ACCOUNTING SEPARATION REGIME

July 2003

CONTENTS

1 Introduction............................................................................................................4 1.1 Submissions in response to this paper ...........................................................5

2 Legislative Basis ....................................................................................................6 2.1 Regulatory Accounting Framework...............................................................6 2.2 The Ministerial Direction...............................................................................7

3 Current Cost Accounting Framework..................................................................10 3.1 Objectives of CCA.......................................................................................10

3.1.1 Government objectives ........................................................................10 3.1.2 Commission’s objectives .....................................................................11

3.2 An Appropriate CCA Regime for Telstra....................................................13 3.2.1 Initial Report ........................................................................................13 3.2.2 Subsequent Reports..............................................................................14

3.3 Conceptual Basis for Subsequent Reports ...................................................15 3.3.1 The basis for measurement of assets (and liabilities) ..........................15 3.3.2 The concept of capital maintenance and the determination of profit...18 3.3.3 The depreciation backlog issue............................................................24

3.4 Basis of Preparation of Initial Report ..........................................................25 3.4.1 Telstra’s Modified Current Cost Valuation Process ............................25 3.4.2 Phased Reporting Approach ................................................................27

3.5 Auditing of CCA Reports ............................................................................27

4 Imputation testing ................................................................................................30 4.1 Relationship with the bundling draft information paper..............................30 4.2 Background on imputation testing ...............................................................31

4.2.1 Vertical price squeezing and imputation testing..................................31 4.2.2 What are the elements of an imputation test? ......................................31

4.3 Principles for the imputation RKR ..............................................................32 4.3.1 Identifying retail services which closely reflect the wholesale inputs.32 4.3.2 Calculation of retail price for purpose of imputation test ....................33 4.3.3 Calculation of access price for purpose of imputation test ..................34 4.3.4 The cost basis for calculating the retail costs.......................................34

4.4 Implementation of the imputation RKR ......................................................36 4.4.1 Telstra’s sources for providing the data each quarter ..........................36 4.4.2 Allocating revenues and costs to retail and wholesale services...........37 4.4.3 Allocation of service data to customer groups.....................................38 4.4.4 Use of the data to calculate the access price ........................................38

4.5 Margin analysis............................................................................................39 4.6 Economies of scale and scope......................................................................39 4.7 Auditing .......................................................................................................39 4.8 Publication of information ...........................................................................39 4.9 Further issues ...............................................................................................40

Attachment A International Developments .............................................................41 A.1 The European Union ....................................................................................41

A.1.1 Relevant European Union legislation ..................................................41 A.1.2 Recommended current cost method.....................................................42

2

A.1.3 Progress of implementation .................................................................42 A.2 United Kingdom...........................................................................................42

A.2.1 Concept of capital ................................................................................43 A.2.2 Principles of Valuation of Tangible Fixed Assets ...............................44 A.2.3 Choice of valuation method .................................................................44 A.2.4 Cost Adjustments .................................................................................45

A.3 Denmark.......................................................................................................47 A.4 Other European Union members .................................................................48

Attachment B Simplified Illustrations of Accounting Recognitions and Financial Statements Under Various Concepts of Capital Maintenance.....................................49

B.1 Illustration 1: FCM — nominal monetary units (Concept 1) ......................52 B.2 Illustration 2: FCM — purchasing power (Concept 2)................................53

B.2.1 Notes on FCM — purchasing power ...................................................55 B.3 Illustration 3: OCM (Concept 3)..................................................................58

B.3.1 Notes on OCM .....................................................................................59

3

1 Introduction On 24 September 2002 the Minister for Communications, Information Technology and the Arts (the Minister), detailed a range of measures aimed at increasing the level of competition and investment in the telecommunications market to benefit consumers and business.1

One of the key measures announced was the encouragement of a more transparent regulatory market by requiring an augmented system of Accounting Separation (AS) of Telstra’s wholesale and retail operations. AS was seen as a means of addressing competition concerns arising from the level of vertical integration between Telstra’s wholesale and retail services and improving the provision of costing and price information to the Australian Competition and Consumer Commission (the Commission), access seekers and the public.

On 19 December 2002 the Telecommunications Competition Act 2002, which made certain amendments to the Trade Practices Act 1974 (the Act), came into force. Section 151BUAAA of the Telecommunications Competition Act allows the Minister to give a Ministerial Direction to the Commission about Telstra’s wholesale and retail operations.

On 19 June 2003, the Minister released a Ministerial Direction instructing the Commission to use its existing powers under Part XIB of the Trade Practices Act 1974 (the Act) to ensure that:

Telstra will prepare and provide to the Commission current cost accounts, as well as existing historical cost accounts. This will allow the Commission to better understand the costs Telstra faces as an ongoing sustainable business.

Telstra will make public current cost and historical cost key financial statements for fixed line network services-core interconnection services-that have already been declared by the Commission as being subject to the telecommunications access regime. This will improve the quality of information available to the market regarding Telstra's internal supply of the core interconnection services.

The Commission will publish an 'imputation' analysis, based on information provided by Telstra, which assumes that Telstra purchases the core interconnect services from itself at the price that it charges external access seekers. This will allow the Commission and the market to clearly assess whether Telstra is engaging in anti-competitive 'price squeeze' conduct.

Telstra will publish information comparing its supply of core services internally and to external access seekers in terms of key non-price terms and conditions. This report will provide a transparent comparison of Telstra's actual performance in supplying non-price services internally and to others (non-price terms and

1 DCITA, Government Boost to Telecommunications Competition, media release, 24 September

2002.

4

conditions include matters such as faults/maintenance, ordering and supply, availability and performance).

The Commission will prepare and publish a six monthly report on competition in the corporate segment of the market. This qualitative report will assist in identifying any emerging or long-term trends or concerns about possible systemic discrimination in this highly contested sector of the telecommunications market.

This paper focuses on the first three of the above measures of the Ministerial Direction. A Discussion Paper on key performance indicators relating to certain non-price terms and conditions was released in April 2003 for public comment. A separate paper discussing how the Commission should report on the corporate market is currently being prepared and will be issued in due course.

1.1 Submissions in response to this paper The Commission invites submissions in response to this paper. The Commission prefers that all submissions be in writing and publicly available to foster an informed, robust and consultative process. Accordingly, submissions will be treated as public documents unless otherwise specified. It is preferred that where industry participants wish to submit confidential information they should provide confidential and non-confidential versions of their submission. In these circumstances, the confidential version will need to highlight any such information.

Submissions should be addressed to:

John Bahtsevanoglou Telecommunications Branch Australian Competition and Consumer Commission GPO Box 520J Melbourne VIC 3001

Submissions can also be lodged by e-mail to: john.bahtsevanoglou@accc.gov.au.

Electronic lodgement of submissions is encouraged. All submissions are requested by 5pm Friday 25 July 2003.

Enquiries about the discussion on CCA in this paper, or about the making of submissions, can be directed to John Bahtsevanoglou on (03) 9290 1849 or Carl Toohey on (03) 9290 1872. Enquiries about the discussion of imputation testing in this paper can be directed to Ken Walliss on (03) 9290 1869 or Elizabeth Carlile on (03) 9290 1953.

5

2 Legislative Basis Under Section 151BU of the Trade Practices Act 1974 (the Act), the Commission has the power to establish RKRs by written instrument and require that carriers/carriage service providers (CSPs) comply with these rules. Section 151BUAAA also states that the Minister may give a Direction to the Commission, requiring it to exercise its powers under 151BU, 151BUDA, 151BUDB or 151BUDC.

In exercising these powers, the Commission can require the keeping of records that contain information relevant to its legislative responsibilities. For the purposes of section 151BU, these responsibilities include the operation of Parts XIB and XIC of the Act, establishing if the competition rule or tariff filing directions have been complied with, Part 9 of the Telecommunications Act 1999 (which deals with retail price controls of Telstra), and division 3 of Part 20 of the Telecommunications Act 1997 (which deals with rules of conduct relating to dealings with international telecommunications operators).

2.1 Regulatory Accounting Framework On 14 May 2001 the Commission, under Section 151BU of the Act, notified Telstra, Optus, Primus, Vodafone and AAPT of their requirement to report under the Telecommunications Industry Regulatory Accounting Framework (the RAF).

The RAF requires notified carriers and carriage service providers to generate and report to the Commission on the retail and wholesale components of the business. This assists the Commission in a number of its responsibilities including:

enforcement of the competition provisions in Part XIB of the Act;

arbitration of access disputes under Part XIC of the Act; and

potentially assisting with the assessment of whether the declaration of a particular telecommunications service, or revocation/variation of an existing service declaration, is in the long-term interests of end-users (the LTIE).

The RAF is constructed on the basis of certain regulated and unregulated services, using an agreed set of allocation rules. Three specific and defined sets of financial statements are prepared under the RAF, for each of the following three business units:

retail business;

internal wholesale business; and

external wholesale business.

The RAF does not seek to represent or cover the entire operations of a reporting carrier/CSP. Financial statements produced in accordance with RAF rules do not include items such as intangible assets, domestic investments, overseas operations and investments, liabilities and equity. In this regard, the RAF financial statements have a

6

more limited scope which has a specific regulatory purpose and are therefore not directly comparable to the statements of financial position and performance.

2.2 The Ministerial Direction On 19 June 2003 the Minister issued a Direction entitled Australian Competition and Consumer Commission (Accounting Separation — Telstra Corporation Limited) Direction (No. 1) 2003 (a “special Telstra Direction”) to the Commission under section 151BUAAA of the Act.

Under this provision, a “special Telstra Direction” is defined as one that:

(a) relates to Telstra’s wholesale and retail operations

(b) requires the Commission to exercise its powers under section 151BU to make rules requiring Telstra to:

(i) keep and retain particular records

(ii) prepare reports consisting of information contained in those records; and

(iii)give those reports to the Commission; and

(c) requires the Commission to exercise its powers under at least one of the sections 151BUDA, 151BUDB and 151BUDC in relation to those reports.

In this paper, the special Telstra Direction is referred to as the ‘Ministerial Direction’. A critical requirement of the Ministerial Direction is that the Commission is required to develop, implement and administer a system for preparation of CCA reports. More specifically, the Ministerial Direction requires the Commission to issue an RKR that will ensure Telstra:

keeps/retains records in the form of financial statements in relation to all its services to which the RAF applies and that are prepared on both a historic and CCA basis in accordance with a methodology determined by the Commission; and

prepares financial statements that:

- relate to all services of Telstra to which the RAF applies;

- are consistent with the financial statements that Telstra is required to prepare and provide to the Commission under the RAF; and

- are prepared on both a historic and current cost basis in accordance with a methodology determined by the Commission and in a manner that reconciles the historic and current cost reports.

The requirement on Telstra to produce current cost statements in relation to all services to which the RAF applies, means that the CCA reports produced by Telstra will also be of similar scope. Like the historic RAF reports currently produced by

7

Telstra, the CCA reports will not include intangible assets, domestic investments, overseas operations and investments, liabilities and equity.

The Ministerial Direction requires Telstra to provide the Commission with the initial CCA reports (the “initial” reports) by November 2003. The initial reports will cover the six months ending 31 December 2002, the six months ending 30 June 2003, and the year ended 30 June 2003.

Telstra must provide the Commission with “subsequent” CCA reports (the “subsequent” reports) on a periodic six-monthly and annual basis as outlined in the Ministerial Direction. The subsequent reports will periodically cover the six months ending 31 December, the six months ending 30 June and the financial year.

In addition, the Ministerial Direction requires the Commission to publish CCA and historical cost financial reports (or extracts from those reports) in respect of “core” interconnect services. The Commission must publish the initial CCA reports by no later than 31 December 2003, and subsequent CCA reports no later than one month from when they are received by the Commission. These reports are to be accompanied by a statement from the Commission which assesses the accuracy of the reports and the extent of compliance of the reports with the RAF, other RKRs or directions of the Commission.

The Ministerial Direction also requires the production of records and reports in relation to imputation (‘imputation RKR’).

Clause 5 stipulates that the Commission must, as soon as practicable, make rules requiring Telstra to keep and retain records, and to prepare reports consisting of information contained in those records, that:

a) record the values of Telstra’s internal supply of the ‘core services’ as if Telstra had purchased these services at arm’s length at wholesale prices that are the respective volume weighted averages of the prices that Telstra charges access seekers for those services; and

b) identify individual cost and revenue elements by customer group and the retail margins for each retail services.

For the purposes of this draft Ministerial Direction, core services are those defined in paragraphs 152AQB(1)(a) to (d) of the Act. These services are all declared under Part XIC of the Act, and their description can be found in the relevant declarations:2

a) Domestic PSTN Originating Access Service;

b) Domestic PSTN Terminating Access Service;

c) Unconditioned Local Loop Service (ULLS); and

2 Copies of the relevant declarations are available on the Commission’s website at

<www.accc.gov.au/telco/fs-telecom.htm>. Follow the link to the register of declared services.

