Group Title: computer simulation analysis of alternative methods of accounting for utility construction work in progress
Title: A computer simulation analysis of alternative methods of accounting for utility construction work in progress
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Title: A computer simulation analysis of alternative methods of accounting for utility construction work in progress
Physical Description: xv, 315 leaves. : illus. ; 28 cm.
Language: English
Creator: Quick, Gordon Douglas, 1948-
Publication Date: 1974
Copyright Date: 1974
 Subjects
Subject: Public utilities -- Accounting   ( lcsh )
Construction industry -- Accounting   ( lcsh )
Accounting -- Computer programs   ( lcsh )
Management thesis Ph. D   ( lcsh )
Dissertations, Academic -- Management -- UF   ( lcsh )
Genre: bibliography   ( marcgt )
non-fiction   ( marcgt )
 Notes
Thesis: Thesis--University of Florida.
Bibliography: Bibliography: leaves 312-314.
General Note: Typescript.
General Note: Vita.
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Bibliographic ID: UF00098349
Volume ID: VID00001
Source Institution: University of Florida
Holding Location: University of Florida
Rights Management: All rights reserved by the source institution and holding location.
Resource Identifier: alephbibnum - 000585136
oclc - 14191605
notis - ADB3768

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A COMPUTER SIMULATION ANALYSIS OF
ALTERNATIVE METHODS OF ACCOUNTING
FOR UTILITY CONSTRUCTION WORK IN PROGRESS









GORDON DOUGLAS QUICK


A DISSERTATION PRESENTED TO THE GRADUATE
COUNCIL OF THE UNIVERSITY OF FLORIDA IN PARTIAL
FULFILLMENT OF THE REQUIREMENTS FOR THE DEGREE OF
DOCTOR OF PHILOSOPHY





UNIVERSITY OF FLORIDA
























































UNIVERSITY OF FLORIDA


3 1262 08SS2 8502




























This dissertation is dedicated to--




My parents, who have always given unselfishly,

and

Jeanelle, who means everything to me.
















ACKNOWLEDGMENTS


I would like to thank the University of Florida and countless out-

standing professors for making this dream a reality. There are many

professors that provided instruction, stimulation, and friendship who

cannot be named individually; to them I express my most sincere apprecia-

tion.

I am most grateful to the members of my supervisory committee, Dr.

Eugene F. Brigham, Dr. Russ Fogler, Dr. Sanford Berg, Dr. Rick Jesse, and

Dr. Milford Tysseland for their time and effort on my behalf. A most

respectful and sincere special thanks is extended to Dr. Brigham, who as

chairman provided the guidance, criticism, and encouragement necessary

to the preparation of a dissertation.

The Public Utility Research Center and its members are gratefully

acknowledged for their financial support and the facilities made avail-

able. I am indebted to Messrs. James Taggart and Dick Koble of the Tampa

Electric Company for their most capable assistance in the developmental

stages of the project.

I would like to thank Dr. Normal Keig who, perhaps unknowingly, has

been so helpful. His frank opinions, advice, and friendship have been

most rewarding.

A special note of thanks goes to Barbara Brown, for her excellent

typing and her thoughtful assistance in so many ways.

My acknowledgments would be incomplete unless three other people

are mentioned. To my parents I owe more than I can express. Were it

iii










not for their constant prompting and encouragement, understanding and

support, I would not have aspired to, let alone achieved, this degree.

Finally, and most important, is my wife, Jeanelle, who read drafts,

edited, and helped in numerous other ways. Her greatest contribution,

however, was her tolerance, understanding, and encouragement, not only

in the preparation of the dissertation, but in the years before the dis-

sertation was even considered.
















TABLE OF CONTENTS


Pae

ACKNOWLEDGMENTS iii

LIST OF TABLES vii

LIST OF FIGURES xi

ABSTRACT xiii

CHAPTER

1 INTRODUCTION 1
Objective of the Study 2
Scope of Interest 3
Plan of the Study 4

2 PROVIDING A RETURN ON CONSTRUCTION WORK IN PROGRESS 6
The Return on Construction Work in Progress 6
The Increasing Interest in Construction Ac-
counting 10
Providing a Return on CWLP 14
Problems Encountered in Providing a Return on
CWIP 21
Summary 31

3 THE PROTOTYPE FIRMS 33
Derivation of the Alternative Firms 33
The Firm as an Aggregation of Assets 42
Illustration of the Alternative Firms with the
Single Asset Model 45
The Continuous Growth Model 64
Examination of the Results 66
Depreciation Policies 76
Summary 77
APPENDIX 79

4 THE SIMULATION MODEL 82
General Features of the Model 83
Input Options 93
Output Variables 99
Summary 113
APPENDIX A 114
Variable Definitions 115
Equations 116









TABLE OF CONTENTS (CONTINUED)


CHAPTER

APPENDIX B 125
Input Value Combinations 126
Validation of Subroutines 127
Validation of Equations 130
APPENDIX C 137

5 ANALYSIS OF THE RESULTS 169
The Typical Firm Case 170
The Atypical Firm Case 247
Conclusion 257
APPENDIX A: THE SENSITIVITY ANALYSIS 259
APPENDIX B: THE EARLY PERIODS 269
APPENDIX C: THE LARGE FIRM CONSTRUCTION PROGRAM 275
APPENDIX D: INCLUDING THE FUNDS GENERATED BY
DEPRECIATION IN THE CONSTRUCTION BUDGET 285

6 CONCLUSIONS AND IMPLICATIONS 288
A Summary of the Results, their Significance,
and Some Conclusions 288
Implications 305

BIBLIOGRAPHY 312

BIOGRAPHICAL SKETCH 315















LIST OF TABLES



TABLE

1: RATIO OF IDC TO EARNINGS BASED ON 114 ELECTRIC
COMPANIES 14

2: SUMMARY COMPARISON OF METHODS RB AND IDC 20

3: NET INCOME AND INTEREST CAPITALIZED. FOR-PRIVATE
OWNED ELECTRIC UTILITY INDUSTRY 1965-1971 28

4: RELATIONSHIP OF INTEREST DURING CONSTRUCTION TO
EARNINGS AND DIVIDENDS FOR SELECTED UTILITY
COMPANIES IN 1970 29

5: ILLUSTRATION OF THE INTEREST-TAX BENEFIT 36

6: SUMMARY OF THE KEY DIFFERENCES BETWEEN THE FIRMS 42

7: LIFE CYCLES OF ASSETS FOR A FIRM OVER A THREE-
YEAR PERIOD OF GROWTH 43

8: SINGLE ASSET: BALANCE SHEETS AND INCOME STATE-
MENTS FOR FIRM RB 48

9: SINGLE ASSET: BALANCE SHEETS AND INCOME STATE-
MENITS FOR FIRMS RB-IDC AND IDC 52

10: T-ACCOUNTS FOR FIRM RB-IDC FOR 1971 TRANSACTIONS
REGARDING IDC 54

11: SINGLE ASSET BALANCE SHEETS AND INCOME STATE-
MENTS FOR FIRM RB-IDC-ITB 56

12: COMPARISON OF RESULTS WHEN THE RATE FOR COMPUTING
IDC DIFFERS FROM THE ALLOWED RATE OF RETURN FOR
FIRM RB-IDC 61

13: SINGLE ASSET: BALANCE SHEETS AND INCOME STATE-
MENTS FOR FIRM IDC-ITB 62

14: REVENUE REQUIREMENTS: SINGLE ASSET MODEL 67

15: TIMES-INTEREST-EARNED : SINGLE ASSET MODEL 72








LIST OF TABLES (CONTINUED)


