Regulation of Financial Statements

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Regulators apply two systems of rules for controlling how an operator reports its financial results.1 The first system of rules is called the Uniform System of Accounts (USOA), which outlines how operators are to keep and report their financial records for regulatory purposes.2 Typical reports include balance sheets, income statements, cash flow statements, and operating statistics. Having a USOA decreases opportunities for abuse and helps in overcoming the operators’ information advantage over the regulator. The objectives of accounting regulation are to provide accurate records for ratemaking, clearly identify assets and asset values (for ratemaking, stranded cost calculations, and asset transfer at the end of a franchise), assess operator earnings, separate utility from non-utility activities, benchmarking, monitoring performance on investment and other license requirements, and transparency for investors. All financial statements should be expressed for the utility operations of the operator, the operator’s non-utility operations, and the operator’s holding company, if there is one.

The second system of rules that regulators apply to control how an operator reports financial information is called accounting separation (sometimes called ring fencing) and is frequently applied when the operator has lines of business that the regulator does not regulate.3 Market Structure and Competition provides examples of situations in which regulators frequently require accounting separations. The regulator generally requires the operator to provide financial statements for (1) the entire corporation, (2) country-specific operations, and (3) just the regulated operations. Financial statements for the entire corporation cover all domestic and international, regulated and non-regulated operations. Financial statements for country-specific operations cover all regulated and non-regulated operations related to the regulator’s country. Financial statements for just regulated operations cover all of the services under the regulator’s jurisdiction.

Regulatory requirements for accounting separations generally include rules for keeping separate regulated and non-regulated accounts where feasible, allocating costs in accounts that the operator uses for both regulated and non-regulated operations, transactions between corporate affiliates, and procedures for compliance reporting. Costs for facilities and operations that are shared by regulated and non-regulated operations are allocated between the regulated and non-regulated operations according to rules set forth by the regulator. In some instances, the regulator uses pricing restrictions on regulated services or non-regulated services to control cross-subsidization. Pure price caps on regulated services may control cross-subsidization and price floors on competitive services may, too.

The ease or difficulty with which accounting separation can be performed varies with the sector. Regulators perform or require audits and perform comparative analyses to police cost shifting. Numerous factors are available for the cost allocations involved in accounting separations and the regulator generally must make trade-offs between priorities of practicality, accuracy, and auditability when selecting cost allocation factors. Because of these trade-offs, the cost allocations can lose accuracy and give management incentives to make uneconomic investments. Also, accounting separation generally involves asset transfers between regulated and non-regulated operations and regulators set standards for how these transfers are to be valued and recorded. Because of these difficulties with accounting separation, and the cost of implementing it, regulators will sometimes not apply accounting separation if the operator’s non-regulated business is very small relative to the regulated portion. In these situations, regulators will sometimes simply include the non-regulated costs and revenues in with the regulated books. In some instances the regulator may rely on something close to pure price cap regulation, which would not require accounting separation.

Footnotes

  1. At least some regulators will have a single set of rules that cover both the USOA and accounting separation. The authors note them here as separate sets of rules.
  2. See Basic Financial Statements. Because standard accounting procedures may not give regulators all of the information they need to carry out their responsibilities, countries often give regulators authority to determine financial reporting requirements.
  3. See Regulatory Systems of Accounts. Effects of Competition in Tariff Design describes other effects of competition in pricing.