8

d) Local Carriage Service (LCS).

The imputation RKR must require Telstra to prepare the reports each quarter, commencing with the quarter ending 30 September 2003. Therefore, Telstra must start collecting this information on 1 July 2003.

Telstra must submit its reports to the Commission as soon as practicable, but no later than 2 months after the end of each quarter. Subsequently, the Commission must prepare an imputation or margin analysis of the reports.

No later than one month after receiving the reports from Telstra, the Commission must make available to the public copies of the reports provided by Telstra together with a summary of the results of the imputation or margin analysis undertaken by the Commission. The Commission must also provide a statement as to the extent to which it considers that Telstra’s reports are accurate and comply with other reports including the RAF, any other relevant RKR or any direction given by the Commission under clause 8 of the Ministerial Direction.

9

3 Current Cost Accounting Framework

3.1 Objectives of CCA In developing the methodology for the preparation of Telstra’s CCA reports the Commission has focused on ensuring that the CCA reporting regime for Telstra adequately fulfils the Government’s policy objectives, and the Commission’s own objectives under Parts XIB and XIC of the Act.

3.1.1 Government objectives

The Government has stated that proposed AS framework for Telstra (a key requirement of which is the preparation of CCA reports) is to provide the Commission, access seekers and the public with greater transparency about Telstra’s ongoing and sustainable wholesale and retail costs.3 More specifically, the AS framework is intended to promote the following objectives, particularly in relation to “core” services:4

to ameliorate information asymmetries so as to improve the basis for access negotiations;

to provide a high-level of systemic confidence that there is no predatory pricing occurring;

through transparency, to provide incentives for equitable treatment in the supply of core services;

to ensure there is a consistent and appropriate basis to which the regulator can refer when examining any competition issue involving costs;

over time, to improve the regulator’s systemic capacity to identify, and investigate allegations of anti-competitive behaviour in the supply of “bundled” services in an increasingly convergent environment.

In designing the AS framework, the Government has also had the objectives of:

building on work already done by the Commission and the industry with the RAF rather than “reinvent the wheel”;

not degrading genuine economies of scale and scope in the supply of retail services; and

avoiding undue regulatory burdens on industry. 3 DCITA, Draft Direction on Telstra’s accounting separation issued for public comment, media

release, 19 March 2003.

4 Explanatory Statement to the Direction.

10

3.1.2 Commission’s objectives

Part XIB – Anti-competitive conduct The Commission is responsible for administering an industry-specific regime established by Part XIB of the Act which empowers the Commission to deal with anti-competitive conduct in telecommunications markets and obtain information to assist it in monitoring competition in the telecommunications industry.

Part 151AJ of the Act states that the two circumstances in which a carrier will be said to engage in anticompetitive conduct under Part XIB are:

Where a carrier/CSP has sustained market power and has taken advantage of that power with the effect, or likely effect, of substantially lessening competition, or

Where a carrier/CSP engages in conduct which contravenes certain provisions in Part IV of the TPA.

The Commission has the power to issue a “competition notice” or directly seek injunctions in the Federal Court if it considers that a carrier has breached either of these conditions.

Examples of conduct that may breach Part XIB of the Act include:

Predatory Pricing – This describes situations where a carrier/CSP with substantial market power in a telecommunications market takes advantage of that power to sacrifice short-term profit by setting prices below the cost of production with the effect of eliminating or reducing competition. Such pricing practices may increase long-term profit, if the carrier/CSP can price above marginal cost of production once the competition has been removed or substantially reduced.

Retail Margin Squeezing – Can be considered a specific case of predatory pricing. It describes a situation where an incumbent firm sells a particular product at retail prices that are below the rates at which competing firms can gain access to the existing incumbent’s underlying network facilities which are required by them to offer a similar product(s).

Cross subsidisation – Describes a situation where an operator that dominates one market increases or maintains its prices above costs in that market, and use these excess returns from the dominant market to sustain lower prices in other more competitive markets. Consequently, a disproportionately large share of the costs of the operator’s entire business can be recovered from the markets the operator dominates. Cross-subsidisation can be a significant barrier to effective competition since without the ability to cross-subsidise its own competitive services, an economically efficient new entrant may be unable to match the incumbent’s low prices in competitive markets, and may be forced out of business.

Bundling – Generally refers to the situation where two or more products or services are sold as a single package. The price of the bundled package is usually

11

at a discount to that of acquiring given amounts of the products separately, and a consumer is likely to receive only one bill for all of the services provided in the bundle. The Commission recognises that bundling of telecommunication services can lead to increased efficiencies and provide many consumer benefits, such as lower prices and single bills. However there is also the risk that bundling may have anti-competitive effects. In recent times, there have been growing industry concerns about the current and future implications of bundling for telecommunications services, particularly for new and developing services, such as broadband and 3G mobile.5

Vertical Cost Shifting – Describes behaviour whereby a vertically integrated firm shifts costs between its wholesale and/or retail businesses in order to damage competitors. In this regard, the ability to identify upstream versus downstream costs is the key to diagnosing vertical cost shifting.

The Commission believes that the requirement on Telstra to produce regulatory financial reports on a CCA basis will assist it to identify instances of the above-mentioned conduct. In particular, the CCA reports will likely enable the Commission to better identify true economic/replacement costs of particular assets owned and operated by Telstra. The Commission considers that CCA information is more likely to provide costs that underpin prices in a competitive market, and will likely enable the Commission to make a more informed assessment as to whether particular conduct can be deemed anti-competitive under Part XIB of the Act.

Part XIC – Guaranteeing Access to Network Services

Part XIC of the Act governs the way the Commission regulates access in telecommunications markets so as to promote the LTIE through lower prices, increased quality and greater diversity of goods and services. The access provisions in Part XIC of the Act are an attempt to overcome the imbalance of power between existing players and new entrants

One of the Commission’s key roles is the declaration of specific telecommunications services. The purpose of declaration is to ensure that competitors can gain access to bottleneck facilities at fair and reasonable prices in order to be able to compete effectively where this would promote the long-term interests of end users (LTIE). A provider of a declared service is obliged to make the service available to requesting access seekers on reasonable terms and conditions. These terms and conditions can be determined in three different ways:

An access undertaking submitted by the access provider for approval by the Commission

A privately negotiated agreement between access provider and access seeker

5 Australian Competition and Consumer Commission, Bundling in telecommunications markets —

an ACCC Draft Information paper, January 2003.

12

An arbitration by the Commission where access seeker and provider are unable to reach a negotiated agreement

In examining the LTIE, the Commission must consider the achievement of the following objectives:

promoting competition in markets for telecommunications services;

achieving any-to-any connectivity in relation to carriage services that involve communication between end-users; and

encouraging the economically efficient use of, and the economically efficient investment in, the infrastructure by which telecommunications services are supplied.

An important consideration in ensuring that access to declared services is in the LTIE is whether the terms and conditions of access (including the price or a method for ascertaining the price) are reasonable.

The main drawback with using historical information to determine access prices is that the current cost of a company’s assets may bear little relationship to their historic purchase prices because of technological change and general inflation. This means that an access seeker, in paying an access charge, might be paying for the historic purchase costs of the incumbent’s network rather than the economic costs of the service.

The requirement on Telstra to prepare CCA reports will assist to promote the objectives of Part XIC, and as a consequence the LTIE, by providing economic rather than historical financial information on which to base decisions under this provision.6

3.2 An Appropriate CCA Regime for Telstra

3.2.1 Initial Report

The Ministerial Direction requires Telstra to provide the Commission with an “initial” CCA report by November 2003. The initial report will cover the six months ending 31 December 2002, the six months ending 30 June 2003, and the year ended 30 June 2003.

Telstra must provide the Commission with “subsequent” CCA reports on a periodic six-monthly and annual basis. The subsequent reports will cover the six months ending 31 December, the six months ending 30 June, and the financial year.

6 Note that in determining access prices, the Commission has used an economic costing approach

based on TSLRIC which is the forward looking (optimised) economic costing approach. The costs determined under the CCA reporting regime will likely act as a “sanity test” of the economic costs determined by the Commission using the TSLRIC approach.

13

To avoid confusion and allow a degree of flexibility, the Direction allows the Commission to make different RKRs on current costs in relation to the initial and the subsequent CCA reports.

The Commission has sought information from Telstra in relation to its current systems and procedures which can be used for the preparation of the initial and subsequent CCA reports. As a result of these discussions the Commission has determined that Telstra’s current reporting systems are, in certain respects, not presently suitable for the preparation of full CCA reports. More specifically, the Commission has concluded that currently Telstra’s asset register does not identify assets in such a manner as to allow meaningful CCA derivation and analysis.

Given the tight timeframes involved in the preparation of the initial CCA report, the Commission issued on 26 June 2003 a separate RKR for the initial reports. This is a pragmatic approach which seeks to maximise the CCA information which can be produced within the initial timeframe established by the Ministerial Direction.7

The Commission believes that the approach which will be used in the preparation of the initial CCA report will require compromises to be made in relation to the methodology, measurement and reporting to be adopted. The approach adopted for the initial report, therefore, should in no way be construed as the Commission endorsing the initial report framework as a basis for the preparation of subsequent CCA reports. Indeed, the Commission is of the view that the limitations in respect to the methodology, measurement and reporting of the initial CCA report framework make it unsuitable as a longer term approach to the development of an effective CCA regime for Telstra.

Essentially, the areas where compromises have been made in respect to the initial reports relate to the basis for measurement of assets and the treatment of the profit and loss and capital employed statements for the purposes of the initial reports. These issues are at the core of the discussion which will follow in section 3.3. The Commission’s approach in relation to the initial reports is set out in section 3.4.

3.2.2 Subsequent Reports

In relation to the subsequent CCA reports, the Commission considers that there are a number of issues which need to be resolved concerning the appropriate CCA methodology which will best meet the objectives of the Ministerial Direction and of Parts XIB and XIC of the Act.

Essentially, these issues centre on:

How should assets be measured under CCA; and

What form of capital maintenance should be used as the basis for determination of profit.

7 The RKR for the initial reports can be found at the Commission’s website at <www.accc.gov.au>.

14

These issues are discussed in section 3.3. The Commission is seeking submitter’s views on the issues raised in section 3.3 concerning the most appropriate longer term framework for CCA reporting.

3.3 Conceptual Basis for Subsequent Reports As previously stated, in developing a CCA system, two key issues need to be resolved. These are:

the basis for measurement of assets (and liabilities);

the concept of capital maintenance and the determination of profit.

3.3.1 The basis for measurement of assets (and liabilities)

Under CCA reporting, assets and liabilities are valued based on what is referred to as a “current entry value” methodology. This represents the number of units of money which would be needed to obtain assets already under the command of an entity, and recognised in its financial statements.

The replacement cost (RC) of an asset is often used as a basis for estimating current entry values. RC is defined as the present day cost of acquiring an identical or substantially similar present day asset that could provide equivalent services and capacity to the existing asset.

RC is based on current market values, and therefore current technology. In telecommunications, certain classes of assets have been subject to technological change and new technologies have been developed since assets were originally installed. This means existing assets would not be replaced in an identical form. In such cases the replacement cost of a particular asset can be based on the cost of a modern equivalent asset (MEA). Essentially, the MEA is an asset with the same service potential as the existing asset, and as a result, can produce the same stream of services and at the same level of quality.

The use of MEA as a measure of replacement cost should be independent of whether or not the operator has plans to replace the existing technology.

In cases where the MEA provides additional functionality, capacity or quality, adjustments should be calculated for these differences, so that only the level of functionality which is reflected in the existing asset is taken into account.

For some assets, calculating replacement costs might not be necessary. For assets with low values or short lives calculating the current cost of such assets will be time consuming and is likely to provide little additional information. In such cases historical costs, appropriately indexed, will be appropriate as a proxy for the current cost of these types of assets.

The concept of service potential The concept of “service potential” is fundamental to the measurement of assets. In other words, it is equally necessary to apply the concept of service potential in

15

measuring an asset under a historical cost system and under any form of CCA. This point is explicitly stated in accepted Australian accounting standards:

“ ‘Assets’ are future economic benefits controlled by the entity as a result of past transactions or other past events (paragraph 14);” “The definition of assets identifies three essential characteristics. Firstly, there must be future economic benefits (paragraph 15);” and “ ‘Future economic benefits’ or service potential is the essence of assets. ‘Future economic benefits’ is synonymous with the notion of service potential, and is used in this Statement as a reference also to service potential. Future economic benefits can be described as the scarce capacity to provide benefits to the entities that use them, and is common to all assets irrespective of their physical or other form (paragraph 18).” 8

Telstra’s view In discussions with the Commission, Telstra has consistently argued that it is extremely difficult, if not impossible, to apply the concept of service potential to measure Telstra’s assets.