TABLE

16: REVENUES: CONTINUOUS GROWTPIH MODEL 74

17: TIMES-INTEREST-EARNED : CONTINUOUS GROWTH MODEL 76.

18: ILLUSTRATION OF THE EFFECTS OF IDC AND THE ITB
FOR FIRMS IDC-ITB-G AND IDC-ITB-N 80

19: COMPARISON OF DEPRECIATION OF FIRMS RB AND IDC 86

20: GROWTH RATE PATTERN 95

21: VALUES DERIVED USING THE NFCP 128

22: VALUES DERIVED USING TH1E LFCP 129

23: VALUES DERIVED FROM THE BOOK DEPRECIATION SUB-
ROUTINE 129

24: VALUES DERIVED FROM THE ACCELERATED DEPRECIA-
TION SUBROUTINE 130

25: INPUT VALUES FOR THE TYPICAL FIRM CASE 171

26: REVENUE REQUIREMENTS: SINGLE ASSET MODEL 176

27: SUMMARY OF TYPICAL FIRM CASE RESULTS FOR DIF-
FERENT ASSUMPTIONS 239

28: INPUT VALUES FOR THE ATYPICAL FIRM 249

29: UTILITY RATES 251

30: IDC TO EARNINGS RATIOS 251

31: IDC TO DIVIDENDS RATIOS 252

32: CASH FLOW AS A PERCENT OF THE CASH FLOW OF FIRM
RB 252

33: CASH FLOW PER SHARE AS A PERCENT OF CFS OF FIRM
RB 253

34: TIMES-INTEREST-EARNED RATIOS 254

35: PERCENTAGE CHANGE IN VARIABLES AS A RESULT OF 10
AND 20 PERCENT CHANGES IN THE EQUITY RATE OF
RETURN 264









LIST OF TABLES (CONTINUED)


TABLE

36: PERCENTAGE CHANGE IN VARIABLES AS A RESULT
OF 10 AND 20 PERCENT CHANGES IN THE GROWTH
RATE 265-

37: PERCENTAGE CHANGE IN VARIABLES AS A RESULT
OF 10 AND 20 PERCENT CHANGES IN THE DEBT
RATIO 266

38: PERCENTAGE CHANGE IN VARIABLES AS A RESULT
OF 10 AND 20 PERCENT CHANGES IN THE INTEREST
RATE 267

39: PERCENTAGE CHANGE IN VARIABLES AS A RESULT
OF INCREASING THE CONSTRUCTION PERIOD TO
SIX AND SEVEN YEARS 268

40: ONE COMPLETE CYCLE OF CONSTRUCTION PERIOD
COMBINATIONS 270

41: PERCENTAGE DIFFERENCE IN UTILITY RATES BETWEEN
THE EARLY AND STABLE PERIODS 271

42: PERCENTAGE DIFFERENCE IN IDC/EARNINGS RATIOS
BETWEEN THE EARLY AND STABLE PERIODS 272

43: PERCENTAGE DIFFERENCE IN CFS AS A PERCENT
OF FIRM RB BETWEEN THE EARLY AND STABLE
PERIODS 273

44: PERCENTAGE DIFFERENCE IN TIMES-INTEREST-
EARNED RATIOS BETWEEN THE EARLY AND STABLE
PERIODS 274

45: PERCENT OF THE ACTIVITIES .ALLOCATION DEVOTED
TO THE VARIOUS PROJECTS 276

46: STABILIZED IDC/EARNINGS RATIOS 280

47: STABILIZED IDC/DIVIDENDS RATIOS 280

48: CFS AS A PERCENT OF FIRM RB 282

49: STABILIZED TIMES-INTEREST-EARNED RATIOS 284

50: VALUES OF OUTPUT VARIABLES WITH DEPRECIATION FUNDS
INCLUDED IN THE CONSTRUCTION BUDGET 286









LIST OF TABLES (CONTINUED)


TABLE

51: PERCENTAGE CHANGE IN OUTPUT VARIABLES FROM THE
TYPICAL CASE WHEN DEPRECIATION FUNDS ARE IN-
CLUDED IN THE CONSTRUCTION BUDGET 287

52: IDC TO EARNINGS RATIOS OF 116 FIRMS IN 1972 300















LIST OF FIGURES


FIGURE

1: DERIVATION OF ALTERNATIVE FIRMS 34'

2: REVENUE REQUIREMENTS: SINGLE ASSET MODEL 69

3: TIM~ES-INTEREST-EARNED RATIOS: SINGLE ASSET
MODEL 71

4: REVENUE REQUIREMENTS: CONTINUOUS GROWTH
MODEL 73

5: TIMES-INTEREST-EARNED RATIOS: CONTINUOUS
GROWTH MODEL 75

6: PATTERN OF CWIP FOR THREE CONSTRUCTION AC-
TIVITIES 90

7: CWIP TO TOTAL ASSETS RATIOS (FIRM RB) 92

8: UTILITY RATES (NORM.) 179

9: FUTILITY RATES 182

10: IDC TO EARNINGS RATIOS (NORM.) 186

11: IDC TO DIVIDENDS RATIOS (NORM.) 188

12: CASH FLOW OF EACH FIRM AS A PERCENT OF FIRM
RB (NORM.) 190

13: CASH FLOW PER SHARE AS A PERCENT OF FIRM RE
(NORM.) 191

14: CASH FLOWS COMPARING DEPRECIATION POLICY 193

15: ADDITIONAL STOCK (NORM.) 194

16: ADDITIONAL DEBT (NORM.) 195

17: ADDITIONAL STOCK COMPARING DEPRECIATION
POLICY 196

18: TIMES-INTEREST-EARNED RATIOS (NORM.) 198








LIST OF- FIGURES (CONTINUED)


