In May 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers, later codified as Accounting Standards Codification (ASC) Topic 606. This major overhaul of revenue recognition (effective for fiscal years starting after December 15, 2017 for public companies) affects almost every sector of the economy, and the power and utility (P&U) industry is no exception. The complex arrangements between power and utility 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 particularly complicated.
In this article, we provide a brief explanation of the key issues the P&U industry faces when applying ASC 606, drawing on the following guides published by the AICPA’s Financial Reporting Executive Committee (FinREC) and the major accounting firms:
- AICPA Guide: Audit & Accounting Guide—Revenue Recognition
- Deloitte: Power and utilities spotlight
- EY: The new revenue recognition standard – power and utilities
- PwC: Revenue: Implementation in the oil and gas industry
We will also provide references to other RevenueHub articles for more detailed explanations of ASC 606 topics.
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: 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: 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.
FinREC believes that the selected method is an accounting policy election that should be applied consistently and disclosed if material.
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.
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, 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.
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 article 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.
6. Sale of Power-Generating PP&E
If a P&U company sells in-substance real estate1 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.2
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)3. (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.
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.
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 curve4 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.
For the P&U industry, ASC 606 will introduce several changes when compared to the treatment under ASC 605. The framework for defining a customer, identifying performance obligations, determining transaction values, and measuring variable consideration can lead to significant accounting changes for many P&U companies. Given the complex nature of P&U contracts and the many entities involved, we encourage you to carefully analyze your contracts using the resources referenced in this article.
- 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.