Telstra has argued that the determination of service potential in the context of telecommunications networks is made difficult if not impossible by the following factors:

(1) there are very substantial interdependencies in the physical network. These make it impossible to allocate service potential to individual assets or projects. Rather, the capacity of the network is determined through the interaction of the contribution of a myriad of individual assets and projects.

(2) the capacity of the network, or of any individual sub-network, undergoes constant change. These changes cannot be readily or unambiguously allocated back to individual assets or projects, again because they are not referable to individual assets or projects.

(3) as a result of these first two factors, there is no sense in which ‘service potential’ can be attributed to individual assets or projects, so that there is no meaningful sense in which the ‘service potential’ of individual assets can be determined and used to assess the cost of replacement.

(4) at the same time, there is no sense in which future service capacity will be similar to current service capacity . . . . in telecommunication networks, it is certain that future networks will be substantially different from the current network in terms of the range of assets, services and more broadly functionalities that they provide. There is no sense in which ‘maintaining current service potential’ is a meaningful, much less desirable, goal.

8 Statement of Accounting Concepts SAC 4, Definition and Recognition of the Elements of

Financial Statements, issued by the Australian Accounting Standards Board.

16

(5) as a result, there is no meaningful concept of even aggregate ‘current service potential’ that can guide the determination of income concepts.

In Telstra’s view there are significant difficulties in determining service potential for it assets, as there is no direct connection between service requirement and asset capacity. In terms of new projects, each of these projects can consist of a number of assets, and there is no need, from a planning point of view, to determine the service potential of each asset. At the same time, the interdependence between projects means that the contribution to service potential of each project is not capable of unambiguous or meaningful identification.

An additional reason advanced by Telstra to support the argument that the determination of Telstra’s assets service potential is a difficult, if not impossible, task is the fact that Telstra employs a composite asset accounting approach. Accordingly, Telstra has argued that the use of composite asset accounting does not allow for a one for one physical to financial valuation of assets.9

The Commission’s view Given the issues outlined above, a key consideration for the Commission in developing the CCA regime for Telstra’s subsequent reports is how Telstra should measure its assets when undertaking CCA.

The Commission believes that, in light of the Ministerial Direction and the stated policy objectives, the appropriate basis for valuing assets under CCA is based on identifying the RC of the MEA with the same service potential as the existing asset. Where the MEA is the same as the asset currently owned by Telstra, the Commission believes that an absolute valuation approach (i.e. obtaining current unit price data for specific assets and multiplying this by the physical number of units currently in service) is appropriate.

The Commission believes that the MEA method is the most appropriate for estimating the RC of a particular asset with similar service potential, for two main reasons.

Firstly, the telecommunications industry has undergone significant technological developments in recent years and it is likely that some assets currently owned by Telstra have no identical asset for replacement. The MEA method will overcome these issues since the estimated asset cost will be based on the latest technology in the market. Secondly, the MEA method is based on current market prices and as a result will likely provide a more accurate estimate of the true economic costs of acquiring particular assets. Given the Commission’s previously-stated objectives to use current cost information to assist it to administer Parts XIB and XIC of the Act, valuations based on the MEA method are likely to provide cost information that reflects prices that would be found in the current market.

Further, the Commission believes that the concept of service potential is central to 9 Telstra’s view in relation to service potential and the approach to asset valuation appears to be

broadly consistent with Telstra’s understanding of the approach taken by Oftel in the UK. For a more detailed outline of the asset valuation methods employed in the UK system please refer to Attachment B.

17

the planning, acquisition, development, operations, measurement or financial reporting activities currently undertaken by Telstra in relation to its operations. In addition, the Commission notes that Telstra’s financial statements are prepared in accordance with the Statements of Accounting Concepts and Australian Accounting Standards which require assets to be measured and assessed in terms of their future economic benefits or service potential.

In relation to the issue of composite asset accounting, the Commission believes that the adoption of CCA does not mean that composite assets should be measured in terms of the value of individual assets. Rather, such composite assets should be measured (as much as possible) on the same basis as they are for historic cost reporting purposes under the RAF.

The Commission notes that a number of overseas jurisdictions have used the MEA approach when estimating the RC of particular assets. The Commission’s analysis of overseas approaches confirms its view that MEA is an appropriate basis for determining true economic costs where technological change is substantial. For a more detailed outline of the approaches to asset valuation under overseas CCA regimes, refer to Attachment A.

Opportunity for comment

The Commission seeks submitter’s views on the following issues

The appropriateness of Telstra using an MEA approach to estimating replacement cost of a particular asset in certain circumstances.

The appropriateness of using service potential as a basis for measuring Telstra’s assets.

Whether the existence of composite asset accounting impacts on the methodology for valuing assets on a CCA basis?

Whether service potential is an appropriate approach to assess the cost of replacing composite assets?

3.3.2 The concept of capital maintenance and the determination of profit

The concept of capital maintenance is central to the operation of any accounting system and refers to the manner in which the capital of a company is viewed when determining profit.

The choice of capital maintenance approach has important implications for the measurement of profit available for distribution in the Statement of Financial Performance, but it also affects the division between contributed capital and retained profits in the Statement of Financial Position (Balance Sheet). As such, a key issue in developing a CCA framework for Telstra is the concept of capital that will be used when determining profit.

There are two basic concepts of capital maintenance; namely, financial capital maintenance (FCM) and operating capability maintenance (OCM).

18

OCM is concerned with maintaining the physical output capability of the assets of the company. Capital maintenance under this approach requires the company to have as much operating capability — or productive capacity — at the end of the period as at the beginning. Under OCM, profit is therefore only measured after provision has been made for replacing the output capability of a company’s physical assets.

FCM is concerned with maintaining the real financial capital of the company and with its ability to continue financing its functions. Capital is assumed to be maintained if shareholders’ funds at the end of the period are maintained in real terms at the same level as at the beginning of the period. Under FCM, profit is therefore only measured after provision has been made to maintain the purchasing power of opening financial capital.

Under FCM, the capital to be maintained is the financial amount of the net assets. Therefore, under this concept the enterprise earns a profit only if the amount of its net assets at the end of the period exceeds the financial amount of its net assets at the beginning of the period (after adjusting for any distributions to, and contributions from, the owners of the enterprise during the period). The financial amount of the net assets can be measured in either of two ways; either in “nominal money units” or in “units of constant purchasing power”.

Under OCM, the capital to be maintained is the operating capability embodied in an enterprise’s net assets. Therefore, under this concept an enterprise earns a profit only if its operating capability (or the resources or funds needed to achieve that operating capability) at the end of the period exceeds its operating capability at the beginning of the period after adjusting for any distributions to, and contributions from, the owners of the enterprise during the period.

The differences between FCM and OCM can be seen most clearly when accounting for the effects of price changes and particularly in the treatment of what are often referred to as “holding gains”. This is the difference between the measured value to an enterprise of an asset at any point of time and the original cost incurred by the enterprise in purchasing that asset (less accumulated depreciation where appropriate).

Under FCM, where the financial amount of the net assets is measured in nominal monetary units, holding gains may arise during a period but they would not be recognised by the enterprise in its financial statements until the assets are disposed of by the enterprise in an exchange transaction with another enterprise. This is the situation which normally pertains in a pure historical cost system. In the series of simplified illustrations of accounting recognitions and financial statements under various concepts of capital maintenance which follows later in this section, this is Illustration 1 in Attachment B.

Under FCM, where the financial amount of the net assets is measured in units of constant purchasing power, holding gains would be recognised by the enterprise as revenues (or expenses, in the case of holding losses). However, set against such holding gains would be an amount calculated to recognise the decrease (assuming a rising level of general prices) in the purchasing power of the money invested by the shareholders or other owners in the enterprise. Therefore, in a pure application of the FCM concept (and assuming rising prices), only that part of the increase in the prices of the assets held by the enterprise that exceeds the increase in the general level of

19

prices would be recognised in the determination of the enterprise’s profit for the period. The rest of the increase in the prices of the assets held would be treated as a capital maintenance adjustment which would form part of equity. This is Illustration 2 in Attachment B.

Under OCM, ‘holding gain’ terminology would not be seen as appropriate. The effects of all price changes affecting the assets (and liabilities) of an enterprise would be viewed as changes in the measurement of the operating capability of the enterprise and be treated as capital maintenance adjustments which would form part of equity. This is Illustration 3 in Attachment B.

Entity and Proprietary Viewpoints The debate over OCM v FCM can also be considered a debate on whether a firm should be looked at from an “entity” or “proprietary” perspective.

The entity viewpoint considers the enterprise that is being accounted for as being distinct from those parties who can contribute capital thereto – usually the enterprise’s shareholders. The enterprise is considered to be an independent body, and the objective of accounting is to account for the interests of the enterprise.

The proprietary viewpoint perceives an enterprise as being owned by one or more parties, such as a sole proprietor, partners or shareholders. All of an enterprise’s assets, liabilities, gains and losses are considered to belong to the owners, and the objective of accounting is to account for the owners’ interest in the enterprise.

In the area of accounting for the effects of changing prices, the entity viewpoint is closely interrelated with the OCM concept of capital maintenance, while the proprietary viewpoint is closely interrelated with the FCM concept of capital maintenance.

These interrelationships can be seen in the different ways in which the entity viewpoint and the proprietary viewpoint would recognise an increase in the current cost of an asset. The entity viewpoint would seek to ensure that any distribution of profits to shareholders did not lead to a reduction in the enterprise’s operating capability; consequently, such a rise in asset value would be seen as an increase in the current measurement of the enterprise’s capital funds invested in the asset’s operating capability, not as a distributable gain. In contrast, the proprietary viewpoint would view such a rise as being a gain accruing to the shareholders because the rise in value of the asset held by their enterprise has increased their wealth. A proprietary viewpoint would regard such a holding gain as being distributable to shareholders (although under this approach it may be appropriate in some cases to first reduce such a gain by an amount calculated as being required to maintain the general purchasing power of the opening balance of shareholders’ equity).

The Commission notes that given the requirement that CCA reports must be reconciled to the historical cost RAF reports, if the FCM approach is adopted then the RAF will need to be changed to include equity. It is not possible to employ the FCM

20

concept to the RAF in its current form since it does not include equity.10 For this reason, the historic cost reports currently prepared by Telstra under the RAF implicitly employ the OCM concept of capital maintenance. It is possible to employ OCM in this regard since each business unit’s assets are defined and reported in the RAF.

Telstra’s view In discussions with the Commission, Telstra has argued that the OCM approach to capital maintenance is inappropriate in a telecommunications context, and that FCM should be adopted as the basis for its CCA reporting. In addition, Telstra has argued that a “proprietary” rather than an “entity” approach is preferable for CCA reporting in a telecommunications context.11

Telstra has argued these positions for the following reasons.

(1) The telecommunications industry differs from industries such as water, gas and electricity distribution in that it involves the supply not of a single (essentially homogeneous) service, but rather of a very wide range of services. These services are undergoing continuing and rapid change as new technologies alter not only the manner in which existing services are supplied but also lead to the development of entirely new services.

(2) Telstra believes that it is widely accepted that the concept of OCM is not well defined when the services being supplied by the reporting entity change substantially over time. In affect there is no longer a clear meaning that can be given to the service capacity/potential of the reporting entity. In addition, there is no sense in which it can be assumed that the entity needs to reproduce tomorrow, the service capacity it has today. As a result, Telstra considers that an OCM approach cannot usefully guide decisions about whether or not capital is being maintained intact.

(3) Telstra believes that when the nature of the services being supplied is undergoing constant change, the fundamental issue facing regulators and the firm is to ensure that the incentives for efficient investment are preserved. For this to be addressed, a proprietary rather than an entity approach must be adopted (the entity approach implicitly adopts OCM). Telstra maintain that an FCM approach will ensure that efficient investment incentives are preserved.

(4) Telstra considers that there are practical problems with adopting an entity (rather than a proprietary approach) and the associated use of SAP 1 (an Australian Statement of Accounting Practice in relation to CCA which recommends the use

10 Note however that some regulators overseas have taken a hybrid approach by using an FCM

approach but not including an equity component.

11 The Commission notes that Telstra’s approach to the adoption of a capital maintenance concept under CCA and the decision on whether to take an “entity” or a “proprietary” view appears to be similar to the approach adopted in the UK by Oftel; however the Oftel approach is a hybrid. For a more detailed outline of the Oftel approach to CCA see Attachment B.

21

of OCM).12 There is very little experience available on implementing SAP 1 in contexts characterised by a wide range of rapidly changing services. The difficulties involved in full-scale implementation of SAP 1 are aggravated by the fact that Telstra does not maintain unit records of its assets, and as a result, may require a detailed and expensive exercise in unitising the asset base. In addition, compliance with SAP 1 would require Telstra to not only revalue its fixed assets, but also working capital balances, cost of goods etc. This would raise considerable complexities but would be unlikely to have significant consequences for users of the accounts. Indeed, Telstra believes that the UK telecommunications regulator (Oftel) came to the same conclusion when it introduced CCA.

