In 2018, the Accounting Standards Codification (ASC) Topic 606—Revenue from Contracts with Customers became effective for all public companies. This major overhaul of revenue recognition has affected almost every industry, and the power and utilities (P&U) industry is no exception. The complex arrangements between P&U companies, governments, and customers pose some of the most difficult issues. Due to bundled sales contracts, contract modifications and different pricing terms, application of the five-step revenue-recognition model can be complicated.
In this article, we provide a brief explanation of the key issues the P&U industry faces when applying ASC 606, drawing on selected guides published by the AICPA’s Financial Reporting Executive Committee (FinREC) and the major accounting firms:
We will also provide references to other RevenueHub articles for more detailed explanations of ASC 606 topics. The following are key issues that companies in the P&U industry commonly face:
1. Tariff Sales to Regulated Customers
In the P&U industry, governmental regulators often have significant influence in setting rates and contract terms. In industry parlance, these pricing guidelines are referred to as tariffs. Each regulated utility has its own approved tariffs that govern the utility’s relationship with its customers. To prevent discriminatory practices or predatory pricing behavior, tariffs can only be changed by an “independent, third-party regulator” or via legislative action.
In some locales, regulators have allowed utilities to bill customers for specially-approved activities through alternative revenue programs (ARPs). ASC 980-650-25 separates these programs into two categories: 1) Type A programs related to effects of weather abnormalities or conservation efforts and 2) Type B programs related to the utility achieving specific objectives, like cost reductions. Both types of ARPs allow utilities to change future prices based on prior activities or events.
ARP-generated revenues are not within the scope of ASC 606 because ARPs represent contracts between utilities and their regulators, not customers. P&U companies should continue to use the guidance in ASC 980-605-25 to account for ARP arrangements. Under ASC 605, utilities generally reported revenue from ARPs within operating revenue, but ASC 606 requires utilities to present revenue from ARPs separate from operating revenue in the statement of comprehensive income.
Some utilities have recognized ARP revenue in prior periods (when earned) but included customer charges relating to the ARP revenue in subsequent periods. Based on its interpretation of ASC 980 and ASC 606, FinREC has presented two acceptable methods by which utilities can properly present the subsequent billing of ARP charges on the income statement. The total amount of revenue recorded in each period is the same under both methods.
Method A: Reclassify ARP Revenue as Operating Revenue
This method re-classifies revenue from ARP as operating revenue. Utilities record the entire price charged to the customer as revenue when the utility service is performed, including billings related to previously-recognized ARP revenue. To avoid counting the ARP-related revenue twice, utilities must also recognize an “equal and offsetting” reversal to the ARP revenue account by the amount of ARP revenue included in the price of the utility service.
Method B: Exclude ARP Revenue from Operating Income
This method excludes revenue generated via an ARP from operating income. Utilities exclude the billings related to previously-recognized ARP revenue when recognizing revenue from customer charges. On the income statement, ARP revenue includes all of the excess revenue generated by satisfying the regulator-specified conditions for the ARP.
Avista Corp. produces, transmits, and distributes electricity and natural gas for communities across four northwestern U.S. states.
In its 2018 annual SEC filing, Avista discusses tariff sales as part of its note on revenue from contracts with customers. Avista notes the following:
Tariff sales involve the current provision of commodity service (electricity and/or natural gas) to customers for a price that generally has a basic charge and a usage-based component. Tariff rates also include certain pass-through costs to customers such as natural gas costs, retail revenue credits and other miscellaneous regulatory items that do not impact net income but can cause total revenue to fluctuate significantly up or down compared to previous periods. The commodity is sold and/or delivered to and consumed by the customer simultaneously, and the provisions of the relevant tariff determine the charges the Company may bill the customer, payment due date, and other pertinent rights and obligations of both parties. Generally, tariff sales do not involve a written contract. Given that all revenue recognition criteria are met upon the delivery of energy to customers, revenue is recognized immediately at that time.
Discussing non-derivative wholesale contracts, Avista also makes the following disclosure:
The Company has certain wholesale contracts which are not accounted for as derivatives that are within the scope of ASC 606 and considered revenue from contracts with customers. Revenue is recognized as energy is delivered to the customer or the service is available for specified period of time, consistent with the discussion of tariff sales above.
