Power & Utilities Whitepaper Series

International Financial Reporting Standards: Property, Plant and Equipment Accounting Considerations for Power & Utility Companies
International Financial Reporting Standards (IFRS) promises to bring a number of signicant accounting changes for companies in the Power & Utilities (P&U) industry, especially in the area of accounting for property, plant and equipment (PP&E). Several accounting differences between IFRS and U.S. GAAP, including the components approach and impairment test principles, treatment of major maintenance expenses, borrowing costs and asset retirement obligations, can make the IFRS conversion process complex and time consuming. Early identication and analysis of these key accounting differences will likely lead to a successful transition. To help you with this process, this paper provides a summary of the relevant IFRS accounting standards and addresses some of the more common IFRS conversion issues facing companies with signicant investments in PP&E. Introduction to the accounting standards There are several standards under IFRS that address relevant accounting matters related to PP&E. IAS 16, Property, Plant and Equipment (IAS 16), provides general guidance for accounting for PP&E, including PP&E measurement options at and after recognition, derecognition principles and disclosure requirements. IAS 23, Borrowing Costs, Revised (IAS 23), is a broader equivalent of U.S. GAAP guidance provided in SFAS 34, Capitalization of Interest Cost (SFAS 34). IAS 37, Provisions, Contingent Liabilities and Contingent Assets, addresses, among other areas, measurement, recording and disclosure of asset retirement obligations. IAS 36, Impairment of Assets, prescribes procedures to ensure that assets are carried at no more than their recoverable amount and species when an entity should reverse a previously-recognized impairment loss. How this differs from U.S. GAAP Componentization IAS 16 requires the different components of an asset to be identied and depreciated separately if they have differing patterns of benets and are signicant relative to the total cost of the item. This components approach means that different depreciation periods will be used for each component of a xed asset. For example, a power plant is comprised of separate components with different useful lives (turbine, generator, boiler, electronic equipment, etc.), so its total book value will have to be allocated to these separate components. These individual components would then be depreciated over their respective useful lives. Signicant parts of an asset that have similar useful lives and patterns of consumption can, however, be grouped together. Entities that currently recognize plant assets as one overall item depreciated over a single 20- or 30-year useful life may nd componentization to be a challenging process, especially if the PP&E ledger under U.S. GAAP is not sufciently detailed or lacks certain key data necessary to specically identify components. This is particularly true for old plants, plants owned by joint ventures (where data access may be limited), or in the case of acquired assets where legacy pre-acquisition data may be limited. Consequently, you may need to involve plant managers and engineers to review the available asset data, including overhaul and replacement schedules, in order to complete the componentization process. Companies that maintain their PP&E ledger in accordance with the Federal Energy Regulatory Commission Uniform System of Accounts will be better positioned in this regard. Also, you will need to consider whether your current systems applications can perform the required calculations. For components that typically require replacement during the working life of the overall asset, you may also need to update your procedures and systems in order to be able to identify the book value of that particular component and write off the remaining book value when it is replaced. Such precise follow up and identication could represent a challenge.

