Query No. 45                   

Subject:           Revenue recognition for reimbursement of operating and maintenance expenses under a contract governed by Central Electricity Regulatory Commission.[1]

A.      Facts of the Case

1.         A company (hereinafter referred to as the ‘company’) was incorporated as a wholly owned subsidiary of A Ltd. (holding company) on 20.03.2009 and obtained the certificate for commencement of business on 23.03.2010. It is in the business of scheduling and despatch of electricity over inter-regional links in accordance with Grid standards specified by the Authority and Grid code specified by Central Commission.  These functions are being exercised through National Load Dispatch Centre (NLDC) and five Regional Load Dispatch Centres (RLDC) located at Delhi, Mumbai, Kolkata, Chennai and Bangalore. Prior to its incorporation this function was being carried out by the holding company.

2.         The querist has stated that revenue (RLDC fees and charges) of the company is governed by the Regulation notified by the Central Electricity Regulatory Commission (CERC) on the philosophy of cost plus basis. The present RLDC fees and charges have been notified by the CERC for five year term starting from April 2009 and ending on March 2014. The main components of RLDC fees and charges are given as below:

(a) Return on equity;

(b) Interest on loan capital;
(c) Depreciation;
(d) Operation and maintenance expenses excluding human resource expenses;
(e) Human resource expenses;
(f) Interest on working capital;

The basic principle being followed by the Regulator is to allow the RLDC fees and charges on actual reimbursement of expenditure incurred (without any profit motive). This principle is implied from the fact that the Regulations require component (a), (b), (c) and (f) along with any other income earned by the company to be deposited in the LDC Development Fund. This fund is to be utilised for the specific purposes for development of new assets after meeting the statutory payments, like interest, repayment of loan, income tax, dividend etc. No return on equity is allowed by the Regulator on the capital expenditure incurred on the new assets created out of this fund. Extracts of the Regulation have been supplied by the querist for the perusal of the Committee.

The components (d) and (e) i.e., operation and maintenance (O&M) and human resource (HR) expenses (hereinafter referred as the ‘expenditure’) are being reimbursed on actual basis. These expenditure for the years 2009-14 have been determined by CERC based on the actual expenditure incurred for the period 2004-09 escalated with the inflation index and the manpower projection given by the company.

3.         The querist has stated that as per the Regulation, actual expenses shall be allowed by CERC subject to the prudence check by CERC. The difference between actual and allowed shall be considered at the time of truing up exercise after the control period i.e., after 31st March, 2014. The expenditure allowed by the Regulator and the actual expenditure incurred for the period 2009-14 are given as below:

(Rs. in crore)

Upto 31.03.2012, the revenue including reimbursement of above expenditure was being allowed as per the norms notified by the CERC under the Regulations for RLDC fees and charges. In case, the amount allowed by the CERC was more than the actual expenditure, the revenue recognition was restricted to actual expenditure. However, no additional revenue was recognised in case the actual expenditure was more than the reimbursement allowed by the CERC i.e., actual expenditure incurred or amount allowed by the CERC whichever is less (unit wise). Any excess in collection of system operation and market operation charges over the revenue recognised is transferred to the liability to be adjusted on truing up exercise by the CERC after the expiry of the control period.(Emphasis supplied by the querist.)

4.         Since the actual expenditure was more than the approved expenditure allowed by the CERC, the company filed a petition with the CERC for allowing additional expenditure based on actual. The Hon’ble Commission vide its Order dated 28.09.2012 has directed that “any additional legitimate HR expenses over and above that approved by the Commission in its various tariff order may be temporarily met by petitioner out of the LDC Development Fund which will be recouped at the time of truing up”. Order copy has been supplied by the querist for the perusal of the Committee. Considering the outcome of CERC order dated 28th September, 2012, the accounting policy regarding revenue recognition was changed in financial year (F.Y.) 2012-13 to account for revenue on account of reimbursement of such expenditure based on the actual expenditure incurred. The accounting policy was changed with retrospective effect from 01.10.2010 i.e., the date of commencement of business and the difference in revenue was also accounted for in 2012-13. Extracts of revised accounting policy in the annual accounts of F.Y. 2012-13 is given as under:

“System operation and Market operation charges comprising RLDC fees and charges are recognized on the basis of tariff approved by Central Electricity Regulatory Commission (CERC).  Human Resource and Operation and Maintenance expenses component of tariff are accounted on the basis of actual expenditure. Charges towards projected capital expenditure are restricted to charges based on actual capital expenditure.”