2. Bundled Arrangements: Electricity and Capacity
When P&U companies sell electricity to customers, they often bundle it with related products and services, like capacity. The sale of capacity represents the reservation of an electricity-generating facility and the ability to draw electricity from that facility as needed. In addition to end customers requesting capacity, many utility companies secure capacity to demonstrate their ability to satisfy consumer demand.
The first step in accounting for electricity and capacity arrangements is to consider both the existence of (a) embedded derivatives per ASC 815 – Derivatives and Hedging or (b) contract terms that qualify as leases under ASC 840 – Leases. If these sections of accounting guidance apply, the contract may not fall within the scope of ASC 606. Otherwise, the next step for revenue recognition is to identify the contract’s performance obligations.
When identifying the performance obligations in a bundled contract, FinREC believes that the electricity and capacity services are generally “distinct” and should be accounted for as separate performance obligations. Facts that would support this conclusion include (a) if capacity and electricity are sold separately in the marketplace, (b) if pricing for capacity is independent of electricity, and (c) if the customer can benefit from the capacity on its own (by demonstrating the customer’s access to capacity to a regulator, for example). Despite this general rule, FinREC still encourages P&U entities to review each bundled contract because electricity and capacity services can be treated as a single performance obligation in some circumstances.
If a P&U entity determines that the electricity and capacity represent separate performance obligations, the transaction price is divided between the two obligations. The entity would recognize revenue related to each obligation according to its own revenue recognition timing pattern.
FinREC believes that the revenue for most electricity and capacity performance obligations should be recognized over time as measured via the output methods of units of electricity delivered and time elapsed, respectively. This treatment assumes that the P&U company’s promise to provide capacity is a stand-ready obligation that the customer will receive evenly throughout the contract period. Each contract should still be reviewed individually since these conclusions do not represent the proper treatment for all situations.
In its 2018 annual SEC filing, Avista discusses its bundled contracts that contain obligations for both electricity and capacity as follows:
In addition to the tariff sales described above, which are stand-alone energy sales, the Company has bundled arrangements which contain multiple performance obligations including some combination of energy, capacity, energy reserves and RECs. Under these arrangements, the total contract price is allocated to the various performance obligations and revenue is recognized as the obligations are satisfied. Depending on the source of the revenue, it could either be included in revenue from contracts with customers or derivative revenue.
3. Bundled Arrangements: Electricity and Renewable Energy Credits
Renewable energy certificates (RECs) are tradable certificates that signify the production and delivery of one megawatt hour (MWh) of electricity via a renewable energy source. Entities often seek RECs to comply with government regulations or promote environmental causes. Owners of renewable energy assets can either retain possession of RECs or sell them. The RECs may be sold by themselves but are often sold on a bundled basis along with the electricity that created the RECs.
FinREC believes that RECs represent a separate performance obligation within a bundled contract because (a) the buyer can benefit from the RECs on their own and (b) the promise to transfer RECs is often outlined separately from the other promises within the bundled contract. RECs can be used independently of the electricity to satisfy regulatory requirements and have stand-alone value in the secondary market.
Since REC sales do not meet the criteria listed in ASC 606-10-25-27 for a performance obligation satisfied over time, revenue related to REC sales should be recognized at a point in time. Due to the need for regulators to certify and verify the RECs, there is often a delay between when the electricity is produced and when the RECs are transferred to the customer. In some jurisdictions, the certification and verification process can delay the transfer of the REC by up to 60 days. However, the certification process rarely results in the cancellation of REC transfers involving legitimate renewable energy producers.
FinREC generally believes that the certification process is a clerical function that should not delay the recognition of revenue. Using this viewpoint, the renewable energy supplier would recognize revenue related to the REC sale as soon as it delivers electricity to the customer, even if the RECs are still in the certification process. FinREC supports this argument by relying upon the indicators listed in ASC 606-10-25-30 (a), (d), and (e).
However, circumstances may cause a P&U entity to determine that revenue for the REC sale should only be recognized when the customer has received title to the RECs and the certification process is complete.
Algonquin Power and Utilities Corp. (2018 Form 40-F SEC Filing): Bundled Electricity and Renewable Energy Credits
Algonquin Power and Utilities Corp. (2018 Form 40-F SEC Filing1): Bundled Electricity and Renewable Energy Credits
Algonquin Power is a Canadian renewable energy and utilities company with assets across North America. The company is comprised of two operating subsidiaries, Liberty Power and Liberty Utilities.
