5. Financial Disclosure
5.1 Purpose of Financial Disclosure Requirements
62. The purpose of financial disclosure requirements is to facilitate competition by making transparentthe costs and revenues of Telecom's service areas, in order to identify whether:
- Telecom is using its natural monopoly services to subsidise its contestable activities or is treating itself more favourably than its competitors; and
- Telecom is charging excessive prices for its natural monopoly services, compared to costs.
5.2 Current Financial Disclosure Requirements
63. Section 3 of the Telecommunications (Disclosure) Regulations requires Telecom to disclose financial statements that must:
- include a profit and loss statement, a balance sheet, and a set of accounting principles;
- relate to Telecom Corporation of New Zealand's operating subsidiary Telecom New Zealand Ltd (which currently accounts for 86% of Telecom's total revenues);
- be published twice yearly, within three months of the end of the financial year, and within three months of the end of the first half of the financial year; and
- in the case of the financial statements published at the end of the financial year, be audited, comply with generally accepted accounting practices and the Eighth Schedule of the Companies Act 1955 (now interpreted to be a reference to the Financial Reporting Act 1993).
5.3 Analysis of the Current Financial Disclosure Requirements
64. The original intention of the financial disclosure requirements in 1990 was to highlight any excess prices that Telecom may charge on local telephony services, which were expected to retain natural monopoly characteristics for some time. Telecom at the time operated its local services and a limited number of other services through four regional operating companies (ROCs), while a number of other activities such as cellular services and international services were provided through different entities. The regulations originally brought into effect in 1990 accordingly applied to Telecom's ROCs only.
65. In February 1993, Telecom announced a restructuring which involved merging the four ROCs, Telecom Networks and Operations Ltd, Telecom Equipment Supplies Ltd, Telecom Repair Services Ltd, the national telephone operations office and the functions of the corporate office into a new legal entity, Telecom New Zealand Ltd.
66. A review was undertaken of the disclosure regulations, triggered by this merger. As a result of the review, the Government agreed that the financial disclosure regulations should now apply to Telecom New Zealand Ltd, as the entity most closely corresponding to provision of Telecom's local loop services. Consideration was given to more elaborate accounting separation on certain services of Telecom, but as a result of cost and complexity factors, it was decided only to require disclosure of Telecom New Zealand Ltd's financial statements.
67. The Ministry has reviewed the current financial disclosure requirements and identified a number of ways in which they may not now be fully meetingthe objectives set for financial disclosure. Particular issues are:
- Since 1993 the scope of Telecom New Zealand Ltd's activities has grown significantly (including, for example, cellular and international services). Recent experience with the electricity industry, where it has proved necessary to provide robust information on monopoly and contestable businesses, suggests there may now be a case to justify the cost and complexity of increased financial disclosure requirements.
- The financial statements of Telecom New Zealand Ltd include a mix of natural monopoly (local telephony services) and contestable services (long distance, cellular, and leased services, as well as including the hybrid fibre/coax cable network), with the range of contestable services expanding over time. Therefore, the statements do not allow the financial performance of monopoly and contestable services to be effectively assessed.
- No transparent or robust basis is required for allocating costs, revenues, assets and liabilities between the businesses (including transfer payments). This problem is exacerbated by the presence of economies of scope. Therefore, there cannot be confidence that the statements fairly reflect the performance of monopoly and contestable businesses.
- No transparent or robust basis is required for valuing the assets involved.
- The present requirements provide very little useful information beyond that provided in Telecom's published financial statements for its parent company. The parent company's published financial statements include more information on call volumes, interconnection revenues, performance measures, accounting policies and many other matters.
68. The Ministry notes that there are a range of factors which differentiate the telecommunications industry from the electricity industry, in particular technological developments eroding the natural monopoly over time and the limited scope for yardstick competition and benchmarking. However, on balance the Ministry considers the issues highlighted above are sufficient to merit making specific proposals for enhancing financial disclosure requirements
5.4 Proposed Amendments to the Current Financial Disclosure Requirements
69. The specific proposals for amending the financial disclosure regulations, and the rationale for each of these proposals, are provided below.