P g74

FIGURE

19: TIMIES-INTEREST-EARNED RATIOS COMPARING DEPRECIA-
TION POLICY 200

20: TIMES-INTEREST-EARNED RATIOS COMPARING DEPRECIA-
TION POLICY 201

21: RATE OF RETURN ON EQUITY SETTING THE UTILITY
RATE IN PERIOD ZERO (NORM.) 224

22: RATE OF RETURN ON THE RATE BASE SETTING THE
UTILITY RATE IN PERIOD ZERO (NORM.) 227

23: TIMES-INTEREST-EARNED RATIOS SETTING THE UTILITY
RATE IN PERIOD ZERO (NORM.) 229

24: RATE OF RETURN ON EQUITY SETTING THE UTILITY RATE
IN PERIOD ONE (NORM.) 232

25: RATE OF RETURN ON THE RATE BASE WITH ONE PER-
CENTAGE POINT LIMITS 255

26: UTILITY RATES (LFCP) 277

27: IDC TO EARNINGS RATIOS (LFCP) 279

28: CASH FLOWS PER SHARE (LFCP) 281

29: TIMIES-INTEREST-EARNED RATIOS (LFCP) 283

30: PROFITS WITH A FIXED UTILITY RATE (NORM.) 297


xii















Abstract of Dissertation Presented to the
Graduate Council of the University of Florida in Partial
Fulfillment of the Requirements for the Degree of
Doctor of Philosophy



A COMPUTER SIMULATION ANALYSIS OF
ALTERNATIVE METHODS OF ACCOUNTING
FOR UTILITY CONSTRUCTION WORK IN PROGRESS



By



Gordon Douglas Quick
December, 1974



Chairman: Eugene F. Brigham
Major Department: Management



Are the quality and stability of utilities' earnings significantly

influenced by the choice of the construction accounting method? Are

cash flows and coverage ratios affected by construction accounting?

These and many related questions are being raised with increasing fre-

quency. The purpose of this investigation was to examine the impact of

several construction accounting methods in order to provide some of the

information necessary to begin answering these and related questions.

Hopefully, this information will help utilities and their regulators

choose the "best" construction accounting method.

Under regulatory theory, service rates should be set at levels

which allow investors a fair rate of return on the investment needed to

xiii









provide that service. The theory also states that if a part of the plant

is not being used for the benefit of current customers, i.e., it is not

currently "used and useful," then current customers should not be re-

quired to provide a return on this unused plant. Since plant under con-

struction is not directly serving customers, it does not meet the used-

and-useful rule. Yet, investors have funds tied up in construction pro-

grams, and both fairness and the need to acquire capital require that

such funds earn competitive rates of return.

Several construction accounting methods were investigated, including

two basic methods which represent the "polar cases" between which the re-

sults of the other cases lie. Under one of these basic methods (referred

to as method RB), construction work in progress (CWIP) is included in the

rate base and earns a rate of return equal to that earned on used and use-

ful assets. Under the other basic method (referred to as method IDC),

CWIP is excluded from the rate base, and to provide a fair return on CWIP,

an imputed return (IDC) is calculated and reported as income. IDC income

is not cash income, but a credit added to the cost of the asset and even-

tually recovered over the useful life of the asset.

Accounting practices almost always involve compromises; rarely is

one method superior in all respects. Method IDC is clearly superior on

theoretical grounds, but may have serious practical drawbacks. Method

RB is not as theoretically appealing, but it has many practical advantages.

To illustrate the long-run effects of the alternatives, a computer

simulation model was developed and run for a wide range of assumptions

and conditions. Some of the significant findings include the following:

1. In theory, method IDC avoids the need for current
customers to pay the capital costs of assets under
construction. Given real-world conditions of rela-









tively steady growth, this result may not hold in
practice.

2. Method RB minimizes fluctuations in utility rates
and, thus, may provide customers with the best informa-
tion about future price trends.

3. Method RB has no IDC earnings and, thus, none of the
undesirable implications of high IDC to earnings
and IDC to dividends ratios.

4. Method RB produces higher cash flows and cash flows
per share.

5. Method RB produces higher coverage ratios.


Several more general results are:

1. The more discontinuous the construction program, the
greater is the fluctuation in all the variables for
all the methods.

2. With a discontinuous construction program, the
capitalization of IDC increases the fluctuation in
all the variables such that the higher the IDC rate,
the greater the fluctuation.

3. With respect to the differences found: a) the higher
the growth rate, the greater the differences and b)
the longer the average construction period, the
greater the differences.

4. The results are more significant for some firms than
for others. The higher the IDC to earnings ratio,
the greater the differences are likely to be. For
some firms, the differences will be quite substan-
tial.
















CHAPTER I

INTRODUCTION


Is the quality of earnings of many utility companies comparable to

the quality of earnings of nonregulated firms? Are utility companies'

earnings subject to instability because of construction accounting? Are

the cash flows and coverage ratios of the utilities affected by con-

struction accounting? These are a sample of the questions which are

being raised by financial analysts, academicians, regulators, and others

concerning the construction account-ing method currently used by most

utilities. Although this method is generally regarded as the "theoret-

ically correct" approach to providing a return on funds invested in con-

struction, these questions are being raised with increasing frequency.

While the investment community, utility managements, regulators, and

others each have their own feelings regarding these questions, definite

answers cannot be found. Furthermore, little has been done to evaluate

alternatives to the traditional construction accounting method.

Fortunately, much of the criticism has been followed by the sugges-

tion of alternative methods which may eliminate, or at least alleviate,

some of these criticisms. Much of the attention has been directed to-

ward one alternative which represents a sharp departure from the tradi-

tional procedures for accounting for construction. In theory, the meth-

od employed by most utilities and this often-mentioned alternative are

the two basic approaches to providing a return on funds invested in con-

struction. In practice, they represent two extremes along a continuum









and, consequently, a number of alternative procedures have been sug-

gested which lie between the two extremes. These intermediate alterna-

tives are either derived from one of the two basic approaches or repre-

sent a combination of them.



Objective of the Study

The objective of this study is to examine alternative construction

accounting methods for providing a return on public utility construction

work in progress (CHIP). In light of the current criticisms of the con-

struction accounting method most firms now use, four questions are posed

which suggest a format for exploring these alternatives:

1. Do the alternatives result in differences with respect
to certain variables?

2. If they exist, are the differences significant enough
to be of concern?

3. Are these differences such that the cost of capital
could be affected by the choice of the construction
accounting method?

4. What impact will the complexities of utility regula-
tion and the economic environment have upon the basic
theoretical results?

This study is aimed primarily at answering the first two questions. To

definitively answer the third would require an extensive empirical in-

vestigation; consequently, only a tentative answer to this question is

offered. The final question could also be the subject of a separate in-

vestigation, and we merely offer some insights into this area based on

the understanding of the alternatives developed in this study.