Liberty Power revenue consists mostly of electricity, capacity, and renewable energy credits. In its 2018 annual report, Algonquin Power discusses these revenues as follows:
Revenue related to the sale of electricity is recognized over time as the electricity is delivered. The electricity represents a single performance obligation that represents a promise to transfer to the customer a series of distinct goods that are substantially the same and that have the same pattern of transfer to the customer.
Progress towards satisfaction of the single performance obligation is measured using an output method based on units produced and delivered within the production month.
Revenues related to the sale of capacity are recognized over time as the capacity is provided. The nature of the promise to provide capacity is that of a stand-ready obligation. The capacity is generally expressed in monthly volumes and prices. The capacity represents a single performance obligation that represents a promise to transfer to the customer a series of distinct services that are substantially the same and that have the same pattern of transfer to the customer. Progress towards satisfaction of the single performance obligation is measured using an output method based on time elapsed.
Qualifying renewable energy projects receive renewable energy credits (“RECs”) and solar renewable energy credits (“SRECs”) for the generation and delivery of renewable energy to the power grid. The energy credit certificates represent proof that 1 MW of electricity was generated from an eligible energy source. The RECs and SRECs can be traded and the owner of the RECs or SRECs can claim to have purchased renewable energy. RECs and SRECs are primarily sold under fixed contracts, and revenue for these contracts is recognized at a point in time, upon generation of the associated electricity. Any RECs or SRECs generated above contracted amounts are held in inventory, with the offset recorded as a decrease in operating expenses.
The majority of Liberty Power Group’s contracts with customers are bundled arrangements of multiple performance obligations: electricity, capacity, and RECs.
The Company has elected to apply the invoicing practical expedient to the electricity and capacity in the Liberty Power Group contracts. The Company does not disclose the value of unsatisfied performance obligations for these contracts as revenue is recognized at the amount to which the Company has the right to invoice for services performed.
This example demonstrates how Algonquin accounts for bundled arrangements that include electricity, capacity, and RECs. Revenues related to the sale of electricity and capacity are recognized over time as provided, while RECs are recognized at a point in time.
4. Commodity Exchange Agreements
Many P&U companies enter into arrangements to provide a commodity to another entity in exchange for a similar commodity at a different location. These “buy-sell” agreements aim to reduce transportation costs by exchanging the same commodity at different storage sites. Occasionally, P&U firms negotiate an agreement to sell raw materials (wet gas) to a refiner and buy back the finished goods (condensates or natural gas liquids).
Per ASC 606-10-15-2, some transactions are excluded from the scope of the revenue recognition standard including “non-monetary exchanges between entities in the same line of business.” Using this guidance as direction, even contracts involving different products may not be within the scope of ASC 606 if the agreement does not directly involve the end customer.
ASC 606 also requires that a contract with a customer be present before any of the associated revenue is recognized. For commodity-exchange transactions, management should pay special attention to the commercial substance requirement. If a contract exists, P&U companies should continue analyzing the contract under the framework of ASC 606. If not, the arrangement is outside of the scope of ASC 606 and no revenue will be recorded. (For more information about identifying a customer contract and the commercial substance requirement, please refer to our Definition of a Customer article.)
P&U companies with “buy-sell” agreements should reference Topic 845 – Nonmonetary Exchanges for additional guidance about accounting for these transactions. For companies that currently account for commodity exchange agreements as like-kind exchanges, the adoption of ASC 606 is not expected to significantly change the accounting treatment.
5. Take-or-pay Arrangements
In the P&U industry, producers and buyers often enter into long-term sales contracts over a year in duration. P&U companies use these agreements when making investment decisions and securing financing. These long-term contracts usually specify the amount of commodity to be delivered and the transaction price. Given the volatile nature of commodities prices, the sales contracts often include clauses allowing for price adjustments if the underlying commodity prices change drastically over the life of the contract. Some contracts provide the buyers with various options regarding the amount of commodity that the producer will deliver.
Take-or-pay arrangements between P&U suppliers and customers ensure that the customer will either “take” product from the supplier or “pay” a penalty. The two parties will agree on a set price at which the customer will buy product and another price, usually lower, that serves as the penalty even if the product is not accepted by the customer. This structure of contract guarantees the supplier’s minimum level of future demand, thus reducing risk.