(5) Telecommunications regulators overseas have considered the issues raised above and developed CCA methodologies that meet regulatory needs in both a principled and cost effective way. These methodologies appear to rely on FCM and hence are consistent with the analytical framework underpinning access pricing. Telstra maintain these methodologies have been tested by the operators themselves, auditors, regulators and users of the information, and hence have a significant degree of credibility.

The Commission’s view The Commission notes that the European Union prefers the FCM approach to capital maintenance for the purposes of CCA reporting when it stated that:

The use of the OCM concept may systematically incorporate insufficient or excess returns into the level of allowed revenue (depending, respectively, on whether asset-specific inflation was expected to be lower than or higher than general inflation). This is not a desirable feature of any regulatory regime, as it would not provide appropriate investment incentives. Under FCM however, the returns to the providers of capital would equal the required return (as measured by the cost of capital) irrespective of whether replacement costs were rising or falling relative to general prices. Hence, if current cost accounting information is used as the basis to determine interconnection charges, FCM is the preferred capital maintenance concept.13

In addition, the telecommunications regulator in Denmark has outlined three reasons why FCM should be preferred to OCM when undertaking CCA adjustments, as listed below.

(1) OCM becomes of limited value in a world where the mix of assets and the mix of outputs is rapidly changing, as is the case for telecommunications.

12 SAP1 refers to a Statement of Accounting Practice “Current Cost Accounting”. SAP1 was

released in 1984 and was developed by the Australian CCA Standards Committee (which comprised leading industry representatives, practitioners and academics) for use in an Australian context. SAP1 is the most authoritative official position on CCA in Australia. It is a complete system of accounting for the effects of changing prices.

13 Andersen Business Consulting, Study on the implementation of cost accounting methodologies and accounting separation by telecommunications operators with significant market power: Prepared for the European Commission DG Information Society, 3 July 2002, p. 15.

22

(2) Accounting data can provide essential information about whether a firm should continue or discontinue an activity and whether, from a regulator’s perspective, the firm is making acceptable, excessive or insufficient profits. However, one of the conditions for accounting information to perform this role is that it includes holding gains and losses. In other words any inferences drawn about the firm’s performance from OCM measures of profitability, either from a shareholder’s perspective or a regulator’s perspective, may be incorrect.

(3) OCM depreciation implies that the firm will not recover the cost of its investment when asset prices are falling and will over-recover its costs when asset prices are rising.

However, FCM has also been criticised on the grounds that it is a looser concept of capital maintenance than OCM, which can lead to a less robust CCA framework. Advice provided to the Commission suggests that FCM concept is generally vague and capable of varying interpretations. In this regard, the Commission notes that the International Accounting Standards Committee14 has stated that:

The FCM concept does not require the use of a particular base of measurement. Selection of the basis under this concept is dependent on the type of financial capital that the enterprise is seeking to maintain.15

The above quotation suggests that the use of FCM can produce hybrid accounting systems, in which enterprises could combine a looser capital maintenance concept with one of a number of asset measurement bases (irrespective of the degree of conceptual and practical compatibility). The ability to adopt such combinations would allow greater flexibility in the process by which the profit of the enterprise is determined.

Opportunity for comment

There appear to be two key issues for consideration in light of the above discussion (though they appear closely related). First, what form of capital maintenance Telstra should use as a basis for the determination of profit? Secondly, should Telstra be viewed from the “entity” or “proprietary” view for the purposes of CCA reporting? The Commission is seeking submitter’s views on the following issues:

Which approach to capital maintenance (FCM or OCM) is more appropriate for Telstra given the stated policy objectives of current cost reporting in an Australian context?

14 In July 1989 the IASC published its Framework for the Preparation and Presentation of Financial

Statements. This framework is not an International Accounting Standard; rather, it assists the development of such standards and is applicable to a range of accounting models and concepts of capital and capital maintenance. The International Accounting Standards Board has now succeeded the IASC, although the Commission has been advised that the IASC framework cited above is still relevant.

15 IASC, Framework for the Preparation and Presentation of Financial Statements, July 1989, Paragraph 106.

23

When measuring financial performance based on current cost information, is an “entity” or “proprietorship” perspective more appropriate for Telstra given the stated policy objectives of current cost accounting?

Do the different approaches to capital maintenance lead to different investment incentives?

For the purposes of CCA should the performance of Telstra be measured in terms of a return to shareholders (in which case FCM is appropriate) or should the focus be on performance of an entity in terms of its service provision (in which case OCM is appropriate).

To what extent should the Australian CCA regime be based on the methodology set out in SAP 1? Would there be any difficulties in implementing SAP 1 as part of the Australian CCA regime?

The Commission is conscious to ensure that the CCA regime adopted in Australia is not susceptible to subjective interpretation by reporting carriers. In this context, does either FCM or OCM lend itself to subjective interpretation and to what extent would this compromise the transparency and usefulness of the CCA regime?

3.3.3 The depreciation backlog issue

In any CCA framework, a depreciation backlog will arise in the preparation of financial statements for any reporting period. Such a depreciation backlog will arise irrespective of whether FCM or OCM is adopted.

A depreciation backlog will arise because the objective of any CCA system is to ensure that, having regard to changes in specific prices, both the results and the resources of an entity are realistically measured so as to be of maximum value to users. A CCA system must meet this objective in both the statement of financial performance and the statement of financial position. The depreciation backlog arises because of the different ways in which depreciation charges are calculated for the statement of financial performance and accumulated depreciation is calculated for the statement of financial position.

In a CCA statement of financial performance, the result for a period is determined after matching with revenue the current value of resources consumed. For depreciation charges calculated for all depreciable assets (except where they are carried at recoverable amount), the current value of the resources consumed is calculated in terms of average-for-the-period current values of the assets.

In a CCA statement of financial position, the resources of an entity are stated at their written-down current value at end-of-period balance date. For all depreciable assets, their gross current value and, where applicable, the related accumulated depreciation must be calculated and shown separately.

In the mechanics of a CCA system, in order to arrive at the end-of-period accumulated depreciation, accounting entries are needed to restate the following two items which until then have not been stated at their end-of-period current value:

24

the opening balance of the accumulated depreciation account (which was stated at beginning-of-period current value); and

the addition made to the accumulated depreciation account through the depreciation charge (which was stated at average-for-the-period current value).

It is the total monetary amount of the accounting entries that are made in (a) and (b) above that is referred to as “depreciation backlog”.

The issue that arises is whether the corresponding credit/debit should be taken to the statement of financial performance, in the form of lower/higher depreciation charges, or to a current cost reserve or other capital maintenance reserve, which forms part of owners’ equity in the statement of financial position.

If the entry is taken to the statement of financial performance, then the problem is that the depreciation charges for the period will not be limited to the current value of the service potential of depreciable assets consumed or expired during the period. If the entry is taken to the current cost or other capital maintenance reserve, then it is possible that an enterprise’s physical (operating) capability will not be fully maintained. This will occur because in times of rising current values inadequate non-cash depreciation charges will cause an insufficient retention of funds that are needed to be reinvested in the enterprise.

Opportunity for comment

A further issue for consideration is how the depreciation backlog should be treated by Telstra when it prepares its “subsequent” CCA reports. The Commission is seeking submitter’s views on the following issue:

Given the objectives of the Ministerial Direction, is it more appropriate for the depreciation backlog to be taken to the statement of financial performance or to the current cost/capital maintenance reserve.

3.4 Basis of Preparation of Initial Report In discussions with the Commission, Telstra has proposed that the initial report be limited to Telstra’s fixed assets along the lines contained in the RAF’s fixed asset statements16. Telstra’s proposal involves the use of a Modified Current Replacement Cost (MRC) process to adjust the historical cost base of its assets to current replacement cost.

3.4.1 Telstra’s Modified Current Cost Valuation Process

The MRC process to adjust the historical cost base of its assets to current replacement cost primarily via one of the two following methods:

16 This means that a profit and loss statement and a capital employed statement will not be prepared for the initial report.

25

indexation; or

absolute value.

The absolute value methodology involves obtaining current unit price data for specific assets and multiplying this by the physical number of units currently in service. This price data will incorporate volume discounts and escalations for on costs such as installation and commissioning.

Telstra has argued that given the significant asset modernization programme that has been undertaken by the company in recent years many of the existing assets are identical to the MEA and as such the absolute value of the existing asset is essentially the same as the replacement cost of the MEA. The Commission notes that the fact that such a recent programme has been undertaken would suggest that accurate records exist with respect to the nature of the underlying assets, their historical cost and their installed service potential.

Telstra has stated that only 60% of the communications asset classes can possibly be valued using their MRC “absolute value” measurement approach, though it may be necessary to employ the indexation method for some of these assets. Telstra considers that it is not possible to identify the assets in the CAN Copper Cables and CAN Ducts & Pipes assets classes with sufficient accuracy to enable their measurement. Telstra have advanced a number of reasons why it is not possible to undertake this exercise. The primary reason is that these assets’ physical register consists of cable plant records (CPR) which is not an asset register system but rather a geographical map of cable and ducts which allows identification of cable and ducts for maintenance purposes.

Telstra, therefore, propose to adopt a high level approach based on indexing the written down value (“WDV”) of the CAN Copper Cables and CAN Ducts & Pipes. WDVs are available from the asset accounting system. Telstra propose to use “an average composite index of labour material and other costs” to index these assets over their service lives to date.

The Commission notes that based on Telstra’s proposal for the initial report, 40% of the assets in Telstra’s asset register would be valued using an indexation method, and that several classes of assets (including motor vehicles, land and buildings etc) would not be valued at all.

In relation to Telstra’s proposal to use indexation as the primary basis for valuation for a significant portion of its existing asset base, the Commission notes that this is the least preferred measurement approach in all price change accounting systems. In order for indexation to work effectively, two key factors need to be known with a high degree of accuracy and confidence, namely:

what the asset is that is being indexed; and

an accurate index must either be available or capable of being constructed.

26

Telstra did note that this approach would be refined if possible if archival information was available to separately identify asset additions and deletions so that these cost components could be separately indexed. This would provide more rigour, and should result in more reliable information being generated.

Notwithstanding the difficulties with developing an appropriate index for CCA, the Commission has decided that given the timeframes available for the preparation of the initial report, it will accept Telstra’s proposal to adopt indexation as a means of revaluing assets for the initial CCA report only. The Commission has included in the initial RKR a requirement that the indexes developed by Telstra be as disaggregated as possible to ensure that each index used reflects the assets that are being valued.

3.4.2 Phased Reporting Approach

In discussions with the Commission, Telstra has advocated the use of a phased approach for the introduction of CCA. Under this approach, CCA reports in the first instance would not be prepared for the various elements contained within the RAF Capital Adjusted Profit and Loss Statement and Capital Employed Statement.

At this stage, Telstra also proposes to focus only on the communications asset class in the Fixed Asset Statement. This means that not all of the fixed assets will be addressed, such as land and buildings, motor vehicles etc.

The Commission considers that given the timeframes set out in the Direction in relation to the initial CCA report and the fact that there are a number of issues which require industry consultation relating to the methodology for the preparation of the Capital Adjusted Profit and Loss Statement and the Capital Employed Statement, a phased-in approach is appropriate.

However, the Commission would expect that by the time the second CCA report is due in 2004, Telstra will have identified and re-valued all of its assets contained in the Fixed Asset Statement, including CAN assets, and will also be in a position to prepare a Capital Adjusted Profit and Loss Statement and a Capital Employed Statement on a full CCA basis and in accordance with the appropriate CCA methodology set out in the Commission’s RKR for the subsequent CCA reports. It is intended that this subsequent RKR will be issued early in the 2003-04 financial year.

3.5 Auditing of CCA Reports The underlying legislative objective of accounting separation provides a broad context for the Commission’s audit objectives. The Commission has determined a set of audit objectives to assist it to meet its statutory obligations.

These audit objectives, together with the operational implications of each for the auditor, are set out below:

To determine whether Telstra has implemented the requirements of the RKRs appropriately and effectively

The auditor should form an opinion as to the adequacy and completeness of the adoption of the RKR requirements as reflected in the carrier’s Regulatory Accounting Procedures Manual or equivalent (“RAPM”). It is important to note that the RKRs

27

are intended to provide a broad framework for the allocation of revenues, costs and capital employed. Guidance is given as to the manner in which this should ordinarily be undertaken. However, this is guidance only and the carriers and the auditors should ensure that following these guidelines provides information that is in keeping with the overarching principles of the RKRs.

To determine whether Telstra has met the Commission’s procedural requirements as specified within the RKRs

The auditor should form an opinion as to whether Telstra has complied with the accounting policies and procedures set out in its RAPM.

