contract modification was not based on the standalone selling price of the additional units, but instead, the pricing includes a discount for other factors (i.e., a discount in recognition of the significant volumes that will be delivered under the modified contract). In this scenario, the modification would not be considered a separate contract. In effect, the entity would account for the contract modification as a termination of the original contract and the creation of a new contract. This would result in the following revenue recognition profile for Entity C:

Contract period

Volumes (10,000 x 5 years)

Allocated price (CU/MWh)

Revenue recognised (CU)

Contract cash flow (CU)

Accrued (deferred) revenue (CU)

Years 1-5 500,000 55 27,500,000 27,500,000 —

Years 6-10 500,000 65 32,500,000 32,500,000 —

Years 11-15 500,000 65 32,500,000 32,500,000 —

1,500,000 92,500,000 92,500,000

Illustration 3: Energy contract extension


The scenarios on the previous page illustrate when the contract modification relates to goods and services that are distinct from those previously provided under the contract and each individual MWh is a separate performance obligation. If the goods or services in the modified contract are not distinct from goods or services previously provided under the contract, an entity must account for the modification as if it were part of the original contract. The result would be allocating a portion of the change in compensation from the modified contract to goods or services that have already been provided (i.e., changing the amount of revenue previously recognised). This could mean recording a cumulative catch-up entry to either increase or decrease prior period revenue recognised, depending on whether the modified contract compensation is higher or lower than the original contract.

Another modification that could occur for P&U entities is when the parties change the contract pricing for the remaining contract period without modifying the goods or services to be delivered under the contract (i.e., no changes in the scope of the contract). This type of modification may involve a payment from the counterparty as a result of the modification.

While the amounts allocated to performance obligations would be updated to reflect changes in the estimated transaction price as goods and services are delivered, the standalone selling prices used to perform the allocation would not be updated to reflect changes in the standalone selling prices after contract inception. This means that changes in the total transaction price would be allocated to the separate performance obligations on the same basis as the initial allocation.

The proposed model would require contingent consideration associated with a modification to be allocated entirely to a distinct good or service if certain criteria are met. This can have significant implications depending on how the contract is modified.

The following example illustrates some of the considerations that would be made when only the transaction price of a contract is modified.

In practice, there are a number of other considerations that could make the analysis of contract modifications complex. These include: contracts that deliver volumes over time at a fixed price per unit with variable volumes required to be delivered; contracts that are originally priced on a variable price per unit; and contracts that are bundled with other goods or services. As such, the individual facts and circumstances of each contract modification need to be carefully considered under the proposed standard.

There is variability in how the contract modification rules within the ED should be applied by P&U entities. Basic considerations, such as determining the performance obligation within the contract, could significantly impact the accounting. In addition, significant judgement would need to be applied in determining whether the additional consideration resulting from the modification reflects the entity’s standalone selling price for the additional volumes (plus any appropriate adjustments to that price to reflect the facts and circumstances of that particular contract).

How we see it

Illustration 4 — Modification of the pricing of a power contractEntity E enters into a 10-year power purchase arrangement with Customer F to deliver 100,000 MWh/year at a fixed price of CU 60/MWh. Assume that Entity E determines that each individual MWh is a distinct performance obligation under the original contract and the standalone selling price is determined based on the spot rate (see Steps 2 and 4 below for further discussion). As a result, each MWh is allocated CU 60 of the transaction price.

After 5 years, Entity E has delivered 500,000 MWh (100,000 MWh x 5 years) and recognised revenue of CU 30,000,000 (500,000 MWh x CU 60/MWh) under the contract. Customer F decides that it would like to unwind its fixed price power purchase arrangement to change to a market price. Entity E agrees to modify the contract so that the pricing will be based on the market price for power. Customer F pays CU 5,000,000 to compensate Entity E as the fixed price of the original contract is currently higher than the market price.

The modified price per MWh is now based on a highly variable market price and Entity E concludes that this would be considered contingent consideration that can be allocated directly to the undelivered 500,000 MWh in the modified contract (refer to Contingent consideration Section in Step 4 below). However, the payment of CU 5,000,000 would be treated as a change in the transaction price. As a result, Entity E would need to allocate this amount to the total units to be delivered under the contract based on the original standalone selling price (i.e., CU 2,500,000 would be allocated to the units already delivered and CU 2,500,000 would be allocated to the undelivered units).


Step 2: Identify the separate performance obligations The goods or services promised in a customer contract (either explicitly stated in the contract or implied by customary business practices) are referred to as performance obligations in the ED.