Although this is primarily a theoretical study rather than an em-

pirical investigation, our primary concern is with the real-world impli-

cations of the alternatives for public utilities. Thus, a secondary ob-










jective of this study is to provide enough information to allow the

reader to draw his own conclusions about the alternatives, depending on

his environmental expectations at any point in time.




Scope of Interest

This study will examine the factors which cause differences between

firms using different construction accounting treatments and the key

variables which create these differences. Regulators, customers, and

management will be concerned with these differences because they may in-

fluence the firm's cost of capital. Investors will be interested in the

differences between firms because of the potential impact on the riski-

ness of the firm. The differences will be of concern to academicians

inasmuch as different accounting treatments may alter the homogeneity of

subgroups used for study.



Regulators

The monopolistic nature of the utility industry implies the ab-

sence of the competitive forces that tend to eliminate less than optimal

construction accounting methods. Thus, regulatory bodies must thorough-

ly understand the impact of construction accounting practices on the

firm. This is necessary to assure that investors are fairly compensated

if risk differentials exist and that consumers are not required to pay

for operating or financial inefficiencies.



Customers

The customer's desires are adequately expressed in terms of two ob-

jectives: 1) Other things being equal, the customer would like service









provided at the lowest cost and 2) he would like rates established on an

equitable basis. Unfortunately, these may be conflicting goals, with

one being attainable only by partially sacrificing the other.



Management

Utility managements do not want to adopt practices which may create

risk differentials and which may raise their cost of capital. This

would place some managements at a disadvantage in the capital markets.

Capital-intensive utility companies which require large sums for capital

investment could experience serious problems in attracting capital.



Investors

Investors will be interested in whether significant differences

exist between the construction accounting methods which might alter the

riskiness of the firm. Such a risk differential would justify a differ-

ence in the rate of return allowed on equity funds. Hopefully, investors

will better understand why differences occur, and this will assist them

in making the proper assessment of the importance of these differences.



Academicians

Academicians are often in need of homogeneous samples for testing

hypotheses about cost of capital and other variables. Different con-

struction accounting methods may result in significant differences be-

tween the firms which would alter the comparability of the firms.



Plan of the Study

Chapter 2 is designed to provide the reader with a brief but fairly









complete background to the problem of providing a return on CHIP. This

is accomplished by examining the return on CWIP, briefly introducing and

comparing the two basic alternatives, and by exploring some of the prob-

lems which have provided the impetus for this investigation.

In Chapter 3 the five alternatives are introduced and then explain-

ed in detail using a highly simplified model. By reviewing the results

of this simplistic model and a slightly more realistic model, we see

that these alternatives will result in differences with respect to cer-

tain variables. However, the simple models are not detailed enough for

us to assess the magnitude of these differences. Thus, Chapter 4 des-

cribes a computer simulation model which provides enough realism to al-

low these magnitudes to be considered. This detailed explanation is

necessary, since the model is the tool used to evaluate the alternatives,

and the credibility of the model determines the credibility of the

results.

Chapter 5 presents a detailed explanation of the results of the

model and explains the causative factors affecting the variables. In

addition to the basic results, several other cases are examined to pro-

vide a broader base from which conclusions may be drawn. The final chap-

ter contains the summary and conclusions of Chapter 5, along with the im-

plications of the findings.
















CKAPTER 2

PROVIDING A RETURN ON CONSTRUCTION WORK IN PROGRESS


Providing a return on the funds invested in construction is nothing

new in public utilities. Since the early 1900's, regulators in some

jurisdictions have provided some form of compensation to investors for

funds allocated to non-revenue producing construction activities. Why,

then, has construction accounting recently become of interest to all

those concerned with public utilities? Two factors have combined to

create this current interest. However, before we examine these two

factors, it is necessary to present some general background information

concerning the return on construction work in progress (CWIP).



The Return on Construction Work in Progress

A brief discussion covering four topics will provide the necessary

background concerning the return on CWIP. We first discuss the rationale

for providing a return on CWIP and then describe it as consisting of two

components, relating to the sources of capital used to finance construe-

tion. These components are then used in exploring the foundation of a

return in regulatory history. Finally, we indicate why a separate pro-

vision for the return on CWIP is necessary.



Is a Return on Funds Allocated to Construction Warranted?

The primary justification for a return on CWIP is founded in basic

economic theory. Throughout the construction period, funds are invested









in assets which produce no current revenues. However, the individuals

who supplied the funds must be compensated. There is an opportunity

cost long recognized in economics which is based on the fact that these

funds could have been otherwise invested in current revenue-producing

activities. This foregone return should be recognized as a legitimate

cost of converting capital into a productive asset. This cost is as

valid as if funds were actually paid out to acquire the asset.

A commercial lender, such as a bank or savings and loan, that makes

a construction loan charges interest during the construction period. The

funds which utilities use for construction must be provided by someone,

whether it be equity holders, bond holders, or banks. These investors

must be compensated for providing these funds. Without this compensation

these sources of funds will seek other revenue-producing investments.

Having established that compensation must be provided, it is useful

to think of the return as consisting of two components, debt and equity.

The following discussion of these components further supports the conten-

tion that compensation must be provided.



The Components of the Return on Funds Invested in CWlP



Debt Component. There is little controversy surrounding the debt

component of the return on CWIP. This is because out-of-pocket cash ex-

penditures result from the contractual interest on borrowed funds anid,

perhaps, the dividends on preferred stock. These are real obligations

which the company must meet as a result of some of the sources of capital

used during construction.









Equity Component. Some feel that a real distinction should be made

between the debt and equity components.' With debt there is a contrac-

tual obligation, while with equity no such contractual obligation exists.

The equity component is merely an "imputed" return to common equity funds

and some have questioned the legitimacy of "creating" such a return.

This practice is not as questionable as it may first appear. Rare-

ly, if ever, can debt be obtained without some form of collateral to

guarantee repayment of the loan. In a going concern, the "collateral"

is provided by the equity holders. In the event of default or business

failure, the bond holders are paid in full before the equity holders are

even considered. In addition to providing some of the capital, equity

holders bear nearly all of the risks of construction. Without the equity

holders to assume the risks, debt capital would not be available. It

seems obvious that equity holders must also receive fair compensation.

The preceding discussions have illustrated the need for a return on

CWIP. Initially, regulatory agencies allowed only a return on the debt

component. The following discussion indicates that some provision for

the equity component has been allowed by most regulators only in the last

30 years.



The Foundation of a Return in Regulatory History2

In 1909 uniform accounting systems for electric and gas utilities




IFor example, see John H. Bickley,"CnostuinCrteIcm
and Profit?", Public Utilities Fortnightly, Vol. 88, No. 2 (July 22,
1971), pp. 32-33.

