Current Cost Accounting Report

CURRENT COST ACCOUNTING REPORT

RELATING TO THE

ACCOUNTING SEPARATION OF TELSTRA

FOR SECOND HALF AND FULL YEAR 2011-12

November 2012

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Overview

In 2004, the ACCC issued the Current Cost Accounts Record Keeping and Reporting Rules (CCA RKR) pursuant to a Ministerial Direction in respect of Telstra’s accounting separation. Under the CCA RKR, Telstra is required to provide the following financial statements:

·  Fixed asset statement,

·  Capital employed statement, and

·  Capital adjusted profit and loss statement.

This report provides information in those financial statements for the second half and the full financial year of 2011-12 in respect of Telstra’s core regulated services. These core services include the following regulated wholesale services provided on Telstra’s public switched telephone network (PSTN):

·  the unconditioned local loop service,

·  PSTN originating and terminating access services and

·  the local carriage service.

These financial statements have been prepared on the accounting basis of both historical cost and current cost.

This report is intended to provide general guidance only. Particular qualifications to the financial statements are discussed in the report.

It should be noted that the manner in which Telstra estimates costs and asset values in the preparation of its financial statements differs from the approach used by the ACCC in determining access prices for the regulated fixed line services.

It should also be noted that Telstra’s structural separation undertaking (SSU) came into force on 6 March 2012. The SSU contains interim equivalence and transparency arrangements which apply to Telstra’s supply of regulated services to its wholesale customers and Telstra’s own business units. These arrangements surpass those contained within the accounting separation regime. Therefore, this may be the last current cost accounting report should the Minister choose to revoke the Direction requiring the ACCC to administer the accounting separation of Telstra.

1  Introduction

In December 2002, the Government enacted the Telecommunications Competition Act 2002, which introduced a statutory framework for the enhanced accounting separation of Telstra’s wholesale and retail operations.

On 19 June 2003, the Minister for Communications, Information Technology and the Arts made the Australian Competition and Consumer Commission (Accounting Separation – Telstra Corporation Limited) Direction (No 1) 2003 for the purpose of implementing this accounting separation.

The Direction required the ACCC to establish a regular reporting regime under which Telstra would prepare half yearly financial statements based on a historical cost accounting (HCA) and current cost accounting (CCA). The ACCC was also directed to publish the reports as they relate to the ‘core services’, and comment on the accuracy of the reports and other relevant matters. The specified core services were the following regulated wholesale services:

·  the unconditioned local loop services,

·  PSTN originating and terminating access services and

·  The local carriage service.

Historical cost refers to the original purchase price of the existing asset. Current cost refers to the present-day cost of acquiring an asset that is identical or substantially similar in capacity or functionality to the existing asset in use (which may have been purchased a number of years ago).

The bases on which Telstra is required to prepare these financial statements are contained in Current Cost Accounts Record Keeping and Reporting Rules (CCA RKR) made by the ACCC under the Trade Practices Act 1974 (now the Competition and Consumer Act 2010). In addition, these reports must be prepared in a manner consistent with the existing Telecommunications Industry Regulatory Accounting Framework (RAF).

When determining access prices for a number of telecommunications services, the ACCC in the past regularly adopted the total service long-run incremental cost (TSLRIC+)[1] approach as a costing methodology. In September 2004, the ACCC revised the CCA to require using modern equivalent asset (MEA) valuations[2] and the use of financial capital maintenance (FCM)[3] as the basis of reporting. This was to ensure consistency with the ACCC’s TSLRIC+ pricing approach that was adopted at that time. Since then, there has been considerable debate and uncertainty about what constitutes an MEA for a copper network, which should be borne in mind when reading this report.

In July 2011, the ACCC issued final access determinations (FADs) for the regulated fixed line telecommunications services, in which it adopted the building block methodology commonly used in other regulated industries. This new approach is based on the actual costs of a MEA under the TSLRIC+ approach.

Therefore, it should be noted that the manner in which Telstra estimates costs and asset values in the preparation of these financial statements differs from the approach used by the ACCC in its determination of access prices for the regulated fixed line services issued in June 2012.

2  Financial statements

The following financial statements are provided at Attachments A(1) to A(4):

·  A(1) Fixed asset statements (2H and FY 2011-12)[4]

·  A(2) Capital employed statements (2H and FY 2011-12)[5]

·  A(3) Capital adjusted profit and loss statement for 2H 2011-12

·  A(4) Capital adjusted profit and loss statement for FY 2011-12.

2.1  Qualifications to the financial statements

There are a number of matters that should be considered in interpreting the enclosed financial statements. These include:

·  The extract of the financial statements provided in this report only provides limited guidance on Telstra’s overall financial performance, the financial performance of its fixed line services more generally, and the overall valuation of Telstra’s fixed line network. This is because Telstra also uses its fixed line PSTN to supply other services in addition to the ‘core services’ presented in the report. Further, Telstra also operates other networks in addition to the fixed-line PSTN.

·  A significant proportion of the reported costs are common costs of a number of services including those not covered in this report. Hence, reported costs reflect allocations made to the ‘core services’ from the overall cost pools, and changes in reported costs over time may reflect changes in these allocations as well as changes in the cost pools.

·  The financial statements are based on Telstra’s own estimate of its weighted average cost of capital (WACC), which exceeds what the ACCC considers reasonable – a higher WACC will increase the reported cost of capital and reduce the reported capital adjusted profit.

·  CCA revaluations of many of the assets used to supply the ‘core services’ have been prepared on a simple indexation basis, which is likely to have affected the accuracy of the financial statements. Further, CCA revaluations are not undertaken for those individual asset classes representing less than ten percent of the total asset values measured on the historical cost basis.