Goods and services would be accounted for as separate performance obligations when they are distinct, meaning they are sold separately or the customer can benefit from the good or service on its own or together with other resources that are readily available to the customer. These resources can be offered by the entity or by another entity. If a good or service is not distinct, it would be combined with other goods or services until a distinct performance obligation is formed.

Once an entity determines whether the individual goods and services would be distinct, the entity would have to consider the manner in which the goods and services have been bundled in an arrangement. The manner in which the goods and services have been bundled may lead an entity to determine that it is appropriate to account for otherwise distinct goods or services as a single performance obligation.

To account for a bundle of goods and services as one performance obligation: (a) the goods and services must be highly interrelated and transferring the goods and services to the customer requires a significant service of integrating the goods or services into the combined item(s) for which the customer has contracted; and (b) the bundle of goods and services is significantly modified or customised to fulfil the contract.

The Boards also provided a practical expedient whereby an entity could choose to account for two or more distinct goods or services in a contract as a single performance obligation, if those goods or services have the same pattern of transfer to the customer. It is our understanding that consecutive delivery would likely meet the criteria of having the same pattern of transfer (i.e., delivery of a specific number of units of production over a period of time to the customer until the full contracted volumes are delivered). The potential impact of applying the practical expedient would depend on the individual contracts. We will discuss some of these considerations below in Step 4.

Green or renewable certificatesSome countries have schemes to promote electricity production from renewable sources. This is often achieved by the government granting certificates to the producers of ‘green’ energy, which may be referred to as green certificates, renewable energy certificates (RECs), tradable renewable certificates or renewable obligation certificates. Usually, P&U entities that distribute electricity must demonstrate that a certain percentage of power delivered to customers is obtained from renewable sources. A distributor must obtain and remit green certificates for the required amount of renewable energy. Green or renewable certificates are either purchased directly from the generator of renewable energy or from the market in locations where a market exists.

As the schemes for green or renewable credits vary significantly from country to country, the specific terms and conditions need to be carefully considered, particularly in those areas where the green or renewable certificates cannot be sold separately from the energy.

It is important to note that the revised ED has a broader definition of 'distinct' than the original ED that would allow entities to consider whether the “customer can benefit from the good or service on its own or together with other resources that are readily available to the customer”. This means that, provided the green or renewable credit can be expected to provide a benefit to the customer (e.g., a refund from the government) that is separate from the benefit the customer receives from consuming/distributing the energy, it could be considered a separate performance obligation.

Based on the criteria provided by the Boards for determining separate performance obligations, we believe that individual units of production delivered in many power and utility arrangements would be considered to be separate performance obligations.

However, by virtue of the practical expedient provided, we believe that, as these performance obligations are transferred consecutively with a similar pattern of transfer to the customer, multiple performance obligations could be combined into one performance obligation. This grouping could be applied to any number of discrete time periods (e.g., weeks, months, years) or to the entire contract.

How we see it

Properly identifying performance obligations within a contract would

be a critical component of the proposed revenue standard.


For many transactions, this would result in the green or renewable certificates being treated as a separate performance obligation. However, there could still be issues when the customer in the contract is an intermediary who is, in turn, required to sell the combined product to the end user of the energy. In this case, the customer cannot benefit from the good or service on its own. It is unclear whether an entity would look through the contract when the customer in the contract is an intermediary.

Although the determination of whether green or renewable certificates are separate performance obligations will likely not impact the revenue recognition in the majority of transactions, there could still be differences. One difference may result when there is a delay in transfer of the title of the certificates (e.g., as a result of government certification) which could indicate that control has not yet passed to the customer and therefore revenue cannot yet be recognised. Refer to our general Applying IFRS publication for further discussion of the transfer of control.

Long-term service arrangementsIt is common for entities in the P&U industry to enter into arrangements to provide services on a long-term basis, such as multi-period operating arrangements. Under the ED, there appears to be flexibility on how an entity could identify the performance obligations in those arrangements. For example, a three-year operating agreement could be considered a single performance obligation representing the entire contractual period, or it could be divided into smaller periods (i.e., daily, monthly or yearly).

In long-term service agreements when the consideration is fixed, the accounting generally will not change regardless of whether a single performance obligation or multiple performance obligations are identified. However, in arrangements involving variable consideration, this issue could have a significant effect, especially if the entity believes it is appropriate to allocate the variable consideration to a single performance obligation. See Step 4 below for further discussion on allocating variable consideration.

