Accounting separation as an essential remedy for non-discrimination 

Marta Ienco, Senior Consultant

Although accounting separation is generally recognised as an essential remedy for ensuring a transparent enforcement of cost-orientation and non-discrimination principles, its effectiveness remains rather limited in most Member States.

The role of accounting separation

Accounting separation is the method by which price discrimination is assessed; without it, an obligation for non-discrimination is not subject to a periodic and systematic review.

Accounting separation in practice refers to the preparation of separate ‘sets of financial statements’ for different business lines of the dominant operator, and its objective is to provide transparency over the interaction and transactions between those lines. Having accounts for the disaggregated activities of the main business units increases transparency and assures other service providers in the market that there is no discrimination between the provision of services to the incumbent’s own retail business and its other business activities. This is to ensure that there is no element of unfair cross-subsidisation between the different services that dominant service operators provide (i.e. between their regulated and non-regulated activities).

The financial information generated from accounting separation is clearly of benefit to regulators, in particular when determining the ‘fair’ rates that a dominant service operator should be charging to its competitors that seek to interconnect with or gain access to its network. Separated accounts help demonstrate the relationship between the price of a wholesale input and its cost of production.

Complementary remedies for achieving the equivalence of inputs include a structural or operational separation of the dominant operator. In both cases, however, there is little evidence that the benefits of separation sufficiently exceed its costs, and it might be more sensible to implement or enhance the effectiveness of existing framework around accounting separation combined with wholesale price regulation.

The complexity of application and key principles for accounting separation

A correct implementation of accounting methodologies is a key determinant of compliance with a cost-orientation principle, particularly when cost-modeling activities are required to estimate the cost of a regulated service. There are in fact a number of accounting principles and regulatory decisions that need to be considered prior to building a cost model. International best practice suggests the following ten key principles apply:

• Cost causation. Costs should be attributed to cost components, services or business units in accordance with the activities that cause the costs to be incurred. Similarly, revenues should be attributed in accordance with the activities that cause the revenues to be achieved.
  
  
• Activity-based costing. This methodology, based on the cause of costs (cost drivers), traces and allocates costs through the activities performed and establishes a clear cause-and-effect relation between activities, their associated costs and the resulting output from those activities.
  
  
• Transparency. The methods and basis used for allocation of revenues, cost, assets and liabilities should be justified and demonstrated. Costs and revenues that are allocated should be separately identified from those that are apportioned.
  
  
• Transfer charges. Where services are provided by one business unit to another, revenues and costs should be attributed between the business units, through the establishment of transfer charges, in accordance with the activities that cause the revenues to be earned, or the costs to be incurred.
  
  
• Current cost accounting. Although separated accounts may initially be produced using historic cost-accounting techniques, there should be a migration path to current cost accounting. Under this method of accounting, the costs of all assets should reflect the modern equivalent asset value (i.e. the cost of the latest technology that provides equivalent functionality and capacity) rather than book value.
  
  
• Consistent cost standard. The cost standard used for the separated accounts – typically either fully allocated costs (FAC) or long-run incremental costs (LRIC) – should be consistent with the approach adopted for setting interconnection rates.
  
  
• Standard format. Except where justified and agreed in advance with the regulator, the format of the accounts should remain constant so as to provide consistency year to year.
  
  
• Publication. In general, the separated accounts should be prepared ready for publication, subject to approval by the regulator.
  
  
• Auditing. The service provider should arrange for the separated accounts to be audited by a professionally qualified firm of auditors, subject to pre-approval by the regulator. The auditor’s unqualified report should be submitted to the regulator alongside the separated accounts.
  
  
• Timely implementation. Separated accounts should be available within a few months of the completion of the service provider’s financial year.
  
  

However, an EU-harmonised approach based on international best practice for accounting separation is still a work in progress, most likely because of the complexity of its implementation. As reported by the ECTA scorecard, countries such as the UK and Ireland have always been best-practice countries in this respect, and other NRAs in France, Belgium, Poland, Italy and the Netherlands have recently improved the effectiveness of this remedy by establishing clear principles and transparency measures. However, many countries still suffer from lack of transparent and timely publication of information.

Figure 1 ECTA Scorecard summary results on the application of AS remedy by NRAs

Note: The figure shows the average scores assigned to the application NRAs have made of the accounting separation remedy

Source: ECTA 2008 

Cost-allocation principles will face new challenges in an NGN environment

Any approach to regulatory accounting needs to be responsive to changes in the regulatory, technology and competitive environment. The allocation principles around NGN and NGA evolution will require, for example, an understanding of the impact that the new infrastructure investments have on regulated services costs. As recently emphasised by Ofcom in ‘Changes to BT’s 2007/08 regulatory financial statements’:

“Regulatory financial statements, like any form of business information, evolve over time to reflect a range of internally and externally driven factors. These include changes to accounting policies and standards, improved understanding or knowledge of cost drivers, changes in technologies and business processes and changes in the regulatory environment.”

Conclusions

Accounting separation is a vital remedy to price regulation, especially where a certain degree of market power on the access network persists. The delay experienced by national regulators around Europe towards a harmonised approach for accounting separation instead is carrying a double risk: on one side, it is possible that by the time a full application of accounting separation occurs the accounting information required will be constrained by legacy network principles rather than driven by an understanding of next-generation investments; on the other side, there might be a rush towards the implementation of very costly remedies, such as structural separation, without investigating potential alternative access/interconnection regulatory strategies coupled with accounting separation requirements.

Marta is a Senior Consultant with Ovum in the Regulatory and Policy Practice.