To determine whether the information produced and supplied by Telstra in compliance with the RKRs' provisions can be relied upon by the Commission in undertaking its regulatory obligations

The auditor should form an opinion as to the accuracy and completeness of information produced by Telstra in complying with the requirements of the RKRs, including reconciliation of the profit and loss with the audited statutory financial statements; and the capital employed statement, prepared in accordance with the RKRs, with the audited statutory balance sheet.

To determine whether the historical RKR reports produced by Telstra reconcile with the CCA RKR reports produced by Telstra

The auditor will need to develop a process of reconciling the historical RKR reports to the CCA RKR reports and comment on areas where the reports do not reconcile.

To determine whether Telstra exercises consistency in applying the RKR specifications to their accounting systems

The auditor should form an opinion as to whether Telstra has followed a structured approach in its application of the RAPM. It should also be satisfied that the approach taken has been consistent and appropriate, and that adequate audit trails exist.

To ascertain the adequacy of Telstra’s monitoring, review and implementation arrangements with respect to changes which impact upon the RKRs and/or the RAPM

The RKRs, or their application may be subject to change from time to time. These changes may include, but are not limited to: changes in internal accounting practices; the introduction of new services and technologies; and amendments to established functions. The auditor should form an opinion as to whether Telstra has adopted and complied with any such changes affecting the RKRs and/or the RAPM, pertaining to the period under audit.

In conjunction with these audit objectives, the Commission requires that high standards of professional conduct and performance be maintained during the conduct of an audit of Telstra’s compliance with the RKRs. The audit process is to be conducted with due regard to the principles and standards of auditing prescribed by the Australian Auditing Standards (“AUSs”) as issued by the Australian professional accounting bodies. Unless otherwise agreed with the Commission, the audit process is to be in accordance with the “Audit” requirement (as distinct from the “Review” or “Agreed-upon procedures” requirements) of AUS 106.

28

The Commission requires an auditing process to be established both in respect to the initial CCA report produced by Telstra and to subsequent CCA reports. The initial audit will be conducted in the context of the partial CCA report produced in relation to Telstra’s asset register. The Commission will require the auditor to ascertain that assets have been re-valued on an appropriate basis using either the absolute valuation methodology or indexing.

29

4 Imputation testing Section 4 discusses issues associated with the RKR for imputation testing on Telstra’s core services.

It is structured as follows:

it provides an overview of the relationship of this paper with the Commission’s draft information paper on bundling;

it provides background information on imputation testing;

it discusses the Commission’s approach to imputation testing for the initial report; and

it overviews implementation issues associated with the imputation RKR.

4.1 Relationship with the bundling draft information paper The Commission’s draft information paper entitled Bundling in telecommunications markets (the ‘draft information paper’)17 outlined its proposed approach to assessing whether specific bundling conduct in the telecommunications industry is anti-competitive. The paper extends the Commission’s discussion of anti-competitive pricing found in its Anti-competitive conduct in telecommunications markets guideline.18 The draft information paper includes comments on the use of imputation testing for single services and for services supplied as part of a bundle.

The draft information paper outlined the Commission’s purpose for undertaking imputation tests which was to assist it in determining whether certain pricing conduct is anti-competitive. The results of the imputation test may input into the Commission’s consideration of whether the pricing conduct constitutes a breach of the Act, although other evidence would also be required. The Government’s purpose for the imputation testing appears to be similar, in that the testing is intended to determine whether there is any systemic price squeeze behaviour in relation to core services.19 The requirement that the tests be made public is to provide greater certainty and improve transparency about potential price squeezes for key telecommunications services.

17 Australian Competition and Consumer Commission, Bundling in telecommunications markets — a

draft information paper, January 2003. The Commission is in the process of finalising the final information paper, having regard to the submissions made to it. Public versions of these submissions are available on the Commission’s website at <www.accc.gov.au/telco/fs-telecom.htm>. Follow the ‘anti-competitive conduct in telecommunications markets’ link.

18 Australian Competition and Consumer Commission, Anti-competitive conduct in telecommunications markets — Information paper, August 1999.

19 Senator Alston, Government boost to telecommunications competition, media release, 24 September 2002.

30

Whether or not Telstra fails (or passes) the imputation tests pursuant to the imputation RKR is not determinative of a contravention of the Act (or not). Further evidence of the effect of the specific conduct is required (in addition to other requirements of the Act), as discussed in the Commission’s draft information paper.20

Do you agree with the Commission’s interpretation of the objectives of the Ministerial Direction?

4.2 Background on imputation testing

4.2.1 Vertical price squeezing and imputation testing

Broadly, an imputation test can be used as a diagnostic tool to detect an anti-competitive price squeeze in a retail market where a vertically-integrated carrier has some degree of market power.

The scope for a vertically-integrated carrier to take advantage of its market power may arise where that carrier has market power in an upstream market and supplies an essential wholesale input from that upstream market to less-integrated carriers that compete with it in a downstream market.

A price squeeze could occur where a vertically-integrated carrier harms its competitors in the downstream market by reducing the margin between the retail price it charges in the downstream market and the wholesale access price it charges for an essential input. This margin could be reduced by lowering its retail price for the service and/or raising its wholesale access price for the essential input.21 It is at the point where competitors in the downstream market can no longer compete, or their ability to compete is significantly reduced (if retail prices are lower than wholesale access prices and additional costs) that such behaviour results in a price squeeze.

4.2.2 What are the elements of an imputation test?

Whether or not a vertically-integrated firm is engaging in a price squeeze can be examined via an imputation test. Such a test is designed to determine whether the margin between the prices for the wholesale inputs and the retail prices is sufficient to cover the retail costs of the vertically-integrated firm. Therefore, in the present context, an imputation test involves a comparison of:

the retail price charged by Telstra for a particular service; and

the (wholesale) access price charged by Telstra for an essential input to that service plus the additional costs incurred in transforming the essential input to the retail service (the ‘retail costs’).

20 One particular issue would be consideration of the appropriate market definition, which may not be

the same as the service descriptions being used in the imputation rule.

21 It is noted that even though margins may be reduced, carriers could still make profits if access prices were above long-run costs, in addition to any potential benefits for long-run profitability from any anti-competitive conduct.

31

Where the retail price is less than the sum of the wholesale access price and additional costs, a price squeeze is said to exist.

4.3 Principles for the imputation RKR The following section outlines the principles that the Commission applied in implementing the preliminary imputation RKR. Issues pertaining to the specific implementation of these principles are in section 4.4.

4.3.1 Identifying retail services which closely reflect the wholesale inputs

The core services that the Minister has identified for imputation testing are wholesale services purchased by competitors from Telstra that are used as inputs in the provision of retail services.

The domestic PSTN origination and termination services are used as inputs by access seekers primarily to supply long distance, fixed-to-mobile and mobile-to-fixed calls to end-users in Australia. They can also be used by other network operators to interconnect with Telstra's fixed network.

The ULLS involves the use of unconditioned lines (typically copper) between end-users and a telephone exchange, where the line terminates. This service enables access seekers to supply advanced, high-speed data services, such as xDSL (digital subscriber line), to customers as well as local and long-distance voice services in competition with Telstra.

The LCS is a service for carriage of telephone calls from customer equipment at an end-user's premises to separately located customer equipment of an end-user in the same standard zone. It allows access seekers to provide local calls on a resale or wholesale basis in competition with Telstra.

A wholesale service can be used as an input into various retail services. Similarly, in providing a retail service, access seekers have a choice of wholesale inputs. For example, in providing a local call service, access seekers can select either LCS or PSTN as the wholesale input into the service, although LCS is predominately used.

The Commission also notes that inputs in addition to the core service may be required to supply a retail service. For example, a service such as transmission may be required for long-distance telephony in addition to billing, marketing and other costs more closely associated with retailing. For the purposes of this paper, all costs required to transform the core service into the retail service will be called ‘retail costs’. Retail costs are discussed further in section 4.3.4.

For the purposes of undertaking imputation testing for the Ministerial Direction, the Commission must select retail services that use the core wholesale services.

Retail services are defined in the Ministerial Direction as:

(a) line rental;

(b) local calls;

32

(c) national long distance calls;

(d) international calls;

(e) fixed to mobile calls; or

(f) any other service that is supplied to an end-user and that the Commission considers makes extensive use of the core services.

The Commission’s view for the preliminary report is that undertaking imputation tests on the retail services outlined in will achieve the Government’s objective of ensuring that Telstra is not engaging in price squeeze behaviour in relation to the core services.

Table 1

Table 1 Retail services used in imputation testing

Retail Service Core service input

Line rental and local calls LCS22

National long-distance calls Domestic PSTN (originating and terminating)

International long distance calls Domestic PSTN (originating)

Fixed-to-mobile Domestic PSTN (originating)

ADSL ULLS Telstra provides numerous retail products, such as HomeLine Plus or BigPond internet, that use these underlying retail services. The Commission’s view for the preliminary report is that the Ministerial Direction does not intend for imputation testing on all individual products that provide these retail services, but rather on the average retail price of these services.

Do you consider the Commission’s approach to the preliminary report appropriate for subsequent reports?

4.3.2 Calculation of retail price for purpose of imputation test

Telstra is required to provide the Commission with the individual revenue elements by customer group, for each retail service.

The Commission notes that the retail price Telstra charges for any one retail service can vary not only between business and residential customers, but also within those segments through practices such as different pricing plans, discounts for bundling and promotional offers. However, as noted in section 4.3.1, the Commission does not consider that the intention of the Ministerial Direction is to undertake imputation

22 Line rental is typically required by an access seeker as part of their acquisition of the LCS. See

Australian Competition and Consumer Commission, Local carriage service pricing principles and indicative prices — Final report (revised), April 2002.

33

testing on individual retail products, but rather on the average retail price of the underlying retail service.

The average retail price of the retail service can be calculated by using the total revenue and volume data provided by Telstra. The revenue data effectively provides a weighted sum of the different retail prices charged by Telstra for its retail products. Dividing the total revenue by the total volume will provide an average retail price charged by Telstra per unit of the service. As Telstra increases its levels of discounting, this average retail revenue per service will decline.

The Commission notes arguments that competitors face the deepest-discounted price offered by Telstra on individual products for a particular retail service when trying to attract customers in the different customer groups. However, preliminary consideration of this issue would seem to indicate that the average retail price for the retail service is likely to be appropriate. This would ensure that both Telstra and its competitors have the flexibility to offer differentiated pricing structures but that competitors who are equally-efficient to Telstra will, on average, be able to match Telstra’s retail price offers for that service.

For the purposes of the preliminary RKR report, the Commission calculated the average retail price using total revenue and total volume data.

Do you consider the Commission’s approach to the preliminary report appropriate for subsequent reports?

4.3.3 Calculation of access price for purpose of imputation test

The Ministerial Direction instructs Telstra to provide to the Commission the access price for the purpose of the imputation test. The methodology that Telstra must use is the volume weighted average of the prices that Telstra charges its access seekers for the service.

4.3.4 The cost basis for calculating the retail costs

There are two pertinent issues associated with determining the methodology and data to be used as input for calculating these costs.

Does the Commission utilise the current cost accounting (CCA) or historical cost accounting data provided in the Regulatory Accounting Framework (RAF) to determine the retail costs?

On what basis does the Commission calculate these costs?

Appropriate data The imputation RKR is designed to determine whether the margin between the access price for a core service and the retail price of a retail service is sufficient to cover the retail costs of Telstra.

The Commission notes that it will receive historical cost and CCA data from Telstra in relation to the RAF. Current cost information, which is based on the cost of

34

replacing the asset with a similar asset that provides the same service potential, should be a more accurate reflection of Telstra’s retail costs. Comparatively, historical cost accounting does not take into account any improvements in technology over time or other forms of dynamic efficiency in the asset, which can result in lower cost and/or improved functionality. As CCA data should provide a more accurate calculation of the retail costs of Telstra, the Commission proposes to use it where possible.

The Commission notes, however, that there will be a transition stage until full CCA cost data is implemented, and as such the imputation test results may reflect this transition, at least in the early stages.

Do you agree with the Commission’s approach to the use of CCA data?

Cost basis The Commission’s draft approach to undertaking an imputation test for the purposes of investigating potentially anti-competitive pricing behaviour in telecommunications markets was outlined in its draft information paper.

The discussion in the draft information paper focused on two differing cost basis: marginal cost and average total cost. A marginal cost approach estimates the change in total cost resulting from an extremely small change in output (although marginal costs can be difficult to identify, and average variable costs are often used as a proxy). An average total cost approach calculates the total costs of producing a given quantity of output, divided by the total number of units produced. If an imputation test based on average total costs is passed, a marginal approach would generally also be passed.

In the context of telecommunications markets, the Commission’s view in the draft information paper was that using an average total cost basis is an appropriate starting point. This partly reflected the view that in industries such as telecommunications, short-run marginal costs are likely to be low and in some cases close to zero.