The change of accounting policy and its impact were disclosed in the notes and accounts as under:

“Revenue recognition of HR and O&M expenses was hitherto being made based on actual expenditure incurred or amount allowed by CERC whichever is less. However, such actual expenditure incurred is allowable as per CERC regulations subject to truing up after the end of the control period i.e., 2009-14.  On the petition filed by the company, CERC vide order dated 28th September 2012, has directed that “Any additional legitimate HR expenses over and above that approved by the Commission in its various tariff orders as mentioned in para 3 of this order may be temporarily met by the petitioner out of the LDC Development Fund which will be recouped at the time of truing up”.”

5.         Management’s view regarding change of accounting policy:

(i)       Change in accounting policy was solely attributed to the CERC order dated 28th September, 2012, wherein it was mentioned that “Any additional legitimate HR expenses over and above that approved by the Commission in its various tariff orders may be temporarily met by the petitioner out of the LDC Development Fund which will be recouped at the time of truing up”. It was very clear from this order that all legitimate expenses incurred by the company shall be approved by the Hon’ble Commission at the time of truing up. In view of the management, all the expenses incurred are legitimate expenses and deemed to be allowed by the Hon’ble Commission (CERC), though after prudence check.
(ii)      Management was of the view that outcome of the CERC order dated 28th September, 2012, confirms the certainty of receipt of additional expenses (O & M including HR expenses) over and above allowed by the CERC in its earlier tariff orders.
(iii)       The revised accounting policy shall be fulfilling the criterion of matching revenue with expenditure incurred.
(iv)       The revised accounting policy shall be fulfilling the criterion of accrual system of accounting and shall give true and fair view of accounts and will avoid the deferment of income of the entire control period till the truing up exercise by the CERC.
(v)           The same is in line with Accounting Standard (AS) 9, ‘Revenue Recognition’. Paragraph 12 of AS 9 also emphasises on revenue recognition where no significant uncertainty exists regarding the amount of consideration. The paragraph is reproduced as below:

“12. In a transaction involving the rendering of services, performance should be measured either under the completed service contract method or under the proportionate completion method, whichever relates the revenue to the work accomplished. Such performance should be regarded as being achieved when no significant uncertainty exists regarding the amount of the consideration that will be derived from rendering the service.”

6.         The statutory auditors have qualified the change in accounting policy and have stated in their auditors’ report that:

“Except for the matters described in the Basis for Qualified Opinion paragraph, in our opinion, the Balance Sheet, the Statement of Profit and Loss and Cash Flow Statement comply with the accounting standards referred to in sub-section (3C) of section 211 of the Act.

Basis for Qualified Opinion:   During the year, the company has changed the Accounting Policy regarding Revenue Recognition (Refer Note No 2.39 of other Notes). The change of Accounting Policy has resulted in increase of Profit for the year by Rs. 52.92 crore, Income Tax Provision by Rs. 17.17 crore and Shareholders’ Funds by Rs. 35.75 crore, same  is subject to admissible by Central Electricity Regulatory Commission (CERC) after prudence check at the time of truing up. The extent of uncertainty involved on account of additional revenue is dependent upon outcome of CERC order. Recognition of such additional revenue to the extent of uncertainty involved is departure from the Accounting Standards referred to in sub section (3C) of section 211 of the Act.”

Management reply to above qualification as produced in the annual report is reproduced below:

“The HR and O&M expenses were accounted for as ‘actual expenditure or expenditure allowed by CERC, RLDC wise whichever is less’, upto F.Y. 2011-12. However, such actual expenditure is allowable as per CERC regulations subject to truing up after the end of the control period i.e., 2009-14. On the petition filed by the company, CERC vide order dated 28th September, 2012, has directed that “Any additional legitimate HR expenses over and above that approved by the Commission in its various tariff orders as mentioned in Para 3 of this order may be temporarily met by the petitioner out of the LDC Development Fund which will be recouped at the time of truing up”.