5.4.1 Separate Financial Statements for Monopoly and Contestable Businesses
70. Telecom would be required to publish twice yearly, within three months of the end of the financial year, and within three months of the first half of the financial year separate audited financial statements for its monopoly and contestable businesses. These would be termed the "local loop" and "other telecommunications" businesses as defined in section 5.4.2. Telecom would be required to disclose statements of financial performance, financial position, movements in equity, and cash flows, and financial performance measures for its local loop business. Telecom would be required to present a reconciliation between the information disclosed for the two businesses and the aggregated information in Telecom Corporation of New Zealand's financial report. The financial performance measures would consist of:
- Accounting return on total assets (pre-tax)%:
Earnings Before Interest and Tax
Average Total Funds Employed
- Accounting return on equity (post-tax) %:
Net Profit After Tax
Average Total Funds Employed
- Accounting rate of profit (post-tax) %:
EBIT - Cash Tax - Interest Tax Shield + Revaluations
Average Total Funds Employed - (Revaluations/2)
71. While conceptual support for the principle of disaggregation is provided by the Statement of Standard Accounting Practice No. 23, the financial statements would be required to be prepared on the basis of the avoidable cost allocation methodology discussed in section 5.4.3 and to comply with generally accepted accounting practice. The separate businesses would be regarded as independent and unrelated companies, rather than as business segments.
5.4.2 Definition of "Local Loop" and "Other Telecommunications" Businesses
72. The "local loop" and "other telecommunications" businesses would be defined in such a way that:
- the local loop business is confined solely to provision of natural monopoly telecommunications activities. Natural monopoly activities are activities which can be provided at a lower cost if they are provided by only one business, rather than two or more businesses. While it is recognised that through technological change natural monopolies in telecommunications are eroding over time, for the purposes of financial disclosure it is proposed to define the local loop specifically as the provision, support and maintenance, including as relevant the necessary billing, sales, marketing, fault reporting and repair etc, of the following telecommunications services:
- telecommunications circuits, including telephone access circuits, between customers' premises and the Telecom network;
- telecommunications switching between local telephone exchanges in the same local calling area including transmission between exchanges;
- telecommunications switching between local telephone exchanges and the long distance calls network access point in the local calling area;
- telecommunications value added services which are either primarily supported by local telephone exchanges or are provided as an integral component of telephone service, and for which there are no widely available competitive alternatives (at present this would include directories and some value addedproducts); and
- all other telecommunications activities are provided by the "other telecommunications" business.
73. Defining the "local loop" and "other telecommunications" businesses in this way means the businesses will effectively be providing services to one another and that transfer payments are being made between the businesses. These transfers may not have been made explicit before. A requirement to make transfers explicit is made in section 5.4.4.
5.4.3 Avoidable Cost Allocation Methodology to Be Used
74. The financial statements would be required to be prepared on the basis of the avoidable cost allocation methodology (ACAM). ACAM defines the local loop business as the "stand-alone" business and makes an assessment of the costs, revenues, assets and liabilities ("items") that would be avoided by the company if it did not operate its "incremental" business7. The components of the items that would not be avoided are allocated to the local loop business, and the components that would be avoided are allocated to the "other telecommunications" business.
75. Items that are directly attributable to either the local loop or "other telecommunications" businesses are allocated to that business. Items that are shared by the local loop and "other telecommunications" businesses are allocated amongst those businesses, by:
- direct allocation of any components of these items which are directly attributable to one of the businesses; and
- for any components that are not directly attributable;
- assessing the proportions of these components which are avoidable and non-avoidable; and
- allocating these components amongst the businesses on the basis of those proportions (in a manner consistent with the definition of the businesses).
76. A mandatory ACAM is necessary to avoid arbitrary allocations between the business activities. Baumol, Koehn and Willig8demonstrate that using a "fully distributed" (fully allocated) cost methodology can result in meaningless information. Using a railroad example, they showed how the financial statements for the railroad business activities could vary wildly by using different allocators - all of which are consistent with the fully distributed cost methodology9.