Where pricing falls below average total cost, but passes an imputation test based on marginal costs, the Commission considers a ‘grey area’ occurs. In the event that the conduct does fall within the ‘grey area’, the Commission is likely to consider other factors to assist it in determining whether the conduct is anti-competitive. These factors are outlined in its draft information paper.23 In saying that, the Commission must ultimately have regard to the elements of the relevant section of the Act to establish that the conduct is anti-competitive.24

The Commission considered whether its approach to investigating potentially anti-competitive pricing behaviour is appropriate for the imputation RKR. The imputation RKR allows Telstra to demonstrate that there are no systemic problems with price 23 Australian Competition and Consumer Commission, Bundling in telecommunications markets — a

draft information paper, January 2003, p. 19.

24 For example, imputation tests do not demonstrate whether the carrier or service provider is taking advantage of its market power for anti-competitive purposes, or is simply engaging in robust competition by legitimately exploiting economies of scale and scope. This may need to be considered when establishing the elements of the relevant section of the Act.

35

squeeze behaviour. Instead of looking at particular instances of pricing conduct, the imputation RKR looks at Telstra’s pricing across entire retail services at quarterly intervals.

The probability of a systematic price squeeze will become an issue once Telstra supplies at a retail price which does not cover the cost of the core service and the average total cost of transforming that core service into a retail service. That is, at this point, a competitor that is equally as efficient as Telstra would not be able to meet its average costs.

Presumably, the imputation RKR is intended to focus on the long term impacts of Telstra’s pricing. While the imputation RKR in this case will assess whether competitors in the market are able to meet their costs in the long run, it will also assess whether potential entrants are being deterred from entering the market. This longer term approach will provide a ‘bigger picture’ of the effect of Telstra’s pricing behaviour on competition in the relevant telecommunications markets.

In conducting imputation tests with reference to the longer term, an imputation test based on average total costs is appropriate. The draft information paper noted that, as the time period in which to assess the relevant conduct increased, a greater proportion of costs would be classified as marginal.25 Indeed, NERA has advised the Commission that for a relatively long timeframe, the analysis may approach an average total cost imputation test.26

The Commission recognises that pricing below average total cost in the long run may not be anti-competitive. In this regard, the Commission does not consider that the effect of the imputation RKR is that Telstra will be forced to price at average total cost, unless to do so would be anti-competitive. In any event, an imputation test conducted with reference to the longer term would provide an important input to understanding the industry more generally and also could indicate where further investigation into pricing conduct may be required.

Do you consider the Commission’s approach to the preliminary report appropriate for subsequent reports?

4.4 Implementation of the imputation RKR While the Commission has outlined the principles it applied to the preliminary imputation test, specific methodological issues also need to be addressed. The preliminary RKR puts forward the Commission’s position on many implementation issues, and a few of these issues are discussed below.

4.4.1 Telstra’s sources for providing the data each quarter

25 The Commission sought consultancy advice from NERA in relation to imputation testing.

NERA’s paper noted the importance of the time dimension in determining which costs are assessed. Refer NERA, Imputation tests for bundled services — a report for the Australian Competition and Consumer Commission, Sydney, January 2003, p. 17.

26 ibid.

36

The Ministerial Direction requires that Telstra provide the specified information to the Commission on a quarterly basis. Telstra currently provides RAF information to the Commission on a six-monthly basis. To address the time disparity, the Commission proposed in its preliminary RKR that Telstra:

obtain revenue information for core and retail services from Telstra’s general ledger accounts where the data relates to the relevant quarter;

obtain volume information for core and retail services from Telstra’s management information systems where the data relates to the relevant quarter; and

obtain cost information for retail services each quarter by multiplying the volume data for the relevant quarter with the unit costs of the service derived from the RAF accounts for the six-month reporting period preceding that quarter.

Do you consider the Commission’s approach to the preliminary report appropriate for subsequent reports for where Telstra should source its data?

4.4.2 Allocating revenues and costs to retail and wholesale services

Telstra provides financial information to the Commission in the RAF. Under the RAF, Telstra is required to provide capital adjusted profit and loss statements in relation to its retail services, internal wholesale services and external wholesale services. Telstra is also required to provide capital employed and fixed asset statements in relation to these three services.

The retail business service’s capital adjusted profit and loss statement allocates revenues and costs across various retail services provided by Telstra. These costs and revenues are disaggregated on the following basis:

a direct cost or revenue is solely generated by the particular service;

an attributable cost or revenue is part of a pool of common costs or revenues that are identifiable to a particular service by a cause and effect relationship; and

an unattributable cost or revenue is part of a pool of common costs or revenues but is not identifiably related to a particular service by a cause and effect relationship.

Therefore, the RAF allocates common costs as well as direct costs. The Commission notes that the current allocations of revenues and costs in the RAF were achieved in consultation with Telstra and other carriers. Therefore, the RAF principles for allocations between the wholesale and retail activities and between services should be appropriate for the purposes of the Ministerial Direction.

The Commission has recognised in the past that the RAF data may need to be modified to address specific issues.27 However, the Commission’s position for the 27 For example, the data was altered for the purposes of examining Telstra’s avoidable cost

allocations for the provision of retail line rental and local calls.

37

preliminary report, outlined in section 4.3.4, was that retail costs should be calculated on an average total cost basis. In this regard, the RAF allocations for services should also be an appropriate starting point for calculating retail costs for the purposes of the imputation RKR.

While it would appear that the costs attributed to retail services in the Telstra’s retail business services in the RAF are appropriate for calculating ‘retail costs’ for the Ministerial Direction, the RAF costs do not include all costs in the transformation of a core service to a retail service (such as transmission). Therefore, the Commission proposed in its preliminary RKR that costs in addition to those allocated as ‘retail costs’ in the RAF should be listed separated as ‘other costs’ in Telstra’s reports.

Do you agree with the Commission’s approach to use the RAF allocations as a basis for allocating revenues and costs?

4.4.3 Allocation of service data to customer groups

The RAF does not allocate cost and revenue data from retail services to customer groups. The Commission’s position for the preliminary report is that the allocation should be made on the basis of the line rental payable on the standard telephone service.

Where Telstra bills a customer line rental at a price that is available to a residential customer group according to its Standard Form of Agreement, then the revenues, volumes and costs should be allocated to the residential customer group. Similarly, if Telstra bills a customer line rental at a price that is available to business, charity or not for profit organisations according to its Standard Form of Agreement, then the revenues, volumes and costs should be allocated to the business customer group.

The allocation method proposed by the Commission seeks to avoid instances of businesses paying the ‘home phone’ bills of employees and those revenues and costs being allocated as business instead of the more appropriate residential allocation.

Do you consider the Commission’s approach in the preliminary report on allocations to residential and customer groups is appropriate for subsequent reports?

4.4.4 Use of the data to calculate the access price

The Ministerial Direction requires that the access price be calculated as the volume weighted average of the prices at which Telstra charges access seekers for the service.

The preliminary RKR proposed a yield approach to calculating the access prices, that is, total revenues divided by total volume for each core service. This approach may result in substantial fluctuations of the access price between quarters if access seekers are not billed on at least a quarterly basis or billing disputes arise and it is settled at a later period with a lump sum payment. To address this, the Commission could take into account the accounts receivable line item in the general ledger.

An alternative approach could be that Telstra record list prices and the volumes provided at each price. This would include multi-part tariffs such as geographic zones. Such an approach may however be burdensome for Telstra to calculate.

38

What approach do you think is appropriate? If applicable, please draw on any relevant commercial experience in providing your response.

4.5 Margin analysis Telstra is required to keep and retain records, and to prepare reports consisting of information contained in those records, that identify the retail margins for each core service.

The Commission considers that the margin analysis should apply to the retail services identified in section 4.3.1 of this draft paper. The Commission’s approach for the preliminary report is that the margin should be calculated as:

Telstra’s retail price minus the access price minus the retail costs.

Do you consider the Commission’s approach for the preliminary report appropriate for subsequent reports?

4.6 Economies of scale and scope The Ministerial Direction provides the Commission the discretion to allow adjustments in Telstra’s records for economies of scale and scope. The Commission considers that there are likely to be savings from economies of scale and scope already recorded in the RAF accounts. However, if Telstra makes arguments that these savings are not recorded in the RAF, then it will need to provide evidence to the Commission supporting this.

4.7 Auditing The Commission is required to make a statement in relation to the accuracy of the reports provided by Telstra. In this regard, the Commission considers it appropriate that Telstra submitted audited reports.

The Commission understands that Telstra is intending to align the auditing of the historical cost and CCA RAF accounts, and so the Commission considers that it would be logical for the imputation tests to be audited as part of that process.

As the RAF accounts are audited only once a year, the Commission proposed in the preliminary RKR that for the 3 quarters when the imputation RKR data is not audited, Telstra provide a record-keeping declaration with the RKR. This declaration should be a statement by the Chief Executive Officer of Telstra, or a delegated authority, that the reports are accurate.

Do you consider the Commission’s approach for the preliminary report appropriate for subsequent reports?

4.8 Publication of information The Ministerial Direction requires that the Commission make available to the public copies of the reports provided by Telstra together with a summary of the results of the imputation or margin analysis undertaken by the Commission.

39

Public copies of the reports provided Telstra must be accompanied by a statement from the Commission on the extent to which it considers that Telstra’s reports are accurate and comply with other reports including the RAF, any other relevant RKR or any direction given by the Commission under clause 8 of the Ministerial Direction.

Therefore, in relation to the retail services identified by the Commission in section 4.3.1, the Commission proposes to release the information provided by Telstra, that is, the volume weighted average of the prices that Telstra charges access seekers for those services, individual cost and revenues elements by customers group, and the retail margins for each retail service.

4.9 Further issues The Commission invites interested parties to comment on any other issues that they think are relevant in relation to the imputation RKR.

40

Attachment A International Developments CCA issues in telecommunications have been considered in some depth in a number of countries around the world, particularly in Europe.

In some of these countries telecommunications incumbents are required to produce periodic, separate current cost reports and a demonstrated reconciliation between current and historical cost information. In other countries current cost accounting is used on a more limited scale as a cost basis for interconnection costs and unbundled local loop (its use for the leased lines and voice telephony is more limited).

A.1 The European Union The EU has recommended that its members should prepare separate regulatory accounts using a current cost base.

A.1.1 Relevant European Union legislation

Relevant EU Directives, which are in the process of being replaced by a new set of directives, set general principles for interconnection charges and cost accounting systems. Council Directive 97/33/EC (on interconnection in telecommunications with regard to ensuring universal service and interoperability through the application of the principles of open network provision) requires that operators notified as having significant market power (SMP) publish a detailed reference interconnection offer where charges are derived from actual costs. In conjunction with this, it also imposes the obligation of keeping separate accounts for activities related to interconnection and to make these publicly available and have them independently audited.

More specific guidelines were issued in the Commission Recommendation of 8 April 199828, which specified that revenues and costs should be disaggregated into: core network, local access network, retail and other activities. Furthermore, it requires the allocation of costs to be done in accordance with the principle of causality (so that at least 90% of the costs can be allocated through direct or indirect causality) and for the cost allocation system to be sufficiently detailed to allow costing of unbundled interconnection services. Although no specific costing system is identified by the Commission, in the above-mentioned Recommendation it invites National Regulatory Authorities to set deadlines for “implementation by incumbent operators of new cost accounting systems based on current costs and activity-based accounts”.

In July 2002, Andersen Business Consulting, on behalf of the European Union (EU), released a Study on the implementation of cost accounting methodologies and accounting separation by telecommunications operators with SMP.

The study noted that although European Recommendations mention that separate regulatory accounts should be prepared using a current cost base, only three Member States comply. The EU also noted that five member states still use only a full HCA base, whereas only one (Finland) sees some SMP operators reassessing the capital

28 Interconnection in a liberalised telecommunications market – Part 2 Accounting separation and

Cost accounting

41

expenditures at their current value using the Modern Equivalent Asset (MEA) approach. In the Netherlands and Greece a different cost basis is used to prepare separated accounts for each business. Finally, in Ireland three sets of accounts are prepared using in the first set of historical costs, in the second set current costs with the FDC standard and in the third set current costs applied to the LRAIC standard.

A.1.2 Recommended current cost method

The EU states that FCM is the superior capital maintenance concept noting that:

The use of the OCM concept may systematically incorporate insufficient or excess returns into the level of allowed revenue (depending, respectively, on whether asset-specific inflation was expected to be lower than or higher than general inflation). This is not a desirable feature of any regulatory regime, as it would not provide appropriate investment incentives. Under FCM however, the returns to the providers of capital would equal the required return (as measured by the cost of capital) irrespective of whether replacement costs were rising or falling relative to general prices. Hence, if current cost accounting information is used as the basis to determine interconnection charges, FCM is the preferred capital maintenance concept.29

Hence, the EU recommends that if current cost accounting information is to be used as the basis to determine interconnection charges, FCM is the preferred capital maintenance concept.