The first step in accounting for take-or-pay and other long-term contracts is to consider whether the contract contains any embedded derivatives or qualifies as a lease. In these situations, management should refer to the relevant accounting guidance: ASC 840 – Leases or ASC 815 – Derivatives and Hedging.
If no other accounting standards apply, companies should treat product deliveries (the “take” scenario) as they would any other transaction under ASC 606. Additional complications arise when accounting for situations where the customer opts to pay a penalty instead of receiving product (the “pay” scenario). The revenue associated with these penalties classifies as breakage under ASC 606.
Breakage occurs if customers do not exercise their rights to receive goods or services. ASC 605 forced companies to treat breakage revenue as contingent consideration. Under ASC 606, companies can recognize the estimated amount of breakage as revenue by using historical breakage patterns to guide their estimates. If management cannot estimate the amount of breakage, they should consider if any breakage minimum amounts are needed. (See our Variable Consideration and the Constraint and Unexercised Rights (Breakage) In ASC 606 articles for more information about this process.) Unexpected breakage should be recognized when the customer’s probability of exercising their rights becomes remote. Management should re-evaluate their breakage estimates each reporting period.
Under ASC 606, companies may be able to recognize the future payment penalties as breakage revenue prior to the expiration of the customer’s exercisable rights if they can reliably estimate the amount of future payment penalties. However, companies may not be able to predict customer behavior sufficiently enough to utilize this accounting treatment.
When accounting for take-or-pay contracts, managers should consider the reasons for the price changes when determining how to allocate the transaction price to the performance obligations. Depending on how P&U companies view these price changes, the metric for allocating the total transaction price to the individual performance obligations may vary between stand-alone selling price, contractual pricing, straight line, or other methods. The accounting standard is likely to develop further in this area to provide additional clarification.
Altagas is a Canadian energy company operating with two business segments, utilities and midstream, across North America. In its 2018 annual report, Altagas describes its take-or-pay arrangement as follows:
Take-or-pay — The customer has agreed to a minimum volume commitment whereby the customer must have AltaGas process or deliver a specified volume at a rate per unit that is specified in the contract. Quantities that the customer is unable to deliver are considered deficiency quantities.
Certain of AltaGas’ take-or-pay contracts contain provisions whereby the customer can make up deficiency quantities in subsequent periods. Under this type of arrangement, any consideration received relating to the deficiency quantities that will be made up in a future period will be deferred until either: (i) the customer makes up the volumes or (ii) the likelihood that the customer will make up the volumes before the makeup period expires becomes remote.
If AltaGas does not expect the customer to make up the deficiency quantities (also referred to as breakage amount), AltaGas may recognize the expected breakage amount as revenue before the makeup period expires. Significant judgment is required in estimating the breakage amount.
For contracts where the customer has no make-up rights, revenue is recognized on a monthly basis based on the higher of (i) the actual quantity delivered times the per unit rate or (ii) the contracted minimum amount.
6. Sale of Power-Generating PP&E
If a P&U company sells in-substance real estate2 or equipment that is considered an integral part of the business, the contract is not within the scope of ASC 606 and the proceeds should not be considered revenue. The contract should be accounted for using ASC 610-20 – Other Income – Gains and Losses from Derecognition of Nonfinancial Assets. Some contracts may not fall within the scope of ASC 606 nor ASC 610-20. For example, the sale of a subsidiary or collection of assets must be accounted for using ASC 810 – Consolidation if (a) it is a business and (b) it is not an in-substance nonfinancial asset.3
7. Series of Distinct Goods or Services
Many P&U contracts involve the transfer of identical units of specific product (like electricity) over time. Although each delivery is distinct from the deliveries at later time periods, ASC 606-10-25-14 allows companies to treat a “series of distinct goods or services” as a single performance obligation if they “are substantially the same” and “have the same pattern of transfer to the customer.” Furthermore, per ASC 606-10-25-15, each good or service in the series must (a) satisfy the requirements for revenue recognition over time and (b) use the same method to measure progress toward satisfying the obligation.
This accounting treatment greatly simplifies revenue recognition and allows companies to recognize revenue related to many different deliveries on an aggregate basis. FinREC believes that electricity contracts meet the requirements to be treated as a single performance obligation. Contracts relating to other commodities may represent a series of distinct goods or services, but more judgement is required to make those decisions. (For more information on this topic, see our Series of Distinct Goods or Services article.)