77. Telecom would be required to disclose the full methodology used for preparing the financial statements, including any models used, all significant assumptions and estimates underlying the calculations, and the nature of, reasons for and financial impact of any changes in methodology. Telecom would also be required to retain all data, including calculation models and associated documentation, for at least seven years.
5.4.4 Disclosure of Transfer Payments
78. Disclosure of transfer payments is necessary to ensure that Telecom is not setting these payments inappropriately in order to hide excessive charges, compared to costs, or cross-subsidies between businesses. Experience in the electricity industry suggests that without a clear specification of the details of transfer payments, disclosures will tend to be inadequate for assessing the appropriateness of transfer payments.
79. In addition, disclosure of transfer payments should facilitate interconnection negotiations by providing cost-based information relating to the provision of local loop services to contestable businesses. It should also act as a check on the comparability of Telecom's charges to itself and to its competitors.
80. Telecom would be required to disclose all material transfer payments between the "local loop" and "other telecommunications" businesses (as defined above), including:
- a detailed description of the good or service provided;
- the price and quantity and/or frequency of each good or service provided (both the unit price and the total amount paid per year would be required);
- the terms of the payment for each good or service provided; and
- the period during which the good or service was provided.
5.4.5 Items to Be Individually Disclosed
81. Telecom would be required to disclose individually the following costs, revenues, assets and liabilities in its financial statements:
- all material transfer payments;
- a range of significant items as specified in Annex 3;
- those items which form the basis of the financial performance measures; and
- all items that are of such a size, nature or incidence that their disclosure is necessary for understanding of the business.
82. This list is not exclusive and does not preclude further individual disclosures required under generally accepted accounting practice. The Ministry is particularly interested in feedback from industry on the level of disclosure that should be required for specific elements of the local loop.
83. Overall, these financial disclosure proposals are intended to focus scrutiny of Telecom's natural monopoly activities and make it more difficult for Telecom to hide any excessive profits or cross-subsidies to contestable activities by allocating items inappropriately amongst its business activities. The requirements are broadly similar to the Electricity (Information Disclosure) Regulations, and the amendments announced in 7 April 199810.
5.5 Valuation Methodology
84. The method used in valuing assets has substantial implications for Telecom's disclosed financial performance measures. At present there is no mandatory basis on which Telecom is required to value its assets. Telecom currently uses an historic cost approach. Such an approach means that the task of reasonably assessing profitability is not straightforward and requires more information and analysis to be brought to bear.
85. Use of the Optimised Deprival Valuation (ODV) methodology11has the potential to overcome this sort of problem. Under the Electricity (Information Disclosure) Regulations, electricity companies are required to use a mandatory ODV methodology (which is similar to forward-looking cost valuation methodologies). The Gas (Information Disclosure) Regulations - consistent with the Telecommunications (Disclosure) Regulations - do not include a mandatory valuation methodology, although in practice gas companies use some form of ODV methodology.
86. However, there are potential problems in introducing a mandatory ODV methodology for Telecom. In particular, rapid technological development means that assets, asset lives and replacement costs in a mandatory ODV methodology could quickly become out-of-date.
87. Telecom's ability to ramp up its valuation in order to hide monopoly charges is constrained by the inclusion of revaluations in its financial performance measures (accounting rate of profit). These revaluations will be transparent as they result in one-off jumps in rates of return. Under financial reporting standards fixed assets must be revalued at least every three years and Telecom is required to disclose the valuation methodology used. In addition, the Commerce Commission has the power to request more detailed information on asset valuation.
88. On balance, the Ministry does not consider the introduction of a mandatory ODV methodology for Telecom would be cost-effective.
5.6 Compliance Costs
89. The Ministry recognises that the proposed financial disclosure requirements are likely to involve additional costs for Telecom. While Telecom already does considerable work in identifying the costs of the KSO, the financial separation proposal will involve significant new work and start-up costs. The proposals outlined in the document are designed to achieve robust and meaningful disclosure and not to be any more onerous than absolutely necessary. The Ministry's preliminary view is that the additional costs for Telecom are likely to be justified given the economic benefits likely to arise from increased disclosure. In particular, it will facilitate competition including by bringing more pressure to bear on Telecom's prices and profits.
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