Step 3: Determine the transaction priceThe ED defines the transaction price as “the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties (for example, sales taxes).” In some cases, the transaction price is readily determined because the entity receives payment at the same time it transfers the promised goods or services and the price is fixed.

Determining the transaction price may be more challenging when it is variable in amount, when payment is received at a time different from when the entity provides goods or services or when payment is in a form other than cash.

Variable considerationThe transaction price reflects an entity’s expectations about the consideration it will be entitled to from the customer. A portion of the transaction price could vary in amount and timing due to discounts, rebates, refunds, credits, incentives, bonuses, penalties, contingencies or concessions. For example, a portion of the transaction price would be variable at contract inception if it requires meeting specified performance conditions and there is uncertainty regarding the outcome of such conditions.

When a contract contains variable consideration, an entity would estimate the transaction price using whichever of the following two methods better predicts the ultimate consideration to which the entity will be entitled:

• Expected value approach — the entity would identify the possible outcomes of a contract and the probabilities of those outcomes

Or

• Most likely outcome approach — the entity would predict the most likely outcome

The entity would apply the selected method consistently throughout the contract and would update the estimated transaction price at each balance sheet date.

Given the potentially significant effect the determination of separate performance obligations can have on the allocation and recognition of variable consideration, we believe the Boards should provide further clarity on how an entity should make this determination for long-term service arrangements.

How we see it

Applying IFRS in Power & Utilities — The revised revenue recognition proposal — power and utilities 10 Applying IFRS in Power & Utilities — The revised revenue recognition proposal — power and utilities

For the P&U industry, variable consideration does not just refer to charging a different price per unit delivered or linking the price to a variable reference price, but would also include variability in the transaction price based on the number of units that will ultimately be delivered under the contract.

Contributions from customers and upfront feesP&U entities may receive items of property, plant and equipment from their customers, or cash from their customers to acquire or construct specific assets. These assets are often used to connect customers to a network and/or provide them with ongoing access to a supply of goods and/or services such as electricity, gas or water. These contributions are currently in the scope of IFRIC 18 Transfers of Assets from Customers, except when they relate to government grants (IAS 20 Accounting for Government Grants and Disclosure of Government Grants) or service concessions (IFRIC 12 Service Concession Arrangements). The ED would replace IFRIC 18 and transactions that include contributions from customers that are outside the scope of IAS 20 and IFRIC 12 would be accounted for under the ED.

Under the ED, when an entity receives, or expects to receive, non-cash consideration, the transaction price is equal to the fair value of the non-cash consideration. This would only apply to transactions that are in the scope of the ED (i.e., contracts with customers). An entity would measure the fair value of the non-cash consideration in accordance with IFRS 13 Fair Value Measurement when a reliable estimate of fair value can be made.

Transactions in which the customer contributes goods or services (such as property, plant or equipment) to facilitate the fulfilment of the contract are common in the P&U industry. In these transactions, if the entity obtains control of the contributed goods or services, it should consider them as non-cash consideration and account for that consideration as described above. This is consistent with current treatment under IFRIC 18.

In many cases, the asset or consideration transferred is an upfront fee in exchange for the delivery of services. These upfront fees are often related to connecting a customer to a transmission network and/or providing ongoing access to a supply of goods or services. Upfront fees may also be paid to grant access to or a right to use a facility, product or service. Often the upfront amounts paid by the customer are non-refundable.

Entities must evaluate whether non-refundable upfront fees relate to the transfer of a good or service that needs to be identified as a separate performance obligation (based on the criteria to be considered a distinct good or service in Step 2 above). In most situations, the upfront fee does not relate to any transfer of a goods or services. Instead, it is an advance payment for future goods or services.

Additionally, the existence of a non-refundable upfront fee may indicate that the arrangement includes a renewal option for future goods and services at a reduced price (if the customer renews the agreement without the payment of an additional upfront fee). For example, if the upfront fee is associated with an arrangement that is month to month, the entity may determine that the ability to renew each subsequent month without having to pay any connection fee represents a material right. The up-front payment would be recognised over the period when those goods and services are provided (i.e., the customer relationship period in this case).

The treatment of variable consideration under the ED could represent a change from current practice for certain contracts in the P&U industry.

Currently, IFRS preparers often defer measurement of variable consideration until revenue is reliably measurable, which could be when the uncertainty is removed or when payment is due. The ED would require entities to estimate variable consideration at contract inception and only provides a restriction on recognising variable amounts that are not reasonably assured.