2Litke, Arthur L., "Allowance for Funds Used During Construction,"
Public Utilities Fortnightly, Vol. 90, No. 7 (September 28, 1972), pp.
21-22.









were adopted in New York and Wisconsin. Both systems provided for capi-

talizing interest paid on debt attributable to CWIP. However, until

1914 no provision was made for the equity component of CWIP. At that

time the Interstate Commerce Commission first released the Uniform Sys-

tem of Accounts for Steam Railroads. In 1922 the state regulatory com-

missions, through the National Association of Railroad and Utilities

Commissioners and in cooperation with the utilities, developed a classi-

fication of accounts which recognized an allowance for both debt and

equity capital devoted to construction. Also in 1922, the Federal Power

Commission (FPC) prescribed an accounting system which provided for an

allowance for both debt and equity components. Similar provisions were

made in the system of accounts adopted in 1936 by the FPC for electric

utilities and in 1939 for gas companies.

The relatively late acceptance of a return on CWIP is perhaps part

of the reason why a separate provision for the return is necessary. The

following discussion will briefly discuss why funds invested in CWIP are

not compensated directly, thus forcing regulators to use another method

to compensate investors for funds allocated to CWIP.



Why a Separate Provision for the Return on CWIP is Necessary

Because of the monopolistic nature of the industry, utilities are

regulated by public authorities. These regulators govern the prices

utilities may charge for their services, thereby regulating the profit,

within limits, which utilities may earn. Historically, regulators have

used the net amount of plant currently in service as an indicator of the

funds "prudently" invested. These "used and useful" assets are desig-

nated as the base upon which investors are entitled to a return. The







10

regulators also specify a rate of return which the utility company may

earn on the base. The "fair rate of return" and the "rate base" are

then used to determine the rates utility companies may charge and, con-

sequently, the profits they earn. By definition, "used and useful"

plant excludes plant under construction. Therefore, the funds devoted

to construction are not being offered any return. If a return is to be

provided on CWIP, some other allowance must be made.



The Increasing Interest in Construction Accounting

Having provided the reader with some background concerning the re-

turn on CWIP, we can now explore the reasons construction accounting has

generated so much interest in the last several years. There are essen-

tially two reasons: 1) The return on construction has become a signifi-

cant component of the total earnings of many utilities and 2) the method

currently used by most utilities has apparently created some problems.

Each factor considered individually would not present a problem for

utilities. The problems resulting from the construction accounting meth-

od used by most firms have always existed. However, as the size of the

return on construction increases relative to the total earnings of the

firm, the resulting problems become increasingly significant. As the

following discussion reveals, the return on CWIP has become an increas-

ingly large proportion of the total earnings of utilities.



The Increasing Significance of the Return
on CWIP Relative to Total Earnings

The ratio of the return on CWIP to total earnings is directly re-

lated to the bases upon which these earnings are computed; that is, the

ratio CWIP to total assets. If CWIP is large relative to total assets,







11

then the return on CWIP is large relative to the total earnings of the

firm. While aggregate statistics on CWIP as a percentage of total as-

sets are not currently available, there is every reason to believe that

the percentage has been increasing in recent years, and that this in-

crease will continue in years ahead.

The size of CWIP relative to total investment depends primarily

upon two factors: 1) the annual investment in construction relative to

total assets and 2) the average length of the construction period. Sup-

pose annual construction expenditures are 5 percent of net assets, and

the construction period is one year. In this case CWIP will represent

about 5 percent of total assets and the income from CWIP will be about

5 percent of total income.

Now suppose increased demand, stepped up environmentally-related

expenditures, and inflation combine to double investment as a percent of

net assets, to 10 percent. If the construction period remains constant,

then CWIP as a percent of total assets will double, as will CWIP income.

However, if the construction period also doubles, to two years, the com-

bined effect will be a four-fold increase in CWIP, and income from CWIP

will increase from 5 to 20 percent of total income. Thus, CWIP and its

related income increase exponentially with increases in construction ex-

penditures and in the length of the construction period.

Construction expenditures have increased dramatically in recent

years; for the electric companies, construction expenditures as a percent

of net assets rose from about 7 percent in 1962 to almost 14 percent in

1972.3 In view of the fact that the industry's reserve ratio was lower



3These percentages are based on 104 electric companies listed on
the S&P Compustat tapes.







12

at the end than at the beginning of the period, the forecast of much

higher environmentally-related expenditures, plant modifications made

necessary by the energy crisis, and so on, it seems safe to assume that

construction expenditures as a percent of net assets will remain high

if not actually continue to rise.

We have no aggregate statistics on the length of the construction

period, but from all reports this period has risen dramatically and will

continue to rise. The construction period for distribution facilities

has increased significantly, largely because of a trend toward under-

ground lines. Nuclear plants represent an increasing percentage of

generation expenditures, and these plants have very long construction

periods. Fossil fuel plants today are larger than in the past, and

larger plants take longer to build. Both increased plant sizes and en-

vironmental considerations are causing plants to be located further from

power users, and this factor and the trend toward interties has caused

an increase in transmission construction. Finally, and probably most im-

portant of all, is the shift in construction expenditures from distribu-

tion to generation:'


Percentage of construction
budget devoted to: 1962 1971

Generation 35% 56%
Transmission 24 21
Distribution 41 23
100% 100%


Since generating plants take much longer to construct than transmission

lines and distribution facilities, this shift in the construction budget,



Source: Statistical Year Book, Edison Electric Institute, 1972,
p. 59.







13

even without the changes in the individual construction categories,

would have lengthened the construction period appreciably. When all

factors are combined, it would be easy to visualize a doubling or even

tripling of the average construction period.

As noted earlier, direct evidence on the trend in the ratio of CWIP

to total assets is not currently available. However, the evidence pre-

sented indicates that the primary determinants of this ratio, construc-

tion expenditures as a percentage of total assets and the length of the

construction period, have both increased substantially. As a result, it

seems clear that the ratia CWIP to total assets must have risen dramat-

ically. And as the CWIP/assets ratio rises, so must the ratio of CWIP

income to total income.

If CWIP is excluded from the rate base, and IDCs is computed and

used as compensation for funds invested in CWIP, then the ratio of IDC

to operating income provides a direct measure of the increasing impor-

tance of construction accounting. The average ratio of IDC to earnings

for the electric companies for the period 1964 to 1972 is shown in Table

1. These figures also suggest that the importance of construction ac-

counting has increased markedly in recent years.

These facts have demonstrated that the return on CWIP has become an

increasingly significant component of the total earnings of utilities.

If the construction accounting method used by most utilities produced

satisfactory results, there would still be little interest in construc-

tion accounting. However, this widely-used method has some shortcomings,

and as the return on CHIP becomes more important relative to the total



A formal explanation of IDC is provided later, but at this point
it is sufficient to say that IDC is the return on CWIP.







