Renewables are proving complex for utility management in terms of how they should be dealt with under IFRS accounting rules, says David Coulon.

Generators and other utility companies are under mounting pressure to make investments in alternative energy. Increased awareness of climate change, concerns about the sustainability of non-renewable energy sources, the desire of consumer and corporate entities to be green and government incentives to encourage investment in alternative energy have all created strong demand for environmentally friendly energy production.

This, coupled with European Union requirements that the UK should generate 15 per cent of its energy from renewable sources by 2020, has led to a substantial growth in alternative energy.

However, while investment in alternative energy has experienced double digit growth in the past ten years, and the global market is expected to reach £44 billion a year in the next decade (despite the recnt downturn in the market), little clarity has emerged about key accounting issues under International Financial Reporting Standards (IFRS), which are still bedding down. This has raised concern that senior management is trying to explain performance (for which it is accountable to the board and to the investor community) under difficult circumstances. Not only is there a lack of tried and tested standards, but because this is still a new and changing field, decisions are being made in the absence of established industry best practice.

The first accounting dilemma in the event of a renewables investment is whether a business combination or an asset acquisition has occurred. Currently, IFRS 3 Business Combinations require that an entity distinguishes between the acquisition of a "business" and a group of assets. Since deciding where to draw the line between the two options creates completely different outcomes in a company's financial statements, this decision has always required judgement, and diversity in practice is already evident in the industry.

If the acquisition is a business combination, the various elements must be assessed to determine whether they are "operating assets" - for example a group of operating wind turbines with a connection to the grid - or "projects", which have much less precise parameters and could include anything from an identified location with a positive wind study, to a lease of land, including planning permission and an operations and management agreement.

Intangible assets

In a business combination, any difference between the amount paid and the value of the operating assets is treated in financial statements as intangible assets or goodwill. The value of goodwill cannot be spread evenly over time. Instead, its carrying value must be tested at least annually and any decrease must be recognised immediately. The timing of this can be unpredictable, causing difficulties in managing earnings expectations. This can make company performance look volatile.

Conversely, if a company believes it has not entered into a business combination, but has merely acquired a group of assets, these can be depreciated by a standard amount each year, making the earnings expectations more straightforward to manage.
Making the distinction between business combination versus asset acquisition has always been tricky. More complexity will be added with effect from July next year with the introduction of a revised IFRS3 that states that a business need no longer create outputs that generate revenues.

Some companies may consider the revised standard broadens the definition of a business and brings more transactions within its scope. In the absence of specific guidance under IFRS, this presents management teams with a problem as regards whether it is a business or an asset that has been acquired, and what accounting treatment is most appropriate. This could create greater inconsistency within the industry and suggests businesses will need to apply care as they explain the impact on their financial results.

When determining the fair value of an asset (whether as a result of a business combination or for impairment purposes), IFRS often require that the associated future revenues are estimated. Determining revenues for alternative energy assets can cause difficulties because of frequent changes to incentive schemes, which can affect assumptions over the price of power, or the ability to trade emissions rights.

Incentives

For example, Renewables Obligation Certificates (Rocs) are provided as an incentive to produce energy from renewable sources in the UK. When testing renewable energy generation assets for impairment, the difficulty for management is that the value of many of these incentives is only reliable for a relatively short term, but the life of the asset to which they relate may be upwards of 20 years.

In the absence of specific guidance, management teams are forced to guess what direction renewables incentives will take and what their value will be. This is a key assumption when impairment tests are undertaken. For analysts and other accounts users, the fact that companies may be making different assumptions about the same incentives and so recording different asset values is not helpful.

For example, assume that two companies have identical windfarms. They estimate future revenues using different assumptions about the future value of Rocs (current buyout price and recycle component). One company assumes there will be an increase in the Roc buyout price and another that it will remain stable. Both assumptions are reasonable but lead to a difference of up to 50 per cent in the value of the asset, as such incentives could account for up to 50 per cent of revenues.

Decommissioning is another area fraught with difficulty. It is inevitable that, in most jurisdictions, alternative energy companies will face a requirement to restore land (or seabed) to its original state. However, many companies would like to adopt a pragmatic approach to accounting for this requirement, and offset the cost of decommissioning against the scrap value of the assets. This is not allowed under the current accounting regime, which requires that these two events be treated separately. In addition, the provision is difficult to estimate because there is no history of decommissioning such assets.

Windfarms re-powered

Another issue when accounting for decommissioning is the belief that existing windfarms will be "re-powered" and therefore will not need to be decommissioned. If companies end up re-powering, then the original provision made for decommissioning costs will be reversed, which could lead to a significant profit being recognised. Again, in the absence of guidance, it is up to management to exercise judgement to apply the appropriate accounting treatment.

Another accounting issue causing significant debate is how utilities should classify long-term (say 25-year) power purchase agreements with renewable energy producers. Should such agreements be classed as a normal executory contract or should they be treated as leases?

The answer can have a big impact on the reported gearing of a company. If the contract ends up as a finance lease, the company purchasing the power must recognise the generation assets and a corresponding financial liability on its balance sheet, even though they do not legally own the generation assets. Such an obligation could potentially put a company in breach of its covenants.

IFRS has not yet reached the status of what accountants call Generally Accepted Accounting Principles. Because the alternative energy industry is relatively new, company executives will be engaged in a series of delicate balancing acts for some time to come as they compile their financial statements. The key question, for management and users of the financial statements, is whether they give a true and fair view of activities. Since this is something of a subjective assessment, there will always be room for interpretation and management must continue to seek ways to explain underlying performance so that the market has a clear and complete understanding of corporate activity.

David Coulon is partner and co-head of the London utilities assurance practice at Ernst & Young. Email: dcoulon@uk.ey.com

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