 

Considering certainty of receipt as per AS 9, matching revenue concept and accrual system of accounting, the accounting policy has been changed as ‘Revenue recognition based on actual HR and O&M expenditure incurred’. In view of CERC Regulations, CERC order dated 28th September, 2012 and past CERC orders on the above matters, management is of the view that uncertainty involved on account of additional revenue is negligible. Only the legitimate expenditure eligible under CERC Regulations has been considered for additional revenue.”

7.         Comptroller and Auditor General (CAG) during the audit of accounts issued a half margin which has been provided by the querist for the perusal of the Committee, along with management reply. However, CAG in its report under section 619(4) of the Companies Act, 1956 has not commented upon the qualification included in the auditors’ report.

8.         The querist has separately clarified as follows:

(i) As per the Regulation, actual HR and O&M expenditures incurred during the block period of 2009-14 shall be allowed by CERC subject to prudence check.  The amount of reimbursement allowed during the period 2009-14 has been determined by CERC based on the actual expenditure incurred for the period 2004-09. The same are to be adjusted with the escalation factor based on inflation index and manpower projection given by the company.   

(ii) Based on the petition filed by the company for reimbursement of additional expenditure incurred   the Hon’ble Commission vide its order dated 28/09/2012 has directed that ‘any additional legitimate HR expenses over and above that approved by the Commission   in its various tariff order may be temporarily met by petitioner out of the LDC Development Fund which will be recouped at the time of truing up’. (Emphasis supplied by the querist)

 

(iii) As such, the regulatory framework in general and regulator in the specific order provides for reimbursement of actual expenditure incurred.

(iv) The management is of the view that quantum of amount to be allowed by the CERC, while determining the truing of petition, may not vary in a very significant way.  This view is based on earlier practices of the regulator on the similar issues. In this regard copies of the following orders issued by CERC have been supplied by the querist for the perusal of the Committee:

                                                                                                                     
(a) order issued by CERC dated 17.12.2013 (Petition No:59/TT/2012) pertaining to NR-ULDC (A Ltd. portion) for revision of O&M charges for the period 2009-10 to 2012-13, wherein this issue has been dealt with from paragraph No. 38 to  43 of the said order.

In this case petition was made for reimbursement of O&M expenditure actually incurred. The CERC after prudence check allowed entire O&M expenditure except very negligible amount of miscellaneous expenditure for which details could not be provided by the petitioner as detailed below:

Rs. In lakh

  
(b) order issued by CERC dated 03.08.2011(Petition No:48/2010) pertaining to ER-ULDC (A Ltd.) for revision of O&M charges for the period 2004-09, wherein this issue has been dealt with from paragraph No. 12 to  19 of the said order.

In this case, petition was made for reimbursement of O&M expenditure actually incurred. The CERC after prudence check allowed entire O&M expenditure except the provision for wage revision for which no cash out flow happened during the said block period. As per paragraph 14 of the order, the actual O&M charges as per accounts for the 2004-09 block period were Rs. 4495.03 lakh which included provision of Rs.501.63 lakh; therefore, the cash O&M expenditures were Rs. 3993.40 lakh (Rs. 4495.03 - Rs. 501.63). After truing up and prudence check, the CERC allowed the additional O&M expenses amounting to Rs. 890.77 lakh from the earlier allowed O&M charges (Rs. 3993.40 - Rs. 3102.63).

 (v)  After issuance of order by the CERC as stated above, the company shall revise the billing for each financial year of the block period 2009-14 and supplementary/revised bills /credit/debit note shall be issued by the company to the same customers  (mainly state utilities) to whom the bills were issued earlier. It has no relationship as far as billing for the next block period, i.e., 2015-19. 

(vi)   The amount to be allowed by the regulator after truing up exercise, is towards the services which have already been provided in the block period 2009-14. As such, it is covered under AS 9 since the services have already been provided and there is no significant uncertainty regarding the amount of consideration.

 

(vii) CERC regulations permit billing only when specific orders have been issued.  It is  a practice in the Power Sector  to recognize the revenue which  is permitted under the norms & for which  billing is pending for want of specific orders to be issued by CERC. The same is included under unbilled revenue.  The practice is based on matching concept in which revenue and expenditure are accounted for in the year to which it pertains.