14

TABLE 1

RATIO OF IDC TO EARNINGS BASED ON 114 ELECTRIC COMPANIES


Year IDC/Earnings

1964 4.03%
1965 4.09
1966 5.15
1967 7.17
1968 10.00
1969 14.14
1970 19.64
1971 25.03
1972 29.28

Source: S&P Compustat tapes.



earnings of the firm, the shortcomings of this method become much more

noticeable. But before we can explore these problems, it is necessary to

explain the construction accounting procedure used by most firms. Thus,

the next section provides a brief introduction and comparison of the

basic methods for providing a return on CWIP.



Providing a Return on CWIP

There are three basic ways a return on CWIP may be recognized. The

first method would be to allow a rate of return higher than would nor-

mally be allowed, after the plant has been placed in service. The second

way would be to allow a return currently, by including CWIP in the rate

base as the investment in CWIP is made. The third method would be to al-

low the return to be capitalized during the construction period, with it

being included as part of plant cost when computing allowable deprecia-

tion and as part of the rate base in future rate determinations.

The first method would require the determination of an increment to

the normally allowed rate of return. This higher return would be main-







15

tained until adequate to provide a return on funds invested during con-

struction. The objective is simply to allow a higher return in the

future; the increment would presumably be equivalent to the return fore-

gone during the construction period, adjusted for the time value of

money. While this is a feasible alternative, it has rarely been sug-

gested for use by regulated companies. As a result, a detailed proposal

of this nature is not available. Thus, this method is excluded from

further consideration in this study.

The second method has been advocated quite frequently. By including

the costs of construction in the current rate base, investors immediately

receive full fair compensation on funds allocated to construction The

rate of return provided on assets "used and useful" is also provided on

CWIP .

The third method is the one most commonly used today. This method

provides for an immediate return, in the form of a credit, which may or

may not represent a full fair return to investors. Whether or not it

does depends on the rate at which the return is to be calculated. This

return is also a part of the cost of the asset, which is eventually re-

covered through depreciation.

Thus, we are left with two basic procedures for providing a return

on CWIP. These two procedures are briefly explained and compared in the

discussions which follow.



Method One: Include CWIP in the Rate Base

This method is the easier of the two remaining basic methods to


Tiasueof course, that the currently allowed rate of return

is equitable.







16

understand. CWIP is included in the "rate base" which is used by regu-

lators to determine the rates necessary to provide a "fair rate of re-

turn" to investors. The same rate of return allowed on "used and use-

ful" assets is also allowed on CWIP. To the extent that the fair rate

of return is adequate, investors are fully compensated for their invest-

ment in CWIP. Under this method, current customers bear the capital

costs of construction. Under current regulatory interpretations, this

could be justified if CWIP could be defined as "used and useful." De-

fining CWIP as "used and useful" would be possible if the construction

were: 1) to lower operating costs, 2) to provide assurance of continued

service, or 3) to meet expanded needs of old customers. Making the cur-

rent rate payer bear the costs of capital would appear to be unjustified

if the construction were primarily to meet the needs of new customers.

It can be argued that current rate payers should not have to pay for as-

sets which will be "used and useful" to others in the future. This is

often countered by noting that construction is seldom for entry into

completely new areas previously without service. New construction is

mainly to replace or upgrade service in existing areas. Then, it is ar-

gued, there is little distinction between present and future customers.

This argument must assume that people do not move, which is clearly an

invalid assumption. However, a short construction period will minimize

the problem since the return would be small.

The question of shifting the burden is an important consideration

where CWIP is included in the rate base. To avoid this problem, the

capital costs of construction may be capitalized so that payment of these

costs is deferred to future periods. This is the essence of the other

basic approach to providing a return on CWIP.









Method Two: Capitalize the Return on CWIP

As an alternative to the previous method, CWIP could be segregated

and excluded from the rate base. In this way current customers will be

charged only for the investment in plant currently in service. To meet

the obligation to investors, a return could be calculated at some rate

(probably the "fair rate") and this amount would be capitalized. This

return is commonly referred to under this method as "interest during con-

struction," or IDC.7 The essence of this approach is as follows. First,

the amount of funds invested in CWlP must be determined. Then the re-

turn, or IDC, is computed as the product of CWIP and the rate of return

allowed on CWIP. This return is then credited to income on the income

statement o In addition, at the end of the period IDC is added to the

cost of construction (CWIP). Therefore, when construction is completed

and the asset is included in the rate base, the total cost of the asset

exceeds the actual dollar outlay by the amount of IDC accumulated over

the construction period. The total cost of the asset (including IDC) is

finally depreciated over its useful life. Obviously, the total cost of

the asset, or book value, is greater under this method than when CWIP

goes directly into the rate base.g



'The term "interest" in IDC is unfortunate and has created numerous
misconceptions about IDC. A more descriptively appropriate term is "al-
lowance for funds used during construction," or AFDC. "Interest" implies
that the construction program is debt financed; in reality, it is finan-
ced by the same debt-equity mix as the "used and useful" plant.

BTwo methods have been employed in the past to account for IDC. One
is to add (credit) IDC to income as mentioned above. The other is to use
the interest credit to reduce the interest expense. The net result, in
terms of earnings, is the same,

SThe cost of the asset, including IDC, is presumably close to what
it would be if the asset was purchased on a "turn-key" basis. Here the









A Comparison of the Two Basic Methods

In comparing these two methods we will examine the effect of each

on three key variables: 1) the size of the rate base, 2) customer

charges (revenues), and 3) investors' returns. This comparison is pro-

vided to begin to familiarize the reader with the basic construction ac-

counting methods which are fully developed in the next chapter.



The rate base. Given the same initial plant, then during the con-

struction period the rate base will be higher for the method which in-

cludes CWIP in the rate base (hereafter the rate base method is referred

to as method RB). This is because this method includes CWIP in the rate

base as soon as the funds are used in construction. Conversely, where

IDC is capitalized (hereafter referred to as method IDC), no costs re-

lating to construction are included in the rate base during the construc-

tion period. Therefore, for method IDC, the rate base will be lower by

the amount of CWIP throughout the construction period. The situation is

reversed once construction is completed and the asset is placed in ser-

vice. For method RB, there is no change in the rate base. But for meth-

od IDC, the total amount of CWIP, which includes accumulated IDC, is now

included in the rate base. Therefore, for the period following construc-

tion and until the asset is fully depreciated, the rate base will be

larger for method IDC. The difference will always be the net amount of

accumulated IDC.


contractor would add a profit, as well as a cost of debt used during the
construction period, that would be roughly equivalent to IDC.