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Componetization is one of the most signicant conversion issues facing P&U companies. In a poll of utility companies conducted by Deloitte in November 2008, over half of the respondents perceived componetization as the most signicant conversion hurdle related to PP&E, followed by cost eligibility for capitalization under IFRS versus U.S. GAAP and accounting differences related to impairments and asset retirement obligations. As componentization is one of the conversion areas that is expected to take the most up-front time and effort, many companies in the industry have already started performing internal assessments in this area. As of the date of the poll, 37 percent of the respondents had started brainstorming on how their companies should address the componetization process, 6 percent had formed a transition team and 4 percent had already held discussions with a depreciation consultant. Major overhaul Under U.S. GAAP, in 2006, FASB Staff Position AUG AIR-1, Accounting for Planned Major Maintenance Activities, eliminated the accrue-in-advance method as an acceptable method for the accounting of major overhauls, but retained the built-in overhaul, deferral and direct expensing methods as acceptable. Under the built-in overhaul method, major maintenance costs are considered a component of the initial asset. The estimated cost of the rst planned major maintenance activity is separated from the purchase price of the equipment and amortized to the date of the initial planned major maintenance activity. The cost of that rst planned major maintenance activity is then capitalized and amortized to the next occurrence of the planned major maintenance activity, at which time the process is repeated. The deferral method is similar to built-in overhaul method but without the initial segregation requirements. Under this method, the actual cost of each planned major maintenance activity is capitalized and amortized to expense in a systematic and rational manner over the estimated period until the next planned major maintenance activity. Under IFRS, costs related to major inspection and overhaul are recognized as part of the carrying amount of PP&E if they meet the asset recognition criteria in IAS 16. The major overhaul component will then be depreciated on a straight-line basis over its useful life (i.e., over the period to the next overhaul) and any remaining carrying amount will be derecognized when the next overhaul is performed. Costs of the day-to-day servicing of the asset (i.e., routine maintenance) are expensed as incurred. Thus, the IFRS accounting treatment is similar to the builtin overhaul method under U.S. GAAP. Companies that elected the direct expensing method under U.S. GAAP will be required to identify and recognize the cost of major maintenance separately in the carrying value of the corresponding asset. Impairment Two major differences exist between U.S. GAAP and IFRS on impairment of long-lived assets: 1. When assessing for impairment under U.S. GAAP, a two-step approach is applied. First, the carrying value of the asset is compared with the undiscounted value of the expected future cash ows to be generated from the asset. Second, where the carrying value is higher, the asset is written down to fair value. Under IFRS, the carrying value is compared with the assets recoverable amount (dened as the higher of the assets value in use, which is based on discounted future cash ows and fair value less cost to sell), and if the carrying value is higher, the asset is written down to the recoverable amount. The value-in-use calculation involves discounting the expected future cash ows to be generated by the asset to their net present value. The ultimate effect is that impairment may be recorded earlier under IFRS. 2. Under U.S. GAAP, reversals of previous impairments are generally not permitted, although one exception is for utility companies with previously disallowed costs that are subsequently allowed by a regulator. Under IFRS, where the indicator that led to the impairment loss no longer exists or has decreased, the previously recognized impairment charge may be reversed. (Goodwill impairment is an exception. Even under IFRS, goodwill impairment may not be reversed.) Under IFRS, companies will have to track asset impairments even after the initial writedown in order to determine whether the impairment should be reversed and the extent of any reversal. If a change has occurred, the asset impairment may be reversed; however, the asset cannot be revalued to an amount greater than the carrying amount would have been if no impairment loss had been recognized (i.e., the otherwise net carrying amount after regular depreciation expense is deducted). This will require tracking the unimpaired cost of the asset to determine the cap on the amount of any future restoration. Asset retirement obligations (ARO) Both IFRS and U.S. GAAP provide for the recognition of certain costs of dismantling an asset and restoring its site as a liability (e.g., a provision under IFRS), with an offsetting amount included in the capitalized cost of the asset. While both accounting frameworks provide for a present value approach in measuring the obligation, the mechanics of each approach differs. For example, IFRS allows a company to incorporate provision estimates based on internally generated costs, whereas U.S. GAAP requires third-party external costs to be used in the provision estimate.

Asset Impairment Approach IFRS U.S. GAAP

Impairment indicators?

Impairment indicators?

Is carrying value > recoverable value?

Is carrying value > undiscounted Cash Flows?