How we see it

Determining the transaction price may be more challenging when it is variable in amount, when payment is received at a time different from when the entity provides goods or services, or when payment is in a form other than cash.

11 Applying IFRS in Power & Utilities — The revised revenue recognition proposal — power and utilities

Time value of moneyFor certain transactions, the timing of the payment does not match the timing of the transfer of goods or services to the customer (e.g., the consideration is prepaid or is paid well after the services are provided). While the time value of money would have to be considered in an arrangement, the Boards tried to reduce the number of contracts to which that provision would apply. Under the ED, the time value of money would be considered only when there is a significant financing component in an arrangement. In addition, an entity would not be required to assess whether the arrangement contains a significant financing component unless the period between the customer’s payment and the entity’s satisfaction of the performance obligation is greater than one year.

IAS 18 does not explicitly address time value of money. It is implicitly incorporated in the requirement to recognise revenue at the fair value of the amount to be received. However, there is divergence in practice of incorporating the impact of the time value of money. For additional guidance on accounting for the time value of money, see Section 4.2 of our general Applying IFRS publication.

Step 4: Allocate the transaction price to separate performance obligationsOnce the performance obligations are identified and the transaction price has been determined, the ED would require an entity to allocate the transaction price to the performance obligations, generally in proportion to their standalone selling prices (i.e., on a relative standalone selling price basis).

Determining the standalone selling priceTo allocate the transaction price on a relative selling price basis, an entity must first determine the standalone selling price for each performance obligation. Under the ED, the standalone selling price would be the price at which an entity would sell a good or service on a standalone basis at contract inception. Although this is not explicitly stated in the ED, we believe a single good or service could have more than one standalone selling price — that is, the entity may be willing to sell a performance obligation at different prices to different customers.

The ED indicates that, when available, the observable price of a good or service sold separately provides the best evidence of standalone selling price. When the standalone selling price is not observable, the ED provides some examples of alternative techniques that may be used. When an entity must estimate the standalone selling price, the ED is clear that the entity should not presume that a contractually stated price or a list price for a good or service is the standalone selling price. Further discussion can be found in Section 5 of our general Applying IFRS publication.

One thing that is not clear in the ED is how to determine the standalone selling price at contract inception when there is only one type of good (e.g., a unit of energy), and the contract requires selling multiple units of that good in succession. Specifically, should the standalone selling price of one MWh of energy to be sold/delivered today be different to a MWh of energy which you expect to sell/deliver at a future date (e.g., forward price in two, five or even 10 years' time)? Using the spot price for all performance obligations would result in an identical standalone selling price for each performance obligation (i.e., each unit delivered). The forward price would result in a different standalone selling price for each performance obligation. This could impact the allocation of the transaction price (increasing the complexity of applying Step 4 of the model) and ultimately the pattern of revenue recognition. The following examples illustrate some of the complexities and potential differences in outcomes between using a spot price and a forward price as the standalone selling price.

Applying IFRS in Power & Utilities — The revised revenue recognition proposal — power and utilities 12 Applying IFRS in Power & Utilities — The revised revenue recognition proposal — power and utilities

Illustration 5: Estimating the standalone selling prices

For simplicity, the scenarios below use yearly pricing for purposes of estimating the standalone selling price for the forward prices. We also assume the practical expedient has been applied to group distinct goods together into one-year performance obligations as discussed above in Step 2.

Scenario 1: Fixed price contract

Entity G enters into a three year fixed price contract with Customer H to deliver 1,000,000 units of electricity each year for a fixed price of CU65/MWh. There is an active market for electricity and the forward prices are as follows at contract inception: Year 1 – CU60/MWh, Year 2 – CU70/MWh, Year 3 – CU75/MWh.

Fixed price contract

YearCurrent

practice (CU)

Spot price (i.e., same standalone selling price for each unit)

Forward price (i.e., different standalone selling price for each unit)

Calculation1 Revenue (CU) Selling price % of price allocated 2

Revenue (CU)

1 65,000,000 1,000,000 x CU 65 65,000,000 1,000,000 x CU 60 29% 56,550,000

2 65,000,000 1,000,000 x CU 65 65,000,000 1,000,000 x CU 70 34% 66,300,000

3 65,000,000 1,000,000 x CU 65 65,000,000 1,000,000 x CU 75 37% 72,150,000

195,000,000 195,000,000 195,000,000

Note 1 – For the spot price-based standalone selling price, the transaction price is allocated based on the average price per unit of CU 195,000,000 / 3,000,000 units

Note 2 – For the forward price-based standalone selling price, the percentage calculated to allocate the transaction price of CU 195,000,000 is based on the standalone selling price for the year divided by the total standalone selling price of the entire contract.