19

Customer charges (revenues). The cost to the customer is deter-

mined, in part, by multiplying the rate base by the allowed rate of re-

turn. Since the rate base is higher when CWIP is included in it, cus-

tomer charges will also be higher during the construction period for

method RB. Once the asset goes "on line," customer charges will be

higher for method IDC, in direct proportion to the amount of IDC includ-

ed in CWIP. From this we see that current customers bear part of the as-

set cost under method RB, while future customers pay the full cost under

method IDC.



Investors' returns. Investors will be fairly compensated by either

method as long as these methods are handled properly.10 Using method

RB, investors receive an immediate return at a rate identical to the fair

rate of return on funds invested in "used and useful" assets. Under

method IDC, investors receive a deferred return, or credit, at the rate

specified for calculating IDC. If this rate is equal to the fair rate

of return, the compensation under both methods is the same.

Table 2 presents a summary of the comparison and is sufficient to

illustrate that significant differences exist between the two basic meth-

ods of providing a return on CWIP. We shall now explore the usage of

these methods by regulated and nonregulated firms.



Use of the Two Basic Methods

This section explores the available data on the actual usage of the



As long as these methods are handled properly" is a critical
qualification which may not be met in the real world. In later chapters
we discuss some of the implications when this qualification does not
hold.















RB IDC

Include CWIP in the
rate base during
construction Yes No

Capital costs borne by Present Those who benefit.
customers from the asset

The rate of return on
CWIP is equal to Rate of return The IDC rate
on the rate base




basic methods of providing a return on CWIP by regulated firms. Unfor-

tunately, complete and timely data are not readily available. However,

these data provide some idea of the relative use of the two methods.

A study by Goodbody and Company in 1964 indicated that approximately

90 percent of the gas and electric utility companies in this country use

method IDC." Another study by Haskins and Sells found similar results:

Of a group of 138 gas and electric companies with revenues in excess of

$20 million each, 124 companies, or 89.9 percent, capitalized interest

during construction in 1963 and 1964.' After a detailed examination of

reports filed by 212 electric utilities with the Federal Power Comrmission

in 1966, another writer reported that 171, or 80.7 percent, of these

companies capitalized IDC, while 41 did not.' In 1968, of these same



Sayad, Homer E., "An Accountant Looks at Capitalized Interest,"
Haskins and Sells--Selected Papers, 1966, p. 122.

"Ibid.

M3orris, Everett L., "Capitalization of Interest on Construction:
Time for Reappraisal?", Public Utilities Fortnightly, Vol. 87, No. 5
(March 4, 1971), p. 24.


20

TABLE 2

SUMMARY COMPARISON OF METHODS RB AND IDC






21

212 companies, the number which capitalized IDC had increased to 174, or

82.1%.

These studies indicate that the large majority of utility companies

follow method IDC. None of the studies reported mentioned how many

companies followed method RB; most of those which did not capitalize IDC

apparently did not make any provision for a return on CWIP. Presumably

most of these are smaller companies which do not have substantial con-

struction programs. However, a few may have used method RB.

It is interesting to contrast these findings with similar statistics

on industrial companies. Of a sample of 77 companies from Fortune's 500,

61 responded and not one reported any capitalized interest in 1968."

The accounting procedures applicable to nonregulated firms do not permit

an investment to generate a reported profit, so this finding is not sur-

prising. Industrial companies can adjust prices, hence rates of return,

within the limits of the free market, to compensate investors for funds

employed during construction. Because of the restrictions imposed on

regulated firms, they cannot adjust prices and rates of return to recoup

the return foregone during construction. Consequently, regulated firms

are permitted to capitalize the return and report it as profit.



Problems Encountered in Providing
a Return on CWIP

Among utility companies, IDC is the most widely used method for pro-

viding a return on CWIP. Unfortunately, the use of IDC is beset with

several problems, some concerning implementation and others relating to

the firm's performance. There are three problems in implementing method







22

IDC which are best expressed as questions: 1) What is the proper rate

of return on CWIP?, 2) What is the proper base for computing IDC?, and

3) Are the goals of financial reporting helped or hindered by the use of

method IDC? While these problems have arisen primarily in connection

with the use of IDC, when appropriate we also briefly indicate how meth-

od RB compares with regard to each issue.



What is the Proper Rate of Return on CWIP?

As a practical matter, determining a specific rate of return on

CWIP is difficult enough even if the theoretical rate is agreed upon, and

although the IDC method has been in use for many years, no agreement has

been reached on what the theoretical rate of return on CWIP should be.

This issue must be resolved before a comprehensive, final evaluation of

the methods can be achieved.

Arguments have been made in favor of a rate as low as the after-tax

cost of short-term debt up to a rate as high as the current (or marginal)

weighted cost of capital. Since all funds have a cost, the lower limit

is set by the least expensive source of funds. This lower limit can gen-

erally be regarded as the after-tax cost of short-term debt. Conversely),

equity is usually the most expensive source of funds, and equity is fully

taxable. Since common equity holders assume most of the risks of con-

struction, they must also be compensated. In general, most people argue

for a rate which is a weighted average of the after-tax cost of debt and

the equity rate.Is

Method RB does not require the specification of a separate rate of



"Discussion of a more specific rate of return on CWIP is deferred
to the next chapter.







23

return on CWIP since CWIP is included in the rate base and earns the

same rate as funds invested in "used and useful" plant.



What is the Proper Base for Computing IDC?

This issue is related to the previous discussion in that they both

affect the compensation investors receive on CWIP. Logically, it would

appear that all construction investment not included in the rate base

should be included in the base for computing IDC. However, this is not

always the case. IDC is generally computed only on projects which ex-

tend over a specified period of time (e.g. a month) or exceed a certain

dollar amount. If a large number of projects do not meet these specifi-

cations, a significant amount of CWIP will not earn a return.



Are the Goals of Financial Reporting Helped or Hindered by
the Use of Method IDC?

The accounting procedures currently specified by regulatory agencies

fail to separate the impact of construction activities from the operating

results of the company.' This makes it difficult to assess the opera-

ting results of the company apart from its construction activities. The

separation of utility and construction results is even less clear under

method RB than under method IDC.

Another accounting principle, matching costs and revenues, is ac-

complished through the use of method IDC but not RB. Under the IDC meth-

od, the capital costs of construction (IDC) are deferred until the plant

is placed in service and revenues to offset these costs are being gener-



Frazer, R. E. and R. C. Ranson, "Is Interest During Construction
'Funny Money'?", Public Utilities Fortnightly, Vol. 90, No. 13 (December
21, 1972), pp. 23-27.







24

ated. Method RB would not satisfy this requirement, since the capital

costs of construction are paid out of current revenues and are not de-

rived from the plant under construction.

