Enquiry:

A public listed Gas Company (the Company) is engaged in providing essential services of transmission and distribution of natural gas in the provinces of Sindh and Baluchistan. Being the only transmission and distribution company in both provinces, the Company takes various projects for laying of pipelines including those ones which are initiated based on instructions received from the Government of Sindh (GoS) which provide financing facility to the Company at the interest rate which is lower than market interest rate, due to which requirements of paragraphs 12 of lAS 20 “Accounting for Government Grant and Disclosure for Government Assistance” are triggered with regard to recognition of government grant and its amortization. In ensuing paragraphs, we have provided background facts and described three possible options for accounting of such government grant and request your guidance as to which of these options are appropriate in terms lAS 20.

Regulatory Regime of the company

The Company is regulated by the Oil and Gas Regulatory Authority (OGRA) which is statutory body created under the Oil and Gas Regulatory Authority Ordinance, 2002 (the Ordinance) with a mandate to regulate licensees engaged in the transmission, distribution and sale of natural gas. Under the provision of license given by OGRA, the Company is provided a minimum annual return (ROA) of 17% per annum of the net operating fixed assets (net of deferred credit) for the year excluding financial and other non-operating income and taxation. The determination of annual required return is reviewed by OGRA under the terms of License for transmission, distribution and sale of natural gas, along with the targets and parameters set by OGRA. Income earned in excessI short of the above guaranteed return is payable toI recoverable from the Government of Pakistan (GOP) and is adjusted fromI to the Gas Development Surcharge (GDS) balance payable to I receivable from GOP.

Details of loans obtained from the Government of Sindh (GOS) at lower interest rate, and the related accounting requirements in light of the approved accounting standards as applicable in Pakistan.

The Government of Sindh (GOS) has provided unsecured loans to the Company at interest rate of 2-4% per annum, against a market rate (9% to 13.5%), for period of 12 years under the agreement for supply of gas to the areas in the Sindh province only subject to prior approval from the competent authority of the province.

In the previous years, the Company did not recognize difference between interest rate charged by GoS and prevailing market interest rate, as government grant, as impact of amounts was not considered material and no new loan was obtained since 2013. However, the Company is currently expecting more loans in future and management now considers that cumulative impact owing to changes in financial position may become significant.

Management has evaluated the accounting treatment in the light of accounting standards and prevalent industry practice, and has identified three possible options for accounting the government grant arising from GOS Loans explained below:

1 – Amortization of Grant over the Useful Life of the Asset

If the requirements of lAS 20 are followed as per the agreements, the Company would have to incorporate the following impacts in its books of accounts:

• GoS loans will be discounted at market rate and any difference between the loan amount received and the discounted loan amount will be recognized as a government grant (credit).

• GoS loans will be recognized at present value i.e. discounted loan amounts.

• Interest expenses on the discounted loans will be recognized at market rate, resulting in increase in financial charges every year, except in case of initial years wherein interest expenses will be capitalized to asset for which the loan has been provided by GOS.

• Government grant (deferred credit) will be amortized over the period of useful life of asset, which is considered 20 years, as income in profit and loss account.

The issue with this treatment is that actually there is no cost to the Company, as the assets also get financed through revenue requirements under cost plus formula of 17% return on operating fixed assets except for those assets which may be disallowed by OGRA due to the reason that such projects are not meeting per customer cost criteria being not feasible. In the past, OGRA has been allowing ROA on all such projects, and only in the FY 2013, 14, 15 and 16, OGRA has disallowed certain projects on the basis that such projects were not feasible:

2- Government Grant be amortized over the repayment period of loan

Loans are discounted at market rate and any difference between the loan amount received and the discounted loan amount is recognized as a government grant which is amortized over the repayment period of the loan instead of useful life of the asset.

3- Matching the Government Grant with related cost

As per paragraph 12 of IAS 20 “Accounting for Government Grants and Disclosure of Government Assistance”:

“Government grants shall be recognized in profit or loss on a systematic basis over the periods in which the entity recognizes as expenses the related costs for which the grants are intended to compensate” (emphasis is ours)

Since there are no “related costs” as all costs of assets acquired or constructed by Company are recovered through cost plus return of 17% on operating fixed assets as revenue of the Company through OGRA except for those assets which are disallowed by OGRA from time to time due to the reason that such projects are considered unviable. It can be argued that such government grant is provided to compensate the Company for any unviable projects which are disallowed by OGRA. Therefore, a case can be made to recognize the government grant in profit and loss account at time of recognizing the impairment loss related to unviable projects (if needed) and any remaining unamortized grant in excess of expected impairment to be transferred to profit and loss account immediately.

We request ICAP to kindly advise us as to which of the three options described above reflect right accounting treatment in accordance with the approved accounting standards as applicable in Pakistan.

Opinion:

In accordance with paragraph 10A of IAS 20, Accounting for Government Grants and Disclosure of Government Assistance, the benefit of the government loan at a below-market rate of interest is treated as a government grant, and requires the entity to measure and record the benefit of the below-market rate of interest in accordance with IAS 39, Financial Instruments: Recognition and Measurement. Consequently, the government grant is measured as the difference between total loan amount received and the fair value of the loan on initial recognition.

In addition, IAS 20 requires “the entity shall consider the conditions and obligations that have been, or must be, met when identifying the costs for which the benefit of loan is intended to compensate”. In the enquired scenario, the benefit available to the entity is reflected by the borrowing costs compensated through the loan at below-market rate of interest.

Further, the Committee understands that the borrowing costs (including the imputed interest originating on the below-market rate of interest loan) eligible for capitalization will be included in the cost of the qualifying asset, and subsequently, charged to the profit or loss through yearly depreciation charge. In the ensuing periods, the borrowing costs will be charged to the profit or loss, consequent to the completion of the qualifying asset.

IAS 20, paragraph 12 outlines, the principle for the recognition of grant in the profit or loss, reproduced as under:

“Government grants shall be recognised in profit or loss on a systematic basis over the periods in which the entity recognises as expenses the related costs for which grant was intended to compensate.” (Underline is ours)

IAS 20 also envisages that in most cases, the periods over which an entity recognises the costs or expenses related to the government grant are readily ascertainable and thus grant in recognition of specific expenses are recognised as income in the same period as the relevant expense. Furthermore, paragraph 19, clarifies that it may be appropriate to allocate part of the grant on one basis and part on another.

In the enquired scenario, the Committee is of the view that the recognition of government grant in the profit or loss shall be on the basis of pattern of recognition, as expenses, the costs the grant intends to compensate. As explained above, the borrowing costs related to the below-market interest loan shall be charged to the profit or loss through:

(a) depreciation charge (represents the capitalized borrowing costs); and
(b) the finance costs.

Further, in accordance with IAS 20, the recognition of grant in the profit or loss shall represent an appropriate form of matching with the recognition of related expenses for which the grant intends to compensate.

Based on the above, the Committee is of the view that the accounting treatment of the government grant in the enquired scenario, shall be as follows:

a) Government grant related to the borrowing costs capitalized as cost of the qualifying asset, amortized over the period of useful life of the asset, i.e. 20 years in the enquired scenario; and

b) Government grant related to the borrowing costs charged to profit or loss as finance costs, amortized over the loan term, i.e. 10 years reduced by the years in which borrowing costs is capitalized, a) above, in the enquired scenario.

In this way, the benefit of the grant is recognized on a systematic basis because the entity recognises, as expenses, the costs the grant is intended to compensate.

(March 28, 2017)