8. Determining Standalone Selling Prices for Storable Commodities
Some P&U companies sell commodities (such as oil, natural gas, RECs) that the customer can store for future use rather than consuming immediately. Due to the nature of these products, revenue from storable commodities cannot be recognized over time and therefore these sales do not qualify for recognition as a “series of distinct goods or services.” P&U companies must treat each delivery of storable commodities as a separate performance obligation, with its own standalone selling price (SSP).4 (For more information on SSPs, see our Standalone Selling Prices article.)
FinREC believes that there is no single method for establishing a SSP under paragraphs 32 and 33 of ASC 606-10-32. P&U entities should consider the circumstances surrounding each contract when allocating the transaction price to each performance obligation. Although forward price curves for different commodities are observable indicators of market prices, P&U companies should also consider other factors such as credit risk and delivery location before establishing a sales price. FinREC suggests the invoice price as a reasonable way to allocate the transaction price but acknowledges that many other alternatives exist.
Puget Energy is a regulated utilities company providing electricity and natural gas to communities in Washington. In its Q3 2020 10-Q SEC Filing, Puget describes revenue recognition for biogas, one of its major products, as follows:
Biogas is a renewable natural gas fuel that PSE purchases and sells along with the renewable green attributes derived from the renewable natural gas. Biogas contracts include the performance obligations of biogas and renewable credit delivery upon PSE receiving produced biogas from its supplier. Transfer of control and recognition of revenue occurs at a point in time as biogas is considered a storable commodity and may not be consumed as it is delivered.
9. Strip-price Contracts
In strip-price contracts, customers agree to pay a constant (fixed) price per unit each period in exchange for a fixed quantity of a specific good (like electricity, waste services, natural gas, etc.). Since the total contract price is known in advance, P&U companies can easily determine the overall transaction price. FinREC believes that P&U entities should use an output method (like kilowatt hours delivered) to track progress toward satisfying the overall performance obligation and recognize revenue in proportion to this progress. Alternatively, ASC 606-10-55-18 provides a practical expedient that allows sellers to recognize revenue based on the amount that they have the right to invoice if the amount corresponds directly with the value given to the customer.
Willdan Group provides professional and technical assistance to companies in the P&U industry. In its Q1 2020 10-Q SEC Filing, Willdan describes how it accounts for fixed-cost contracts as follows:
Many of the Company’s fixed price contracts involve a high degree of subcontracted fixed price effort and are relatively short in duration, thereby lowering the risks of not properly estimating the percent complete. Revenue on time-and-materials and unit-based contracts is recognized as the work is performed in accordance with the specific rates and terms of the contract. The Company recognizes revenues for time-and-materials contracts based upon the actual hours incurred during a reporting period at contractually agreed upon rates per hour and also includes in revenue all reimbursable costs incurred during a reporting period.
Certain of the Company’s time-and-materials contracts are subject to maximum contract values and, accordingly, when revenue is expected to exceed the maximum contract value, these contracts are generally recognized under the percentage-of-completion method, consistent with fixed price contracts.
For unit-based contracts, the Company recognizes the contract price of units of a basic production product as revenue when the production product is delivered during a period. Revenue recognition for software licenses issued by the Energy segment is generally recognized at a point in time, utilizing the unit-based revenue recognition method, upon acceptance of the software by the customer and in recognition of the fulfillment of the performance obligation. Certain additional performance obligations beyond the base software license may be separated from the gross license fee and recognized on a straight-line basis over time. Revenue for amounts that have been billed but not earned is deferred, and such deferred revenue is referred to as contract liabilities in the accompanying condensed consolidated balance sheets.
10. Step-price Contracts
In step-price contracts, customers agree to pay a known price each period, but the price per unit varies over the term of the contract. Generally, the pricing at each period is calculated using a formula established by regulators. Similar types of P&U contracts often state different prices based on the time of day (peak or non-peak hours) or season of delivery.
FinREC asserts that contracts with stated, but changing, prices for a fixed quantity of goods do not qualify as variable consideration because the transaction price is known at inception. According to FinREC, P&U entities may decide to use either an input or an output method to determine revenue recognition over time, depending on the contract. For example, if the price escalations relate to changes in the cost of delivering the commodity, the P&U entity may decide to use an input method that includes transportation costs. Whatever measurement method the P&U entity selects, this method should be applied consistently for the specific performance obligation and similar performance obligations in other contracts.