B.        Query

9.         In the above background, the querist has sought the opinion of the Expert Advisory Committee as to whether the change in accounting policy and revenue recognition of re-imbursement of O&M and HR expenditure is as per the Accounting Standards of the Institute of Chartered Accountants of India (ICAI) and as per the prevalent accounting practices.

C.        Points considered by the Committee

10.       The Committee notes that the basic issue raised by the querist relates to recognition of reimbursement of operation and maintenance (O&M) expenses and human resources (HR) expenses by the company under the Regulations of the Central Electricity Regulatory Commission. The Committee has, therefore, considered only this issue and has not examined any other issue that may arise from the Facts of the Case, such as, recognition of recovery on account of expenses other than O&M and HR expenses, whether change in accounting treatment of reimbursement of such expenditure should be classified as change in accounting policy and whether same has been appropriately dealt with or not, accounting for recoupment of HR and O&M expenses out of the LDC Development Fund, accounting for charges towards projected expenditure, etc.  

11.       The Committee notes that the issue relates to recognition of reimbursement of HR and O&M expenses as ‘revenue’ as and when the related expenditure is incurred, or only when the truing up exercise is completed by the regulatory authorities. In this connection, at the outset, the Committee notes that although the term ‘reimbursement’ has been used by the querist and subsequently in this opinion also, in respect of O&M and HR expenses in the extant case, the reimbursement is basically a recovery as a part of the revenue fixed as tariff as per the tariff regulations and accordingly, the principles of revenue recognition as per Accounting Standard (AS) 9, ‘Revenue Recognition’, notified under the Companies (Accounting Standards) Rules, 2006 would be applicable. Therefore, the Committee notes the definition of the term ‘revenue’ as per the following paragraph of AS 9, notified under the Rules:

“4.1     Revenue is the gross inflow of cash, receivables or other consideration arising in the course of the ordinary activities of an enterprise from the sale of goods, from the rendering of services, and from the use by others of enterprise resources yielding interest, royalties and dividends. Revenue is measured by the charges made to customers or clients for goods supplied and services rendered to them and by the charges and rewards arising from the use of resources by them. ...”

From the above, the Committee notes that revenue is the charge made to the customers/clients for the goods supplied or the services rendered. The Committee notes from the Facts of the Case that the revenue (RLDC fees and charges) of the company is governed by the Regulations notified by the Central Electricity Regulatory Commission (CERC) on the philosophy of cost plus basis. The present RLDC fees and charges have been notified by the CERC for the block period of 2009-14. Accordingly, the company charges the existing RLDC fees and charges (tariff) determined by the CERC from its customers. Further, as per the Regulations, actual HR and O&M expenditure incurred during the block period of 2009-14 shall be allowed by the CERC subject to prudence check at the end of the block period. The Committee also notes that after issuance of order by the CERC, the company shall revise the billing for each financial year of the block period 2009-14. The supplementary/revised bills /credit/debit note shall be issued by the company to the same customers to whom the bills were issued earlier and that it has no relationship as far as billing for the next block period, i.e., 2015-19.  Thus, it is the existing customers who are being charged in future for the services rendered to them in the past. Accordingly, the Committee is of the view that in the extant case, incurrence of HR and O&M expenditure gives rise to a right of recovery from the present customers which should be recognised as revenue provided other conditions of AS 9 are fulfilled.

12        With regard to the issue relating to the timing  and measurement of revenue recognition, the Committee notes the following paragraphs of Accounting Standard (AS) 9, ‘Revenue Recognition’, notified under the Companies (Accounting Standards) Rules, 2006:

“9.1 Recognition of revenue requires that revenue is measurable and that at the time of sale or the rendering of the service it would not be unreasonable to expect ultimate collection.
9.2 Where the ability to assess the ultimate collection with reasonable certainty is lacking at the time of raising any claim, e.g., for escalation of price, export incentives, interest etc., revenue recognition is postponed to the extent of uncertainty involved. In such cases, it may be appropriate to recognise revenue only when it is reasonably certain that the ultimate collection will be made. Where there is no uncertainty as to ultimate collection, revenue is recognised at the time of sale or rendering of service even though payments are made by instalments.”