A.1.3 Progress of implementation

The 8th Report from the European Commission on the Implementation of the Telecommunications Regulatory Package (December 2002) noted that:

As regards current cost accounting obligations for the enforcement of EU tariff principles, Member States are moving towards costing methodologies which are in line with EU recommendations. However, there is still considerable work to be done with regard to the verification and certification of accounts by NRAs, with resulting uncertainty in the market as regards compliance by incumbents with transparency and cost orientation.

Further, the EU notes that the implementation of cost accounting and accounting separation in the United Kingdom and Ireland can be regarded as best practice in the EU as regards the approach and methodology used, the detail of the verification carried out by the regulators and the availability of information to third parties.

A.2 United Kingdom British Telecommunications’ plc (BT) has been required, under Condition 78 of its License, to prepare annual financial statements on a current cost basis since 1984. The purpose of Condition 78 is to ensure that BT does not unfairly engage in subsidy or cross-subsidy, nor show undue preference or exercise undue discrimination, and that charges for interconnection and other standard services (including Access Network Facilities) are reasonably and transparently derived from costs.

29 Andersen Business Consulting, above n. 13, p. 15.

42

Oftel has indicated that the implementation of AS and current cost accounting was aimed at establishing a regulatory accounting framework in which cost-orientation could be demonstrated and anti-competitive practices eliminated. In Oftel’s view, CCA provides the best cost-base on which to make these judgements, because it is based on the premise that (in a competitive market) prices will approach economic costs (including the cost of capital) and such current prices should inform a service provider’s build/buy decisions. In this sense, Oftel views CCA as an important improvement on historic data.

The current cost financial statements are prepared in respect of each Business, as defined within the License, and insofar as a Business has been disaggregated in terms of activities of the Business, each activity of that Business. These financial statements are reconciled with the annual statutory (historic cost) financial statements, and that reconciliation must be demonstrated and explained.

The current cost financial statements are prepared in accordance with the “Accounting Documents” (ADs), which were initially agreed between BT and Oftel on 31 March 1995 and modified with Oftel’s agreement, as required by the License. The ADs set out the framework under which the financial statements are to be prepared. They comprise the following and if there is any inconsistency between them, have the following order of priority:

Regulatory Accounting Principles

Attribution Methods

Transfer Charges

Accounting Policies

BT also produces the “Detailed Valuation Methodology”, a reference manual to facilitate the understanding of the current cost financial statements prepared by BT.

A.2.1 Concept of capital

BT purportedly uses the Financial Capital Maintenance (FCM) convention in accordance with the principles set out in the handbook “Accounting for the effects of changing prices” published in 1986 by the Accounting Standards Committee. Under this convention current cost profit is normally arrived at by adjusting the historical cost profit to take account of changes in asset values and the erosion in the purchasing power of shareholders equity during the year due to general inflation. BT explains that the inflation adjustment in respect of shareholders’ equity is not relevant to Businesses and activities.

The Commission understands that the approach to FCM, as implemented in the UK context, can produce hybrid accounting systems, in which enterprises could combine a looser capital maintenance concept with one of a number of asset measurement bases (irrespective of the degree of conceptual and practical compatibility). The ability to adopt such combinations allows greater flexibility in the process by which the profit of the enterprise is determined.

43

A.2.2 Principles of Valuation of Tangible Fixed Assets

Assets are stated in the Balance as their value to the business, usually equivalent to their NRC. This is generally derived from the asset’s Gross replacement cost and is the current purchase price of an identical new asset or the cost of a modern equivalent asset (MEA) with the same service potential.

Changes in asset values are referred to as unrealised holding gains or losses. These include other movements, which are taken directly to reserves in historical cost accounting. The effect of the asset revaluation on the Profit and Loss Statement (P+L) is to increase the historical cost profit by any unrealised holding gains arising in the year and to decrease it by unrealised holding losses. In the Financial Statements, unrealised holding gains for the various categories of fixed assets are treated in the same way as depreciation, so that losses increase costs and gains reduce them. Current cost adjustments to the P+L and Balance Sheet (B/S) values are allocated to Businesses using the same principles and processes as the HCA values for the assets to which they relate.

A.2.3 Choice of valuation method

The valuation methods used for the various asset categories are reviewed each time valuations are prepared to ensure that they are still appropriate in the light of changes in technology and levels of investment. For example, when a new technology is being introduced the purchase price will represent its current cost but in later periods indexation or an absolute valuation will be introduced as prices change and/or the technology of the asset is no longer “modern”.

If the technology of an asset is still “modern” the asset is valued on a like-for-like basis but at current prices rather than the prices when purchased.

Existing technology Where an asset is being revalued on a direct replacement cost basis its replacement cost is usually assessed either by indexation or by absolute valuation. The choice of method involves a judgment as to which method is likely to give a more accurate and robust valuation. Factors considered include the following:

Indexation: This is an appropriate method where there has been little technological change in the asset category and all the direct costs associated with bringing the asset into service that would be incurred if it were to be replaced today. A major advantage of indexation is that the valuation is directly linked to the HCA values of fixed assets, so any assets recorded in the HCA accounts are included in the CCA valuation.

Absolute valuation: In using the indexation method there may be difficulties in establishing appropriate indices and hence it may be more accurate and reliable to use physical volumes and unit prices to derive an absolute valuation. This method in turn may present difficulties. For example, in establishing meaningful current unit prices, the choice of method for a particular asset depends on individual circumstances.

44

Modern Equivalent Asset

In situations where there is technological change, existing assets would not be replaced in an identical form. In such cases the replacement cost is based on the cost of an MEA, that is, the cost of a modern asset with similar service potential. In some cases the rate at which modern assets can be introduced is limited by practical constraints such as manufacturing capacity and lead times. In these instances and where BT has definitive plans to replace the existing assets, the mix of technologies used as the MEA for valuation in BT is generally taken as that forecast to be in place in three years time. The problems of assessing capacity and unit costs are the same as for any absolute valuation, as described above.

Low value/ Short Life Where assets have a relatively low value the asset is accounted for at its historical cost and is not re-valued. Similarly, where the life of the asset is relatively short, such that there is unlikely to be a significant difference between the cost of the asset at the date of acquisition and its gross replacement cost, the asset is not re-valued but retained at its HCA value.

A.2.4 Cost Adjustments

Operating cost adjustments

If there are material differences in operating costs between the MEA and the existing asset, the MEA valuation of the existing asset is adjusted to reflect these. The differences may arise, for example, due to differing maintenance costs over the whole lives of the assets.

At present for assets valued using an MEA approach there are no cases where the differences have been identified as material and hence no adjustments are made.

Functionality Abatements

Where existing assets are valued using a MEA approach, the unit price of the modern asset may reflect a higher level of functionality than that of the existing asset. In such cases the MEA valuations of the existing assets are adjusted downwards to reflect the estimated cost of upgrading these assets to the functionality of the version used in the valuation.

Surplus Capacity An asset is considered to have surplus capacity only if there is capacity within the asset that is not in use and not expected to be put into use over BT’s planning horizon. Thus, assets which have capacity planned to be brought into use or which is needed to meet known planning margins are considered to be part of the operating capacity.

Where there is modularity in the provisioning of capacity, provided that a part of the modular asset is utilised or will be utilised over the planning horizon, these assets are included within the operating capacity in their entirety.

BT has not identified any assets that fall within the above definition of surplus capacity with the exception of specialised accommodation. Assets such as exchange buildings have surplus capacity resulting from the accommodation dimensioned to fit

45

analogue and mechanical exchanges. Vacant areas have arisen where space is no longer required due to the introduction of modern equivalent equipment or where existing old assets are valued on MEA basis and their accommodation requirements are therefore based on the smaller footprint of the modern assets.

Surplus capacity for specialised buildings is valued at “net realisable value”:

New Technology and its use as MEA Emerging replacement technologies are treated as separate asset categories until it is clear that their own costs are lower than those of an older technology and that they have become the modern equivalent. For example, fibre cable is being deployed in parts of the access network but its cost is not yet low enough for it to be considered as the MEA for copper cable.

In considering the use of new technology as the MEA it is assumed that there are no changes to BT’s network topology, i.e. the number of nodes and links between them are valued in the existing configuration, not as a theoretical optimised network.

Unit Costs Unit costs applied to capacity for absolute valuations are based on outturn prices where these are considered representative of the costs that would be relevant if the assets were being replaced at a normal rate in the normal course of business. It is possible that the prices currently being paid are unrepresentative, for example when ordering levels are particularly high or low, or at the end of a technology’s life. In such cases an estimate is made of the appropriate current cost with reference to internal and external data.

Choice and application of indices for Indexation Method For assets valued using the indexation method BT provides price indices for each class of asset. Cost trends based on the purchase price of the class of assets being valued are used to generate indices. Where there is divergence between known historical achievements against predicted trends, this data is taken into account to better reflect the expected movements. 31 March 1989 is generally used as the reference base, with updates made twice a year (March and September). Newer technologies have the base year set in the first year of expenditure. The indices are derived from various sources of information including the following:

the cost base of the elements of BT expenditure for stores items and contract expenditure.

external indices and cost trend studies including the Office for National Statistics information, Retail Price Index and UK average earnings figures.

These indices are used to produce index trends for each asset based upon the appropriate mix of the four cost categories (i.e. BT pay, raw materials, contract and other). The year-end valuation for each asset is built up from the asset data by vintage. Indices at 31 March (current year) are used in the year-end valuations in conjunction with the indices at 30 September (in the year of registration for the asset being valued).

46

A.3 Denmark Legislation effective from July 2000 required Denmark telecommunications regulator — National Telecoms Agency (NTA) at to develop a LRAIC model before 31 December 2002. The model is to serve as a basis for fixing prices for switched interconnection, lease of raw copper and collocation.

As a basis for the LRAIC model, two cost analyses were prepared — a topdown analysis prepared by TDC (incumbent) and a bottom-up analysis which is prepared by providers who want access to interconnection at prices calculated according to LRAIC. The topdown analysis was to be based on TDC's existing cost structures where only outdated technological solutions are replaced by optimal technology.

In April 2001, NTA released a set of guidelines (most recent document listed on website under LRAIC) for the development of the topdown model, that included a section on CCA and specific guidelines on how these adjustments should be made. These included that:

the model should use, as a starting point, replacement cost methodology to calculate current cost of assets. This basis for valuation was considered more appropriate in a regulatory setting than other methods such as Net Realisable Value (NB: current value of service potential is not mentioned).

the model should value those assets that would be replaced with assets using the same technology on the basis of absolute valuation. Any use of indexation will need to be justified by supporting documentation

Where "modern equivalent asset — MEA" is used as a basis for valuation (where technology is changing), the definition should relate to an asset that can produce the same services produced by the existing asset at lowest cost, adjusting where possible to reflect differences in operating costs, quality, asset lives and space requirements.

These guidelines also recommended that the FCM approach to capital maintenance should be used. There are four reasons given for preferring FCM to OCM.

(1) OCM becomes of limited value in a world where the mix of assets and the mix of outputs is rapidly changing, as is the case for telecommunications.

(2) Accounting data can provide essential information about whether a firm should continue or discontinue an activity and whether, from a regulator’s perspective, the firm is making acceptable, excessive or insufficient profits. However, one of the conditions for accounting information to perform this role is that it includes holding gains and losses. In other words any inferences drawn about the firm’s performance from OCM measures of profitability, either from a shareholder’s perspective or a regulator’s perspective, may be incorrect.

(3) OCM depreciation implies that the firm will not recover the cost of its investment when asset prices are falling and will over-recover its costs when asset prices are rising.

(4) Finally, the EC recommends the FCM concept on these grounds when it states:

47

The use of the OCM concept may systematically incorporate insufficient or excess returns into the level of allowed revenue (depending, respectively, on whether asset-specific inflation was expected to be lower than or higher than general inflation). This is not a desirable feature of any regulatory regime.

A.4 Other European Union members Those EU members who currently require telecommunications incumbents to provide separated reports on a CCA basis (i.e. Ireland, Spain and partially in the Netherlands and Greece30) appear to follow an approach that shares similarities to the one adopted by BT in the UK.

30 Study on the implementation of cost accounting methodologies and accounting separation by

telecommunications operators with significant market power — prepared for the European Commission DG Information Society, 3 July 2002.

48

Attachment B Simplified Illustrations of Accounting Recognitions and Financial Statements Under Various Concepts of Capital Maintenance

Concepts of capital maintenance illustrated

1. Title

FCM — nominal monetary units

Description

Financial capital maintenance — nominal monetary units invested by the shareholders or other owners in an enterprise

Synonymous with Historical cost accounting

2. Title

FCM – purchasing power

Description

Financial capital maintenance — purchasing power invested by the shareholders or other owners in an enterprise

3. Title

OCM

Description

Physical capital maintenance, illustrated here as operating capability embodied in an enterprise’s net assets.

In this Illustration, the basis for measurement of assets is assumed to be current entry values — current cost of service potential.