The practical expedient related to ASC 606-10-55-18 allows companies to recognize revenue based on the amount that they have the right to invoice if the amount corresponds directly with the value given to the customer. Management should carefully consider the relationship between the entity’s right to consideration and the value provided to the customer when determining whether the practical expedient applies.
In many step-price arrangements, the change in pricing is correlated to the slope of the forward curve5 applicable to the delivery period. This indicates that the price increases relate to increased value provided by the customer and the practical expedient would apply. By electing to use the practical expedient, P&U entities can choose to recognize revenue at the contract rate applied to each delivery as specified in the contract. P&U entities must be consistent with their decision to use the practical expedient and use the same approach for similar contracts.
If price changes are caused by known or expected changes in the cost of delivering the service, P&U entities should use an input method to determine the progress toward satisfying the performance obligation instead of the practical expedient.
Step-price Contract with a Significant Financing Element
Sales contracts that require the customer to pay substantially before (or after) the delivery of the good or service may indicate that the seller is receiving (or providing) financing in conjunction with the sale. Under ASC 606, entities must recognize interest expense (or revenue) if the contract includes a significant financing component. The revenue standard separates payments related to sales (revenue) and financing (interest), even if both elements are present within the same contract. (For more information about significant financing elements, see our Significant Financing Component article.)
In step-price contracts, changes to the price over the course of the contract term can result partially or completely from a significant financing element. Instead of charging customers the value of the delivered good at each phase of the contract, P&U companies may set pricing terms that accommodate the customer’s ability to pay. For example, a significant financing element may be present in a step-price arrangement where the rates increase over time, even though market prices (based on the forward curve) are expected to decrease. The P&U entity in this example is providing the customer with both (a) goods/services and (b) financing (by shifting much of the payment to the end of the contract term).
11. Variable Consideration
In the P&U industry, several scenarios necessitate the inclusion of variable consideration. One example is a contractual arrangement where the rate per unit of electricity is fixed, but the volume of electricity delivered by the supplier and the overall transaction value is unknown. Another example would be a contract to deliver a fixed quantity of electricity with pricing determined by a formula with inputs relating to projected electricity usage. A third common scenario arises in the form of performance bonuses included in operations and maintenance service contracts.
In all the above cases, the variable consideration element must be estimated using either the “expected value” method or “most likely amount” method. Management should determine which of the two methods has more predictive power for the contract and use that method for similarly-structured contracts. Note that management cannot use whichever method leads to a more favorable accounting treatment, but the method that produces the most accurate estimate of the variable consideration. (See our Variable Consideration and the Constraint article for more information about this process.)
12. Contract Modifications: Blend and Extend Arrangements
P&U companies often enter into “blend and extend” arrangements, where the supplier and customer renegotiate an existing contract by adjusting the pricing and extending the life of the contract. If electricity prices have dropped, the customer may negotiate a lower “blended” rate between the original contract rate and the current market price. The supplier also benefits by guaranteeing future demand via the contract extension. Under ASC 605, P&U companies account for “blend and extend” contracts by applying the new “blended” rate prospectively to the remaining goods yet to be provided to the customer.
Per ASC 606, P&U companies must first determine whether the modification should be treated as a new contract. If additional goods or services are added to the contract and the price of these goods or services reflects their SSPs, the arrangement should be considered a separate contract. For legal purposes, the arrangement would be a single contract, but for accounting purposes, the existing contract and the recent modification are treated as two separate contracts.
If the contract modification results in a separate contract, the payment terms of the newly-created contract should be evaluated for the existence of a significant financing component. The blended rate may cause some of the payment for goods and services to precede delivery, which may be evidence of a significant financing component. (For more information about this issue see our Significant Financing Component article.)
If additional goods or services are added with either higher or lower consideration than their SSPs, the arrangement is not treated as a separate contract. Instead, the old contract is terminated for accounting purposes, and a new contract is created in which the new rate will be applied prospectively to the remaining goods yet to be provided to the customer (from the original contract and the extension period). (For more information about contract modifications see our series of articles on the subject: Contract Modifications Part I, Contract Modifications Part II, and Contract Modifications Part III.)