As can be seen in this scenario, the assumption that each unit delivered has the same standalone selling price would result in the same accounting currently used in practice.


Illustration 5 (continued): Estimating the standalone selling prices

Scenario 2: Stepped price contract

Entity I enters into a three-year fixed price contract with Customer J to deliver 1,000,000 units of electricity each year with the following fixed prices: Year 1 – CU 60/MWh, Year 2 – CU 70/MWh, Year 3 – CU 75/MWh. The contract pricing is also equal to the forward prices in the active market at contract inception.

Stepped price contract

YearCurrent

practice (CU)

Spot price (i.e., same standalone selling price for each unit)

Forward price (i.e., different standalone selling price for each unit)

Calculation1 Revenue (CU) Selling price % of price allocated2

Revenue (CU)

1 60,000,000 1,000,000 x CU 68.33 68,333,333 1,000,000 x CU 60 29% 60,000,000

2 70,000,000 1,000,000 x CU 68.33 68,333,333 1,000,000 x CU 70 34% 70,000,000

3 75,000,000 1,000,000 x CU 68.33 68,333,333 1,000,000 x CU 75 37% 75,000,000

205,000,000 205,000,000 205,000,000

Note 1 – For the spot price-based standalone selling price, the transaction price is allocated based on the average price per unit of CU 205,000,000 / 3,000,000 units.

Note 2 – For the forward price-based standalone selling price, the percentage calculated to allocate the transaction price of CU 205,000,000 is based on the standalone selling price for the year divided by the total standalone selling price of the entire contract.

As can be seen in this scenario, assuming that each unit delivered has the same standalone selling price would result in different accounting compared to current accounting practice. In this scenario, a similar revenue recognition profile to current practice would be achieved using a forward price as the standalone selling price because (for simplicity) we have assumed that the forward prices of energy have been built into the pricing of the contract.


It is important to note that the revenue recognised will depend significantly upon how the performance obligations are determined. An entity could also apply the practical expedient to the entire contract (i.e., to treat multiple units with the same pattern of transfer as one combined performance obligation). As a result, the pricing would be smoothed such that each unit delivered would have an equal amount of revenue allocated. For Scenario 1, using the practical expedient to treat the entire contract as one performance obligation would result in the same revenue recognition as IAS 18 (regardless of whether a spot or forward price is used to determine the standalone selling price).

Contingent considerationThe Boards proposed an exception to the relative selling price method of allocating the transaction price that would require contingent consideration to be allocated entirely to a single performance obligation when both of the following criteria are met:

• The contingent payment terms for the distinct good or service relate specifically to the entity’s efforts to transfer that good or service (or to a specific outcome from transferring that good or service).

And

• Allocating the contingent amount of consideration entirely to the distinct good or service is consistent with the overall principle for allocating consideration (i.e., the amount ultimately allocated to each separate performance obligation results in an amount that depicts the amount of consideration to which the entity expects to be entitled in exchange for satisfying each separate performance obligation).

This proposed approach for contingent consideration would also apply to subsequent changes in the transaction price. A common example of a P&U contract that would likely fall under this exception is a production contract with pricing that is based entirely on a reference or market price (e.g., price based on the average spot price for the month in which the product is delivered). In this case, each unit delivered would likely be determined to be a distinct good. Therefore, when each unit is delivered and the transaction price is known, the model would allow the entity to allocate that known part of the transaction price entirely to that distinct good. It would not be required to allocate that known transaction price over the total number of performance obligations. The result is that revenue would be recognised consistently with current IAS 18 for these contracts.

Even when the practical expedient is applied and the performance obligations are bundled into one performance obligation, the individual goods (e.g., units of energy delivered) would still be distinct. As such, we believe the provisions relating to allocation of a variable transaction price to distinct goods could still be applied in this situation.

In addition to contracts with entirely variable per unit pricing, P&U entities may enter into contracts that have per unit pricing with both a fixed and variable element. For example, an entity could enter into a fixed price contract to deliver energy that includes an adjustment for inflation (i.e., contract price is fixed plus an inflation index in following years) in each of the subsequent years of the contract. As the inflation adjustment can be linked directly to the distinct performance obligations in these separate years, the impact of inflation would not be required to be allocated to energy delivered in other years of the contract.