From the above, the Committee notes that if at the time of booking revenue, it is unreasonable to expect ultimate collection thereof, revenue recognition should be postponed to the extent of uncertainty. The Committee is of the view that to assess the certainty or uncertainty of ultimate collection is a matter of judgement, which should be exercised considering various factors peculiar to the facts and circumstances of the case. The Committee notes that in the extant case, the CERC has a right not to allow the reimbursement of the expenditure if it is not legitimate. In other words, only legitimate expenses will be allowed by the CERC to be reimbursed to the company. Thus, although the company considers that all the expenses incurred are legitimate expenses and is also of the view that the CERC order dated 28/09/2012 confirms the certainty of receipt of additional expenses, the Committee is of the view that whether there is certainty of ultimate collection of revenue is a matter of judgement which should be assessed considering various factors, such as, on the basis of past experience, legitimacy of the expenditure, etc.  Accordingly, the Committee is of the view that the actual O&M and HR expenditure should be recognised as revenue only when and to the extent, there is no such uncertainty of recovery.

13.       Incidentally, the Committee has also examined the applicability of the Guidance Note on Accounting for Rate Regulated Activities, issued by the ICAI, (hereinafter referred to as the ‘Guidance Note’), which contains the guidance on accounting for rate regulated activities. In this regard, the Committee notes the following paragraphs of the Guidance Note:

“13. The objectives of this Guidance Note are to recommend:

the recognition of a regulatory asset or regulatory liability if the regulator permits the entity to recover specific previously incurred costs or requires it to refund previously collected amounts and to earn a specified return on its regulated activities by adjusting the prices it charges to its customers;

 

…”                            
                                                                                                      
“Scope

14. An entity should apply this ‘Guidance Note’ to its operating activities that meet the following criteria:

(i) the regulator establishes the price the entity must charge its customers for the goods or services the entity provides, and that price binds the customers; and

(ii) the price established by regulation (the ‘rate’) is designed to recover the specific costs the entity incurs in providing the regulated goods or services and to earn a specified return. The specified return could be a minimum or range and need not be a fixed or guaranteed return.”

“22. Rate regulation of an entity’s business activities creates operational and accounting situations that would not have arisen in the absence of such regulation. With cost-of-service regulation, there is a direct link between the costs that an entity is expected to incur and its expected revenue as the rates are set to allow the entity to recover its expected costs. However, there could be a significant time lag between incurrence of costs by the entity and their recovery through tariffs. Recovery of certain costs may be provided for by regulation either before or after the costs are incurred. Rate regulations are enforceable and can create legal rights and obligations for the entity.

23. An issue therefore arises as to whether an entity should recognise in its financial statements the right to recover incurred costs or the obligation to refund amounts received for which costs have not been incurred through future tariff adjustments. Recognition of the right to recover incurred costs in the future or the obligation to refund amounts received in the financial statements of the entity would arise if they meet the definition of assets and liabilities as provided in the Framework for the Preparation and Presentation of Financial Statements issued by the Institute of Chartered Accountants of India.”

 On a combined reading of the above paragraphs of the Guidance Note, the Committee is of the view that the Guidance Note does not apply in the extant case as the Guidance Note covers only those ‘costs of service’ type of rate regulation where the recovery of excess cost incurred in the current period is through adjustment of future tariff to be charged from the customers for the services to be provided in future. In the extant case, the recovery of actual cost (O&M and HR) incurred by the company is not to be adjusted for determining the future tariff; rather it is to be recovered by the company from its past customers for the services rendered to them in the past.

D. Opinion

14.       On the basis of above, the Committee is of the opinion that whether there is certainty of ultimate collection of revenue viz., recovery towards expenditure incurred, is a matter of judgement which should be assessed considering various factors, such as, on the basis of past experience, legitimacy of the expenditures, etc., as discussed in paragraph 12 above.  Therefore, the actual O&M and HR expenditure should be recognised as revenue only when and to the extent, there is no such uncertainty of recovery. Accordingly, the accounting policy of recognition of revenue towards recovery of expenditure incurred in the period in which the expense is incurred would be appropriate provided on consideration of various factors as afore-mentioned, it is reasonably certain that the ultimate collection of the revenue would be made.

___________________________________

[1] Opinion finalised by the Committee on 6.2.2015.