13. Contributions in Aid of Construction (CIAC)
Utility companies often receive customer requests for infrastructure additions that cannot be serviced economically. For example, the cost of connecting electrical lines and water pipes to a remote cabin may exceed the expected future cash flows stemming from that connection. Utilities cannot recover the projected costs by raising utility prices (either on the individual or the collective level) due to strict regulations about customer pricing.
Instead, customers requesting uneconomic services must make an upfront payment equaling the amount by which the project’s costs exceed the utility’s investment and allowed return. These customer payments to cover the uneconomic portion of an infrastructure investment are called contributions in aid of construction (CIAC). The CIAC amount is determined using a methodology established by the local regulator and the amount is not subject to negotiation by the customer nor the utility. The utility cannot raise or lower the CIAC amount and does not earn any margin on the prescribed payment. The utility maintains control of the infrastructure along with responsibility for its maintenance and operation.
FinREC believes that accounting for CIAC requires substantial judgement and that various outcomes may result based on the facts and circumstances of each arrangement. In general, FinREC believes that CIAC should be viewed as a cost reimbursement that is not within the scope of ASC 606. Some of the reasons for this interpretation include:
- Infrastructure expansions do not transfer deliverables to the customer because utilities retain title of the infrastructure once the projects are complete. Also, these infrastructure additions do not relate to the delivery of other utility services to the customer.
- Constructing new distribution infrastructure is not part of utilities’ central operations. Utility companies are in the business of selling utility services to customers, not selling distribution assets like power lines or piping.
- Separating the revenues (utility services) and non-revenue (infrastructure additions) portions of a contract is allowed under ASC 606-10-15-4. The inability of utilities to adjust the timing or amount of CIAC provides evidence of a separation between the revenue and non-revenue activities within the contract.
14. Partial Terminations
P&U companies may initially enter into agreements with customers to provide goods or services over a specified period only to later terminate some of the contractual obligations in exchange for a monetary settlement payment from the customer. Customers may request a partial termination of a contract due to changes in market prices or changes in their electricity needs. These contract modifications can represent “vertical” terminations (orders for some periods are cancelled completely), “horizontal” terminations (the quantity ordered changes across all delivery periods), or a combination of the two.
FinREC believes that partial terminations classify as contract modifications under ASC 606-10-25-13(a). Under this accounting treatment, settlement payments made by the customer to the electricity provider should be allocated to the remaining performance obligations in the contract.
For example, imagine a customer who signs a five-year contract to purchase electricity from a P&U company. At the end of the contract’s first year, the customer cancels the last two years of the contract, while honoring the terms of the original agreement for years 2 and 3. To compensate the P&U company for this cancellation, the customer also makes a $1,000 settlement payment after negotiating with the P&U company.
In this scenario, the P&U company would treat the settlement payment as revenue to be recognized over the remaining life of the contract (years 2 & 3). The contract’s overall transaction price would be decreased to reflect the revenue lost in the partial termination and increased to reflect the settlement payment, and the modified transaction price would then be allocated to the remaining performance obligations. FinREC believes that this type of recognition should be used for both vertical and horizontal terminations.
It is likely that many other issues and questions will continue to arise within the P&U industry as entities apply the revenue recognition standard. This article serves as a base reference point for your research into some of the focal issues experienced by industry experts. Other industry-specific issues and discussions are available on the RevenueHub site for all major industries as identified by the AICPA.
- Form 40-F is the equivalent of a 10-K SEC filing, but it is for Canadian companies with securities registered in the United States.
- The term in-substance refers to situations where the economic nature of the transaction takes precedence over the legal arrangement for accounting purposes. Thus, non-real estate assets (like ownership interests) can be treated as real estate if most of the fair value from the assets are derived from real estate holdings. For example, interest in a partnership whose assets are predominately real estate holdings would be considered in-substance real estate.
- A nonfinancial asset is an asset that holds physical value (like equipment or land) rather than deriving its value from a contractual arrangement (like stocks or bonds).
- Standalone selling price – The price at which an entity would sell a promised good/service if it was delivered separately to the customer, not as part of a contract containing other goods/services.
- Forward curve – A graph showing the prices at which market participants can enter into an arrangement to purchase a commodity at various future delivery dates. For example, the forward curve for electricity shows the various prices at which you can enter into a contract to buy electricity 1 month, 3 months, or 6 months from now. The forward rate takes into account market expectations about the future price of the commodity and the prevailing interest rate environment.