How we see it

The examples above demonstrate how decisions about the identification of the performance obligations within a contract and how the standalone selling price is determined can significantly impact the complexity of applying the model and the revenue recognition profile. For example, stepped price contracts could end up with smoothed revenue profiles; or fixed price contracts could end up with gradually increasing recognition profiles depending on whether a spot price or a forward price is used.

Given this, we believe the Boards should provide additional guidance and clarity on these key decisions in the final standard.

How we see it

The changes that have been made to the ED regarding the allocation of contingent consideration could result in the contract price allocated to each individual performance obligation (e.g., unit of energy delivered) better reflecting the underlying economics of the contract than what was proposed in the original ED. However, this may not be the case when estimates of these market costs (e.g., adjustments for consumer price index) are embedded as a fixed price in the contract at inception, potentially resulting in economically similar contracts having different revenue recognition profiles.

Decisions about the identification of the performance obligations within a contract and how the standalone selling price is determined can significantly impact the complexity of applying the model and the revenue recognition profile.


Step 5: Recognise revenue when the entity satisfies each performance obligationUnder the ED, an entity would recognise revenue when each performance obligation is satisfied. This would occur when the goods or services are transferred to the customer and the customer obtains control. The ED indicates that certain performance obligations are satisfied as of a point in time. Therefore, revenue would be recognised at that point in time. However, other performance obligations are satisfied over time. As such, the associated revenue would be recognised over the period the performance obligation is satisfied (e.g., the monthly facilities service contract). Section 6 of our general Applying IFRS publication outlines the relevant considerations for assessing when control has passed.

Performance obligations satisfied over timeFor performance obligations satisfied over time, an entity will need to decide how it will measure its progress towards complete satisfaction of those performance obligations. Two appropriate methods of measuring progress provided in the ED include output methods and input methods. Output methods recognise revenue on the basis of the value to the customer of the goods or services transferred to date (e.g., units produced or delivered, milestones reached). Input methods recognise revenue based on the entity’s efforts or inputs to the satisfaction of a performance obligation (e.g., resources consumed, labour hours expended, costs incurred) relative to the total expected inputs.

For power purchase arrangements and other contracts to deliver units of production, in which each unit delivered is treated as a separate performance obligation, we believe these would be considered to be satisfied at a point in time. However, when an entity elects to apply the practical expedient and treat all units to be delivered under the contract as one single performance obligation or separate annual (or weekly, monthly, quarterly) performance obligations, we believe these would be considered to be satisfied over time.

Given the nature of unit purchase arrangements (e.g., power purchase arrangements), the output method would likely be chosen by many entities to measure progress towards satisfaction of this performance obligation in the case where the entity treats these as an obligation settled over time. For example, an entity could choose to measure progress as units delivered to date as compared to total units to be delivered under the contract.

In addition, the ED states that if an entity has a right to invoice a customer in an amount that corresponds directly with value to the customer of the entity’s performance completed to date, the entity would recognise revenue in the amount to which the entity has a right to invoice. For example, we would expect a contract to deliver units based on a market price to meet the criteria of the invoice amount directly corresponding to the value to the customer of units delivered to date. The result is a simplified approach to accounting for these contracts if the practical expedient is taken and an entity chooses to apply the invoicing output method.

However, it is unclear how the value to the customer of the entity’s performance completed to date is meant to be interpreted in other cases. Is this meant to be fair value, the standalone selling price that would otherwise be allocated or some other consideration? Also, at what date would this value be determined? For example, fair value of a unit delivered in year 5 of a contract would be different at contract inception as compared to the point in year 5 when the unit is actually delivered.

How we see itUsing the invoicing method as a measure of progress towards satisfying a performance obligation in unit based delivery contracts that an entity has elected to treat as a combined performance obligation that is satisfied over time, would greatly simplify the accounting for these contracts. However, it is unclear in the ED under what circumstances the invoicing method could be applied.


Constraining the cumulative amount of revenue recognisedAlthough an entity is required to estimate the total transaction price, the amount of revenue the entity could recognise may be constrained in certain circumstances. The ED states that the cumulative amount of revenue an entity would be able to recognise for a satisfied performance obligation is limited to the amount to which the entity is reasonably assured to be entitled (refer to Section 6.3 of our general Applying IFRS publication for further guidance on determining when the amount to which an entity expects to be entitled is reasonably assured).