Loss based on recoverable amount

Loss based on fair market value

Asset retirement obligations (ARO) Further, under U.S. GAAP, the companys credit-adjusted risk-free rate of interest is used to discount the liability, whereas IFRS requires a rate reecting current market conditions and risks specic to the liability. The selection of the appropriate rate to use in each case requires careful consideration. Under both IFRS and U.S. GAAP, subsequent to the initial recognition of the asset retirement obligation, the provision is reviewed at each balance sheet date and adjusted to reect the current best estimate, which may include adjustments to the discount rate used to measure the provision. However, under IFRS the entire obligation is remeasured using the current discount rate while under U.S. GAAP only the incremental increase in the obligation is remeasured using the current discount rate and the previous portion of the recognized obligation (including reductions in the overall obligation) remains measured using the discount rate in use at the time that portion was recorded. Capitalization of borrowing costs Under both U.S. GAAP and IAS 23 Revised (effective January 2009), capitalization of borrowing costs related to assets that take a substantial time to complete is mandatory. Under the previous version of IAS 23, the capitalization of borrowing costs was an option and this difference will continue to impact companies that are currently reporting under IFRS as retrospective capitalization is not required under IAS 23 Revised. Under IFRS the denition of a qualifying asset is more generic than under U.S. GAAP and depends on whether time for completion is expected to be substantial. Consequently, there may be assets that are considered qualifying assets under U.S. GAAP but not under IFRS, and vice versa. The types of borrowing costs eligible for capitalization under IAS 23 are broader than under SFAS 34. Under IFRS, these costs include interest, amortization of discounts or premiums relating to borrowings, amortization of certain ancillary costs, nance charges of nance leases and exchange differences that are regarded as an adjustment of interest, whereas generally only interest is capitalizable under U.S. GAAP. Also, different from U.S. GAAP IFRS does not permit capitalization of interest costs for investments accounted for by the equity method. IFRS does not currently permit the capitalization of an equity carrying charge by regulated enterprises. Revaluation model IFRS provides companies a choice of accounting for PP&E under either the historical cost model (which is the required model under U.S. GAAP) or a revaluation model. Although the revaluation model is not widely used under IFRS, if elected, it does require companies to re-measure PP&E at fair value and record the change in value directly to equity (to the extent that a net revaluation surplus remains) on a recurring basis. Companies must have a consistent accounting policy for all assets within a particular asset class. When the revalued asset is disposed of, the revaluation surplus in equity remains in equity and is not reclassied to prot or loss. However, under this model, depreciation is recorded on the revalued amount, typically resulting in a higher depreciable basis and higher depreciation expense. In a poll of utility companies conducted by Deloitte in November 2008, only 1 percent of the participants were considering using the revaluation model, 42 percent were denitely not going to use this model and the remaining population had not yet put much thought to this matter or the question was not applicable.

Revaluation Model
Revaluation At fair value

Done for class assets Increase on revaluation Decrease on revaluation

Classied as part of equity revaluation reserve

Previously written down reversed in income statement

Adjusted against existing revaluation reserve

Charged to income statement

Most entities have opted for cost model on initial adoption

Spare parts classication IAS 16 specically addresses classication of spare parts to inventory if the useful life is less than one year while parts with a useful life greater than one year are classied as PP&E. Useful life of the spare part is the lower of the useful life of the spare part or the PP&E to which it relates (except if PP&E will be replaced and the part can be used in the replaced item of PP&E). Under U.S. GAAP the general practice of the industry is to classify such spare parts as inventory and if parts will not be used within the companys operating cycle or one year, they may be included in noncurrent assets or PP&E. Costs eligible for capitalization Under IFRS, costs that are directly attributable to bringing the asset to working condition for its intended use are able to be capitalized. Directly attributable costs do not include administrative and other general overhead costs, which may have historically been capitalized under U.S. GAAP and as part of guidance received from regulators. Initial adoption IFRS requires one year of comparative nancial information to be reported under IFRS based upon the rules in effect at the reporting date. Generally, companies must apply initial adoption rules retrospectivelywith some limited exceptions. Any differences resulting from the change in accounting policies from U.S. GAAP to IFRS upon the initial adoption date of IFRS are recorded directly through retained earnings. With regards to PP&E, under current IFRS rules, companies can either record PP&E at fair value at the date of transition to IFRS or retrospectively restate the net book value of PP&E to meet the accounting treatment under IFRS, including identifying and adjusting for those items of PP&E currently capitalized under the entitys national GAAP, but not permitted to be capitalized under IFRS. Public utilities capitalize an allowance for funds used during construction (AFUDC) - equity return and indirect overhead costs under U.S. GAAP that would not be capitalizable under IFRS. Also, under retrospective restatement approach, the Company would need to assess components of assets and depreciation methods for consistency with IFRS and adjust the depreciation recognized under previous GAAP if the amount that would have been recorded under IFRS is materially different. Both the retrospective restatement and the fair value options of IFRS 1, First-time Adoption of International Financial Reporting Standards, could require signicant effort from rate regulated entities. Considering that PP&E of a rate regulated entity is unique in nature, consists of a large number of assets, and is often internally constructed, establishing the fair value of PP&E at the time of adoption is complex and would require involvement of qualied independent valuation specialists. The adjustment of utility PP&E carrying values created over many decades to remove the impacts of costs incurred under U.S. GAAP that also included recognition of the impacts of utility regulatory economics would be extremely difcult, time consuming, and costly. In response to these concerns raised by standard setters in jurisdictions that are going to adopt IFRS in the near future, IASB issued an Exposure Draft (ED) in September 2008, which, among other amendments, proposed to exempt PP&E of rate-regulated companies from retrospective application of IFRS and to permit these companies to elect to use the carrying amount PP&E at the date of transition to IFRS as their deemed cost, subject to an impairment test at that date. Public comments on the ED were due by January 23, 2009. In May 2009 the IASB agreed not to nalize the proposed exemption, pending the outcome of the exposure draft on rate-regulated activities, issued for comment on July 23, 2009. As a nal consideration regarding initial adoption, PP&E that previously did not require impairment losses under U.S. GAAP if the undiscounted cash ows exceeded carrying value may require write-down at adoption date if recoverable value is less than carrying value.