·  The concept of financial capital maintenance adopted in the CCA financial statements reduces the reported capital adjusted profit below what would be reported in nominal terms.

These matters are discussed further below.

Limited scope of financial statements

The extracts of financial statements provided in this report only cover certain core services which consist of a number of wholesale services that Telstra supplies over its fixed line PSTN. The core services covered only account for a small part of Telstra’s overall service mix for the fixed line PSTN. Further, in addition to the fixed line PSTN Telstra also operates cable and wireless networks, and supplies various retail and wholesale services over these networks. Telstra also supplies other services, such as directories and media services. As a result, the financial statements provided in this report only account for a small share of Telstra’s operating revenues and costs. Consequently, these statements only provide very limited guidance on Telstra’s overall financial performance and the overall valuation of Telstra’s fixed line network (which Telstra uses to supply both wholesale and retail services).

Common costs

A significant proportion of the costs reported for the core services are incurred in common with the supply of at least one other service. Consequently, it is necessary to allocate costs from common cost pools when preparing financial statements for each of the core services. This is done based on an assessment of the relative importance of a service to a particular cost pool.

Given the weight of common costs, these allocations can have a significant influence on the reported figures for a given service. Further, changes in costs over time or between services can reflect changes in the proportion of costs allocated to services as well as changes in the overall cost base.

WACC

A firm’s WACC is the risk-adjusted rate of return on capital required by debt and equity capital providers to the firm. It reflects the return investors could expect to earn by investing in the next best investment with equivalent risk; that is it represents the firm’s opportunity cost of capital.

In preparation of the financial statements, Telstra estimated its WACC values to be 13.92 per cent and 14.24 per cent for the first half and the full year of 2011-12 respectively. These WACC values exceed the estimates used by ACCC in making its fixed line services FADs.

A higher WACC will increase the reported cost of capital and reduce the reported capital adjusted profit. Consequently, reducing the WACC values to levels that the ACCC considers appropriate would reduce the reported cost of capital and increase the capital adjusted profit.

It is also important to note that the profit and loss statements have been prepared on a capital adjusted basis, which accounts for cost of capital when calculating the reported profit or loss.

Approach to CCA asset valuation

Under CCA, assets are to be valued at their current replacement cost rather than historical cost. This could be done primarily via one of the following methods:

·  indexation

·  absolute valuation, or

·  service potential valuation.

The indexation method involves revaluing an asset by indexing its historical/revalued value. On the other hand, both the absolute valuation method and the service potential method involve obtaining current unit price data for specific assets and multiplying this by the physical number of units currently in service. This price data incorporates volume discounts and escalations for installation and commissioning costs. Under both approaches, if an asset is not commercially available, its list price is taken to be the list price for the closest commercially-available substitute for the asset. The service potential valuation method also provides for an adjustment for the differences in service potential between the substitute (modern equivalent) asset and the existing asset.

Telstra has progressively implemented modern equivalent asset valuation in respect of switching, optical fibre, transmission and mobile network assets. In respect of its customer access network (CAN) assets (i.e. CAN copper cables, ducts and pipes), Telstra continues to employ an indexation method, which values these assets by indexing their written down values (WDV) extracted from its asset accounting system.[6]Telstra uses composite indices of labour, material and other costs to index these assets over their service lives to the end of the relevant periods.

This method is likely to give a less accurate measure of the current cost of the relevant CAN assets. However, switching to using the MEA method would require Telstra to make significant system and data improvements, and the ACCC has agreed to Telstra not making these changes while the future of the reporting requirement is unclear.

The use of the indexation method by Telstra for its CAN assets however should not be construed as the ACCC endorsing indexation valuations more generally.

Although the ACCC considers the indexation method less satisfactory, it has recently agreed that Telstra continue using this method for valuation of its CAN assets until

31 December 2012.[7] This decision recognises the significant costs involved in switching to a different valuation basis. It also takes into account the fact that the underlying reporting obligation may become superseded in future as a result of arrangements relating to Telstra’s structural separation undertaking.

Moreover, not all asset classes have been valued on a current cost accounting basis. Those asset classes representing less than ten percent of the cost base measured on a historical cost basis are not required to be valued on a current cost basis. This takes into account that revaluing these asset classes would be unlikely to have a material effect on the overall accuracy of the CCA financial statements.

These asset classes can be identified in the enclosed Fixed Asset Statement as those with the same values under HCA and CCA.

Financial capital maintenance

In determining the level of profit reported in the CCA profit and loss statements, the concept of financial capital maintenance (FCM) has been used.

FCM is concerned with maintaining the real financial capital of the company. Capital is 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. Therefore profit is only measured after provision has been made to maintain the purchasing power of opening period financial capital.

Accordingly, the CCA profit and loss statements have been adjusted to account for holding gains or losses arising from changes in the value of the assets over the relevant period, depreciation differences between historical and current cost accounting and the impact of inflation on the resources invested in the enterprise.

2.2  The extent to which the reports comply with the RAF and other requirements

Telstra has provided a written declaration to the effect that:

·  the enclosed financial statements have been prepared in compliance with the relevant record keeping rules;

·  a manual (which concerns how the relevant record keeping rules have been applied in preparing the enclosed financial statements) has been established and maintained;

·  the manual has been appropriately updated to reflect changes in Telstra’s business or structure and the requirements of the record keeping rules;

·  the enclosed financial statements have been reconciled with audited financial statements.

Telstra has also provided an audit certificate from Ernst and Young. The expressed audit opinion is to the effect that Telstra has complied, in all material aspects, with the relevant record keeping rules as measured by the criteria identified in the audit reports.

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