The examples cited in the ED relate to assessing the types of variable consideration in which an entity would not be reasonably assured to be entitled are sales-based royalties associated with the licence to use intellectual property and asset management fees based on the value of the underlying assets at a defined measurement date in the future. In addition to those examples, we believe settlement of long-term commodity supply arrangements based on market prices at the future delivery date would also be variable consideration in which an entity is not reasonably assured to be entitled to the payment.

Other recognition and measurement concernsTake or pay arrangementsA take-or-pay contract is a supply agreement between a customer and a supplier in which the price is set for a specified minimum quantity of a particular good or service and the price is payable irrespective of whether the good or service is taken by the customer. Take-or-pay contracts are commonly used in the P&U industry and may involve the supply of gas, transmission capacity or electricity. These contracts can be long-term in nature and contain terms and conditions with varying degrees of complexity (e.g., fixed or stepped volumes; simple fixed, stepped or variable pricing). Several of the issues under the ED for these complex terms are discussed above under Step 4.

The initial 'contract' to be accounted for in a take-or-pay arrangement would often be the minimum amount specified in the contract, as this is generally the only enforceable part of the arrangement. However, this may not always be the case and an entity needs to carefully consider these potential additional volumes when identifying its performance obligations in Step 2 above.

There may be instances in which the option to obtain additional volumes provides a material right to the customer that it would not receive without entering into that contract. The ED notes that such a right would be material only if it results in a discount that the customer would not otherwise receive (e.g., a discount that is incremental to the range of discounts typically given for those goods or services to that class of customer in that geographical area or market). If the option does provide a material right to the customer, the option would be accounted for as a separate performance obligation in the original contract. Further details on identifying the contract and accounting for these options, can be found in Section 2 and Section 3.7 our general Applying IFRS publication.

In addition, terms related to payments made for volumes not taken (i.e., when the customer does not take the minimum quantities specified) can vary. For example, some take-or-pay arrangements might include a clause that allows the customer to 'make up' the volumes not taken at a later date. The ability to make up the unused volumes means that consideration has been received in advance by the producer for a product that has not yet been delivered. Alternatively, the contract may contain a 'use it or lose it' clause, under which the customer cannot make up the unused volumes in the future. In such a situation, this payment would be more akin to a type of penalty payment.

The ED discusses the concept that in certain industries customers may pay for goods or services in advance, but may not ultimately exercise all of their rights to these goods and services — either because they choose not to or are unable to. The ED refers to these unexercised rights as breakage.


In take-or-pay contracts, the unexercised rights are effectively breakage. However, it is not clear if the proposed requirements on breakage would be applicable. If they do apply, the unexercised rights would be accounted for as follows:

• If an entity is reasonably assured of a breakage amount, the entity should recognise the expected breakage as revenue in proportion to the pattern of transfer of goods or services to the customer.

• If an entity is not reasonably assured of a breakage amount, it should recognise the expected breakage as revenue when the likelihood of the customer exercising his or her rights on remaining balances becomes remote.

It is also important to note that there is some uncertainty in the ED as to how the requirements for recognising breakage amounts would be applied when they are considered to be reasonably assured. The ED requires that the entity would recognise the breakage amount as revenue "... in proportion to the pattern of rights exercised by the customer." This suggests that the entity would have to take into account either:

• The rights already exercised by the customer to date compared with those the entity expects the customer will still exercise. This would allocate the breakage amounts to all performance obligations (satisfied and still to be satisfied) in the contract.

Or

• Only the rights that have been exercised in the contract. This would lead to full recognition of the breakage amount when reasonable assurance is achieved (or when the likelihood of the customer exercising the rights when reasonable assurance is not achieved).

In take-or-pay contracts, in which payments received for unused volumes can be applied to future volumes, the seller has received consideration in advance for an unsatisfied performance obligation. This amount represents a contract liability, which will differ from current treatment under which such amounts are referred to as deferred or unearned revenue.

When determining how to account for the contract liability on make-up volumes, the ED requires that the transaction price in a contract must be adjusted to reflect the time value of money if the contract has a financing component that is significant to the contract.

How we see it

The ED could have practical implications for, and may increase the complexity of, accounting for take-or-pay contracts. This complexity arises on determining the performance obligations (whether to combine these using the practical expedient), determining the standalone selling price (spot or a forward price) and taking into consideration the unexercised rights.

In addition, the ED is unclear on how or whether the requirements for recognising breakage amounts would be applied in take-or-pay contracts, which could lead to divergence in practice. As such, we recommend the Boards clarify what is meant by recognising revenue "in proportion to the pattern of rights exercised by the customer".