What these differences mean for energy companies Companies that convert to IFRS can expect a complex and potentially lengthy process to inventory their PP&E, identify the applicable components, and to adjust the depreciation calculations of xed assets. But IFRS is more than nancial accounting and will have wide-ranging impacts on your company, from processes, controls and systems to HR. Changes in processes, internal controls and related documentation: Your impairment testing methodologies and procedures will have to be revised to reect IFRS recoverable value basis and impairment reversals. The components approach and the capitalization of major maintenance component will necessitate a regular and detailed identication of all parts of your power plants, costs related to major overhauls, and replacements. IFRS requirement to fully update AROs for changes in the discount rates will also have an impact on your procedures and processes. Technology issues: You may have to put in place new ledgers, such as an IFRS PP&E ledger to track components and an IFRS general ledger to run parallel accounting before full conversion to IFRS. Your systems and chart of accounts will have to be able to incorporate new input data, such as the major maintenance components and the impairment contra-asset account. Current valuation systems may not have functionality to handle IFRS requirements. Human resource considerations: Human resources will also be affected by a conversion to IFRS. A conversion project will place increased demands on your personnel and will create training needs. Taxes: Tax departments of P&U companies will need to understand the impact a conversion to IFRS will have on the nancial and regulatory accounting for income taxes as well as the calculations of taxable income and the associated tax liability. In addition, tax departments will need to assess the effects of conversion on tax accounting software applications, accounting policies and procedures, internal control standards, and human resources. For further information on IFRS income tax considerations on P&U companies, please refer to our whitepaper on IFRS tax considerations, International Financial Reporting Standards: Income Tax Considerations for Power & Utilities, at http://www.deloitte.com/dtt/article/0,1002,cid%253D234726,00.html Financial communication: Communication with, and education of, nancial statement stakeholders will be particularly key to ensure that analysts and investors are able to understand your IFRS nancial statements. Prior lessons learned in the conversion process In July 2002, the European Parliament passed legislation requiring listed companies to convert to IFRS by 2005. The short time frame and extensive reach of the directive had many companies scrambling to comply. The conversion placed signicant resource pressure human and nancial on nance teams and their companies at large. Allow plenty of time: The timetable for implementation should be detailed, realistic and updated regularly. The effort was often underestimated: Calculating depreciation based upon different useful lives is not a complex accounting issue. However, being able to allocate all the parts of a power plant to components is a challenge that many P&U companies struggled with in Europe. Do not limit your componentization exercise to a mere review of PP&E ledgers by accountants. Consider involving plant managers and engineers. Perform a detailed review of major maintenance schedules and signicant parts replacements. Many P&U companies also participate in joint ventures that they do not directly control. Thus, it can be difcult for the company to obtain all the necessary information to accurately convert to IFRS. For example, trying to identify the components of a plant that was funded but not built by your company may prove vexing. In such instances, you may want to reassess (and potentially revise) your requirements for nancial and accounting information obtained from the joint venture. The devil is often in the detail: Perform reconciliations well in advance of the date the nancial statements are due to be published. Do not overlook differences which may appear minor or secondary. Be aware of interdependencies between accounting impacts: for instance, if long-term assets impairments are signicantly impacted by IFRS, your goodwill impairment tests may be impacted as well. Involve stakeholders early in the process: By the time your results are published, there should be no major surprises for your investor community. Keep in touch with other P&U companies. Involve auditors or advisors early in the process: Late changes or last minute debates are never welcomed! Consider preparing a detailed standard-by-standard diagnostic as a rst step, which can then be presented to auditors for comment and agreement.