Concept used in The Australian Statement of Accounting Practice “Current Cost Accounting” (SAP1)

Commentary Each of the three illustrations is complete, in that it shows the accounting recognition for the effects of price changes on at least one item taken from each of the five separate elements that constitute financial statements (assets, liabilities, equity, revenues and expenses). It needs to be observed that the RAF requirements do not include all five elements, nor do they include all items within an element; therefore,

49

the RAF coverage is incomplete when viewed in the context of a total accounting system.

Assumptions An enterprise commences operations on 1 January 20X0. Its initial funds are $1,000, comprising $600 subscribed as shareholders’ equity and $400 as debt financing (interest only) at an interest rate of 6% per annum.

On 1 January 20X0, the enterprise purchases plant and machinery for $1,000. This is the enterprise’s only asset. The gross service potential of the asset is estimated to be the ability to produce 300 units of product in each year of its estimated total useful life of ten years. Both these estimates remain unchanged during the enterprise’s first three years of operations.

In each of the subsequent three years ended 31 December, the enterprise:

produces 300 units and sells them at $3.00 each for total annual sales of $900; and

incurs expenses of;

- a depreciation charge, as separately calculated under each concept;

- interest expense of $24 (being 6% x $400); and

- other expenses totalling $176.

In practice during periods of changing prices, it is likely that both the product selling price of $3 per unit and the other expenses incurred of $176 would vary both during and between periods. However, any such variations would not affect the validity of the illustrated financial statements, because:

in each of Illustrations 1 (FCM-nominal monetary units), 3 (OCM) and 4 (RPCA), both the sales transactions and the other expenses transactions would already be recorded at their current prices or costs at the transaction date and therefore no further restatement would be required; and

in Illustration 2 (FCM — purchasing power), both the sales transactions and other expenses transactions are restated to their current purchasing power at the end of the period, meaning that any variation to the assumed $3 per unit and $176 per year would affect only the quantum of the restated amounts and would not change the concepts illustrated in any way.

To enable the key concepts to be illustrated clearly, it is assumed in respect of the enterprise that:

all transactions are conducted on a cash basis;

no inventories are carried;

50

no taxation is applicable; and

no dividends are declared or paid.

These simplifications have no effect on the validity of the illustrated financial statements, and do not give rise to any significant issues in the context of the accounting systems being illustrated here.

Information relevant to changing prices is as set out below.

1/1/X0 31/12/X0 31/12/X1 31/12/X2 General price index - at point of time 100.0 110.0 108.0 112.0 - average for year 104.0 109.0 111.0 $ $ $ $ Current cost of the service potential embodied in the enterprise’s plant and

machinery 1,000 1,050 980 1,020 Replacement cost of plant and machinery identical to that owned by the enterprise 1,000 1,200 1,500 1,400

51

B.1 Illustration 1: FCM — nominal monetary units (Concept 1) 1/1/X0 31/12/X0 31/12/X1 31/12/X2 $ $ $ $ Statement of financial performance Revenue Sales 900 900 900 Expenses Depreciation 100 100 100 Interest 24 24 24 Other 176 176 176 Total expenses 300 300 300 Net profit 600 600 600 Statement of financial position Assets Plant and machinery Cost 1000 1000 1000 1000 Accumulated depreciation - 100 200 300 Written-down value 1000 900 800 700 Cash - 700 1400 2100 Total assets 1000 1600 2200 2800 Liabilities Debt financing 400 400 400 400 Net assets 600 1200 1800 2400 Equity Contributed capital 600 600 600 600 Retained profits - 600 1200 1800 Total equity 600 1200 1800 2400

52

B.2 Illustration 2: FCM — purchasing power (Concept 2)

Prefacing note This Illustration is concerned with a more complex form of an accounting system which attempts to maintain financial capital, in this case regarded as the purchasing power invested by the shareholders in the enterprise.

The system attempts this maintenance by using a general index to restate all those items in the statements of financial performance and financial position which are affected by changing prices to their (generalised) current purchasing power (“PP”) at the end of the reporting period.

In this Illustration, the amounts expressed in nominal monetary units (“NMU”) that were used in the simple first Illustration (Concept 1) have been shown again so that the items which are restated may be readily seen and comprehended.

53

FCM — purchasing power

1/1/X0 31/12/X0 31/12/X1 31/12/X2 NMU NMU PP NMU PP NMU PP $ $ $ $ $ $ $ Statement of financial performance

Revenue Sales (1) 900 952 900 891 900 908 Expenses Depreciation (3) 100 110 100 108 100 112 Interest (1) 24 25 24 24 24 24 Other (1) 176 186 176 174 176 178 Total expenses (300) (321) (300) (306) (300) (314) (Loss)/Gain - monetary assets (5)

-

(41)

-

19

-

(58)

Gain/(Loss) - monetary liabilities (6)

-

40

-

(7)

-

15

Total charges (300) (322) (300) (294) (300) (357) Net profit 600 630 600 597 600 551 Statement of change in retained profits

Retained profits - opening (7) - - 600 619 1200 1261 Net profit 600 630 600 597 600 551 Retained profits – closing 600 630 1200 1216 1800 1812 Statement of financial position Assets Plant and machinery Cost (2) 1000 1000 1100 1000 1080 1000 1120 Accumulated depreciation (4)

-

100

110

200

216

300

336

Written-down value

1000 900 990 800 864 700 784

Cash - 700 700 1400 1400 2100 2100 Total assets 1000 1600 1690 2200 2264 2800 2884 Liabilities Debt financing 400 400 400 400 400 400 400 Net assets 600 1200 1290 1800 1864 2400 2484 Equity Contributed capital (8) 600 600 660 600 648 600 672 Retained profits - 600 630 1200 1216 1800 1812 Total equity 600 1200 1290 1800 1864 2400 2484

54

B.2.1 Notes on FCM — purchasing power

31/12/X0 31/12/X1 31/12/X2 1. Sales revenue, interest expense and other

expenses are all assumed to occur evenly throughout the year, and therefore must be restated to current purchasing power at the end of the reporting period. They are each restated by a factor calculated as follows:

Price index – closing 110.0 108.0 112.0 divided by Price index – average for year 104.0 109.0 111.0 equals Restatement factor 1.057 (0.991) 1.009 2. Plant and machinery is restated from the

beginning of the period (or from the date of acquisition if this is during the period) to the end of the period, by a factor calculated as follows:

Price index – closing 110.0 108.0 112.0 divided by Price index – opening 100.0 110.0 108.0 equals Restatement factor 1.100 (0.981) 1.037 3. Depreciation expense is calculated as follows: Restated cost of plant and machinery – closing

$ 1100

1080

1120

divided by Total useful life years 10 10 10 equals Depreciation expense $ 110 108 112

4. Accumulated depreciation is, firstly, restated from the beginning of the period to the end of the period and, secondly, increased by the depreciation expense for the period, as follows:

Price index – closing 110.0 108.0 112.0 divided by Price index – opening 100.0 110.0 108.0 equals Restatement factor 1.100 (0.981) 1.037 multiplied by Accumulated depreciation – opening $ nil 110 216 equals Restated opening balance $ nil 108 224 add Depreciation expense $ 110 108 112 equals Accumulated depreciation – closing $ 110 216 336

55

31/12/X0 31/12/X1 31/12/X2 5. The only monetary asset, being cash, is an

amount fixed in money terms, and therefore is not restated. However, the enterprise incurs a “loss” on holding cash during periods when prices rise (and, conversely, makes a “gain” when prices fall). The calculations are as follows:

(a) On opening balance Price index – closing 110.0 108.0 112.0 deduct Price index – opening 100.0 110.0 108.0 equals Increase / (decrease) 10.0 (2.0) 4.0 divided by Price index – opening 100.0 110.0 108.0 multiplied by 100 equals Price index movement % 10.0 (1.818) 3.704 multiplied by Cash opening $ - 700 1400 divided by 100 equals (Loss)/gain on opening balance $ - 13 (52) (b) On increase during period Price index – closing 110.0 108.0 112.0 deduct Price index – average for year 104.0 109.0 111.0 equals Increase/(decrease) 6.0 (1.0) 1.0 divided by Price index-average for year 104.0 109.0 111.0 multiplied by100 equals Price index movement % 5.769 (0.917) 0.901 multiplied by Cash – increase during period $ 700 700 700 divided by 100 equals (Loss)/gain on increase during period $ (41) 6 (6) $ $ $ (c) (Loss)/gain on opening balance - 13 (52) (Loss)/gain on increase during period (41) 6 (6) Total (loss)/gain on monetary assets (41) 19 (58) 6. The only monetary liability, being debt financing,

is an amount fixed in money terms, and therefore is not restated. However, the enterprise makes a “gain” on being partly financed by debt during periods when prices rise (and, conversely, incurs a “loss” when prices fall). The calculations are as follows:

56

31/12/X0 31/12/X1 31/12/X2 Price index – closing 110.0 108.0 112.0 deduct Price index – opening 100.0 110.0 108.0 equals Increase/(decrease) 10.0 (2.0) 4.0 divided by Price index - opening 100.0 110.0 108.0 multiplied by 100 equals Price index movement % 10.0 (1.818) 3.704 multiplied by Debt financing – opening $ 400 400 400 divided by 100 equals Gain/(loss) on monetary liabilities $ 40 (7) 15

7. The opening balance of retained profits is restated from the beginning of the period to the end of the period, as follows:

Price index – closing 110.0 108.0 112.0 divided by Price index - opening 100.0 110.0 108.0 equals Restatement factor 1.100 (0.981) 1.037 multiplied by Retained profits – opening $ - 630 1216 equals Retained profits – closing $ - 619 1261

8. The opening balance of contributed capital is restated from the beginning of the period to the end of the period, as follows:

Price index – closing 110.0 108.0 112.0 divided by Price index – opening 100.0 110.0 108.0 equals Restatement factor 1.100 (0.981) 1.037 multiplied by Contributed capital – opening $ 600 660 648 equals Contributed capital – closing $ 660 648 672

57

B.3 Illustration 3: OCM (Concept 3) 1/1/X0 31/12/X0 31/12/X1 31/12/X2 $ $ $ $ Statement of financial performance Revenue Sales 900 900 900 Expenses Depreciation (1) 103 102 100 Interest 24 24 24 Other 176 176 176 Total expenses 303 302 300 Net profit 597 598 600 Statement of financial position Assets Plant and machinery Gross current cost 1000 1050 980 1020 Accumulated depreciation (2) - 105 196 306 Written-down current cost 1000 945 784 714 Cash - 700 1400 2100 Total assets 1000 1645 2184 2814 Liabilities Debt financing 400 400 400 400 Net assets 600 1245 1784 2414 Equity Contributed capital 600 600 600 600 Current cost reserve (3) - 48 (11) 19 Retained profits - 597 1195 1795 Total equity 600 1245 1784 2414

58

B.3.1 Notes on OCM

31/12/X0 31/12/X1 31/12/X2 1. Depreciation expense is calculated in terms of

average-for-the-period current costs, as follows:

Gross current cost - opening $ 1000 1050 980 - closing $ 1050 980 1020 Gross current cost - average $ 1025 1015 1000 divided by Total useful life years 10 10 10 equals Depreciation expense $ 102.5 101.5 100.0 rounded to $ 103 102 100 2. Accumulated depreciation is calculated in terms

of end-of-period current costs, as follows:

Expired useful life years 1 2 3 divided by Total useful life years 10 10 10 equals Portion of useful life expired % 10 20 30 multiplied by Gross current cost - closing $ 1050 980 1020 equals Accumulated depreciation $ 105 196 306 3. Current cost reserve balance is calculated as: $ $ $ Opening balance - 48 (11) Restatement of plant and machinery asset to gross current cost 50 (70) 40 Backlog depreciation credited to accumulated depreciation amount (4) (2) 11 (10) Closing balance 48 (11) 19

4. Backlog depreciation is calculated as: (a) Opening balance, to restate the accumulated

depreciation calculated in beginning-of-period current cost to end-of-period current cost:

Gross current cost-closing $ 980 1020 deduct Gross current cost-opening $ 1050 980 equals Restatement $ (70) 40 divided by Gross current cost-opening $ 1050 980 equals Restatement factor 0.0666 0.0408 multiplied by Accumulated depreciation-opening $ 105 196 equals

59

60

31/12/X0 31/12/X1 31/12/X2 Backlog - opening balance $ n/a (7) 8 (b) Current period, to restate the depreciation expense

calculated in average-for-the-period current cost to end-of-period current cost as used for accumulated depreciation:

Gross current cost-closing $ 1050 980 1020 deduct Gross current cost-average $ 1025 1015 1000 equals Gross increment $ 25 (35) 20 divided by Total useful life years 10 10 10 equals Backlog - current period $ 2.5 (3.5) 2.0 rounded to $ 2 (4) 2 $ $ $ (c) Backlog – opening balance - (7) 8 Backlog – current period 2 (4) 2 Total backlog depreciation 2 (11) 10