The proposed revenue recognition model could have practical implications for, and may increase complexity of, the accounting for take-or-pay contracts.


Onerous performance obligationsThe ED would require an entity to recognise a liability and a corresponding expense when certain performance obligations (that is, performance obligations satisfied over time and that time period is greater than one year) become onerous. Section 7.2 of the general Applying IFRS publication provides further details on applying the onerous contract provisions of the ED.

As mentioned, the onerous contract performance obligation assessment would be required only when performance obligations are satisfied over time. As such, an entity’s determination of the unit of account for long-term contracts may impact the onerous test.

Another important aspect to consider in connection with the onerous performance obligation assessment is the cost of settling the performance obligation. Under the ED, a performance obligation is deemed onerous when the lesser of the following costs exceeds the allocated transaction price:

• The costs directly related to satisfying the performance obligation (i.e., direct costs)

• The amount the entity would pay to exit the performance obligation

P&U entities that identify performance obligations that are settled over time may have difficulty determining the costs that are directly related to satisfying the specific performance obligations. In some cases, there is no direct link between costs and a specific revenue contract (or the individual performance obligations within that contract). For example, an entity may produce electricity from several power plants (with different cost structures) into a grid that fulfils multiple customer contracts.

DisclosuresIn response to criticism that the current revenue recognition disclosures are inadequate, the Boards have tried to create a comprehensive and coherent set of disclosures. As a result, the ED includes an overall objective that the revenue recognition disclosures should enable users of the financial statements to understand the “amount, timing and uncertainty of revenue and cash flows arising from contracts with customers.” The ED states that preparers would meet that objective by providing both qualitative and quantitative disclosures about:

• Contracts with customers — These disclosures would include disaggregation of revenue, reconciliation of contract asset and liability balances (including liabilities due to onerous performance obligations) and information about an entity’s performance obligations.

• Significant judgements (including changes in those judgements) — This would include disclosures about judgements that significantly affect the determination of the transaction price, the allocation of the transaction price to performance obligations and the determination of the timing of revenue recognition.

• Assets recognised resulting from costs incurred to obtain or fulfil a contract.

The Boards have clarified that the disclosures they listed in the ED are not intended as a checklist of minimum requirements. Instead, entities would have to determine which disclosures are relevant to them. Entities also would not have to disclose items that are not material.

Next stepsGiven the potential consequences, we encourage P&U entities to gain an understanding of the ED and how it may affect their particular facts and circumstances and provide the Boards with feedback. Although comments are due by 13 March 2012, the Boards also plan various outreach efforts to gather more feedback. Entities that would like to participate should express their interest to the Boards.

Entities should also continue to consider the impact the changes may have on their business and discuss these potential changes with their Audit Committee, the Board of Directors and auditors.

Ernst & Young

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© 2012 EYGM Limited. All Rights Reserved.

EYG no. AU1108

This publication contains information in summary form and is therefore intended for general guidance only. It is not intended to be a substitute for detailed research or the exercise of professional judgment. Neither EYGM Limited nor any other member of the global Ernst & Young organization can accept any responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication. On any specific matter, reference should be made to the appropriate advisor.

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Expiry date: 6 January 2013

Ernst & Young’s Global Power & Utilities Center In a world of uncertainty, changing regulatory frameworks and environmental challenges, utility companies need to maintain a secure and reliable supply, while anticipating change and reacting to it quickly. Ernst & Young's Global Power & Utilities Center brings together a worldwide team of professionals to help you achieve your potential — a team with deep technical experience in providing assurance, tax, transaction and advisory services. The Center works to anticipate market trends, identify the implications and develop points of view on relevant industry issues. Ultimately it enables us to help you meet your goals and compete more effectively. It’s how Ernst & Young makes a difference.

ContactsGlobal Power and Utilities LeaderBen van GilsDirect tel: +49 211 9352 21557Email: [email protected]

Global IFRS Leader — Power & Utilities Sector Dennis Deutmeyer Direct tel: +1 212 773 9199 Email: [email protected]

Global Assurance Power & Utilities LeaderCharles-Emmanuel ChossonDirect tel: +33 1 46 93 71 62Email: [email protected]

Global Assurance Power & Utilities Sector ResidentLouis-Mathieu PerrinDirect tel: +33 1 46 93 46 14Email: [email protected]

Documents

Applying IFRS in Power & Utilities