Do not underestimate the impact on your systems: Involve your technical department or IT consultants early. You may decide to use spreadsheets to go through the conversion but you will likely not reach business as usual unless your systems are fully updated to run under IFRS. Closing thoughts Think through your conversion process, and spend the time early on to fully consider the possible accounting consequences and what those changes will mean across your business and across various disciplines. Consider also the resource requirements and what that may suggest in terms of particular resource or timing constraints, so that those issues are also addressed in the conversion plan. Finally, once the plan is in place, start the conversion process early so you can work through the process at a reasonable and measured pace. The process will not be easy, but proper planning and efcient execution will increase the likelihood that your conversion will be successful.

Resources Deloitte has extensive IFRS experience in the P&U industry. With thousands of IFRS-experienced professionals in our global network, we provide a comprehensive array of services related to IFRS. As a multidisciplinary organization, we can help companies address a wide range of IFRS issues. Deloitte offers companies assistance with: Evaluating the potential impacts of IFRS Assessing readiness for IFRS conversions Implementing IFRS conversions, providing support with technical research, project management, and training Addressing the implications of IFRS in such areas as tax, nance operations, technology, and valuation
Contacts IFRS Solutions Center: D.J. Gannon National Leadership Partner IFRS Solutions Center Deloitte & Touche LLP +1 202 220 2110 dgannon@deloitte.com Industry Contacts: For more information, please contact: Greg Aliff Vice Chairman U.S. Energy & Resources Leader Deloitte LLP +1 703 251 4380 galiff@deloitte.com Bill Graf Partner Deloitte & Touche LLP +1 312 486 2673 wgraf@deloitte.com Andy Hickey Partner Deloitte & Touche LLP +1 212 436 5322 ahickey@deloitte.com Brian Murrell Partner Regulatory & Capital Markets Consulting Deloitte & Touche LLP +1 212 436 4805 bmurrell@deloitte.com Mike Reno Partner, Deloitte Tax LLP +1 202 378 5027 mreno@deloitte.com Jan Umbaugh Partner Deloitte & Touche LLP +1 561 962 7706 jumbaugh@deloitte.com David Yankee Partner, Deloitte Tax LLP +1 312 486 9842 dyankee@deloitte.com

Deloittes U.S. Energy & Resources group: We proudly serve power and utilities clients, helping them address their most critical challenges in order to deliver value for their shareholders and execute initiatives designed to further their strategic objectives. Overview of Our Power & Utilities Group: Audits half of the Fortune 1000 utilities and energy companies Provides accounting and enterprise risk services to 79 percent of the Fortune 500 utilities and energy companies Provides consulting services to the entire top 10 utilities and energy companies in the Fortune 1000 Provides nancial advisory services to 9 out of 10 utilities and energy companies in the Fortune 1000 Provides tax services to the entire top 10 utilities and energy companies in the Fortune 1000 More than 1,500 U.S. practitioners serving the industry, including over 350 partners, principals and directors Power & Utilities industry involvement: Our practitioners understand that leadership demands active participation across the industrys diverse community. We actively participate in the following organizations: American Gas Association Edison Electric Institute Electric Power Supply Association United States Energy Association Thought leadership: 2009 Deloitte Energy Conference Summary Report Regulators in a Green State of Mind The Risk Intelligent Enterprise: ERM for the Energy Industry Carbon accounting challenges: Are you ready? Technical Publications: Energy & Resources Accounting, Financial Reporting and Tax Update Energy & Resources Quarterly Accounting Update To download Deloittes Energy & Resources thought leadership, please visit www.deloitte.com/energysolutions. Deloittes online resources: For a wealth of online resources related to IFRS, visit www.deloitte.com/us/ifrs. Available materials include newsletters, whitepapers, pocket guides, timelines, webcasts, podcasts, and more. International accounting resources: The International Accounting Standards Board (IASB) develops international nancial reporting standards for general purpose nancial statements. Visit the IFRS section of www.iasb.org for additional details and copies of the standards.

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