Concerning the performance of utility companies, four areas have

been mentioned where problems might exist: 1) cash flows, 2) times-

Lnterest-earned ratios, 3) earnings instability, and 4) the quality of

earnings. Although the implementation problems are quite important,

they are not as amenable to objective evaluation as are utility perfor-

mance measures. Thus, this study is more concerned with the problem

areas which can be explored objectively. Although these problems have

also arisen primarily from the use of method IDC, we again provide some

comments, where appropriate, about the impact of method RB on these prob-

lem areas.



Reduced Cash Flows

During periods of large, sustained construction activity, a cash

flow problem may develop. This is caused by a number of related factors,

the primary one being that IDC is non-cash income. When dividends are

paid based on total earnings (including IDC credits), the size of the

dividend and thus the cash outflow are larger because of IDC. There is

not a corresponding inflow of cash from IDC to offset the outflow. In

addition, construction itself results in increased cash expenditures.

Finally, increased interest payments result in reduced taxes, which in

turn cause operating income to be overstated." To avoid this over-

statement, utility rates might be reduced, further reducing cash flow.



"A more thorough discussion of this syndrome is provided in the
next chapter.







25

As a consequence of these factors, cash flow is reduced more by

construction programs if the IDC method is used. When projects go "on

line," full revenues are generated (given adequate demand) and cash flow

is increased. Under method RB, operating revenues are provided on both

"used and useful" plant and CWIP, and the result is that the cash flow

problem is eased.



Lower Times-Interes t-Earned Ratios

Since IDC earnings are "imputed" credits which do not result in

cash inflows, they are frequently excluded when computing coverage ratios

on bond interest. If these ratios become too low, the utility's bonds

may be downgraded, and this would raise the rates for future bond issues,

thus raising the overall cost of capital to the company.

The use of method RB will not result in a similar interest coverage

problem. Provided rates are set at the appropriate levels, full cash

revenues are generated on CWIP investment causing no reduction in fixed

charge coverage ratios.'



Earnings Instability'

Financial analysts are particularly concerned over the potential in-

stability of earnings when IDC is capitalized. Earnings instability may

occur because IDC credits boost reported earnings as long as CWIP exists,



'However, lags or other problems may prevent rates from being set
at the appropriate levels resulting in a fixed charge coverage problem
similar to that encountered when using method IDC.

For a good discussion of impact of earnings instability on the
firm, see Richard Schramm and Roger Sherman, "Profit Risk Management and
the Theory of the Firm," Southern Economic Journal, Vol. 40, No. 3 (Jan-
uary 1974), pp. 354-357.







26

but when the project is completed and IDC is no longer being earned,

earnings fall until demand is sufficient to provide full use of the new

plant. If demand builds up slowly, as often occurs, sufficient revenues

will not be generated immediately to offset the loss of IDC credits.

Earnings could be maintained through a rate increase, but this is un-

likely if demand is expected to rise enough to provide adequate returns

in the future, and in any event, lags will be encountered. The problem

can become quite severe if construction is discontinuous or "1umpy." On

the other hand, this problem does not exist if new construction projects,

and thus IDC credits, arise continually.

Method RB may result in a different earnings instability problem.

Under this method, CWIP is included immediately in the rate base. With

significant amounts of investment in construction, the rate base will in-

crease to the point where the earnings from current operations are no

longer sufficient to provide a fair return on the rate base (including

CWIP). To generate a fair return from the existing operating base,

customer rates may have to be increased. After construction is complete

and the plant goes "on line," earnings will increase since the operating

base is larger and demand is growing. Since the rate base does not in-

crease when the plant goes "on line," the increased revenues from grow-

ing demand provide a return in excess of the fair return. This necessi-

tates a reduction in customer rates. This procedure will produce a rise

in earnings when demand is constant and reduction in earnings when de-

mand is expanding. Again, this potential instability problem will be

minimal if the construction program ib stable and continuous.

Whether or not an instability problem will occur depends upon a

number of other factors, including the pattern of growth in demand and







27

economies of scale. It is quite possible that the pattern of demand

grDwth COuld differ from firm to firm. As a result, one firm could have

an earnings instability problem while another, using the same construc-

tion accounting method, may not. For example, if demand grew at a pace

identical to the growth in investment, revenues would grow at a rate

sufficient to provide a fairly constant return on investment, using

method RB. The same could be true depending on the economies of scale

the firm achieves during expansion.



Reduced quality of Earnings

Some have argued that the quality of earnings when IDC is capital-

ized is inferior to that of companies with no IDC credits. The reasons

for this assertion include several of the issues previously discussed,

such as cash flow or earnings instability. But the real criticism is

directed primarily at the fact that IDC earnings are merely "imputed"

credits. These credits are claims to future revenues and as such are

not as highly regarded by investors and analysts as are operating reve-

nues. There is no absolute guarantee, even with regulated industries,

that future revenues will be generated. The railroad industry provides

the best example of this fact.

Several statistics reflect the severity of this problem and indicate

why analysts are questioning the quality of the earnings of many utility

companies. Table 3 presents figures on privately owned electric utilities

that report to the Federal Power Commission (FPC). Between 1965 and 1971,

net income increased 49 percent ($2.6 billion to $3.8 billion). During

this same period, capitalized interest increased 863 percent ($93.7 mil-

lion to $808.8 million). In other words, 57 percent ($715.1 million) of







28

TABLE 3

NET INCOME AND INTEREST CAPITALIZED FOR PRIVATE
OWNED ELECTRIC UTILITY INDUSTRY 1965-1971*
($ Millions)


Interest Capitalized
Reported % Net
Year Net Income Amount Income

1965 2,580.7 93.7 3.6

1966 2,749.1 127.5 4.6

1967 2,908.3 186.3 6.4

1968 2,995.5 274.7 9.2

1969 3,196.0 402.9 12.6

1970 3,407.5 588.4 17.3

1971 3,842.7 808.8 21.0

*Source: Based on E. L. Morris, "The Interest on Construction
Dilemma--A Proposed Solution," Investment Dealers'
Digest--Public Utility Survey, Section Two, Vol. 38
(August 29, 1972), p. 20.



the $1.262 billion increase in net income was attributable to capitalized

interest. While reported earnings grew at an annual compound rate of 7

percent, the rate was only 3.2 percent when capitalized interest is ex-

cluded.2o Looking at another set of data, this same result can be viewed

in another way. Table 1, presented earlier, listed the aggregate IDC/

earnings ratios of 114 companies listed on the Standard and Poor Compus-

tat tapes. Between 1964 and 1972 the ratio of IDC to earnings rose con-

tinuously from 4 percent to over 29 percent. Thus, in the aggregate,



Morris, Everett L., "The Interest on Construction Dilemma--A Pro-
posed Solution," Investment Dealers' Digest--Public Utility Survey, Sec-
tion Two, Vol. 38 (August 29, 1972), p. 20.











































36% 116%
52 198
17 142
31 105
27 102
25 104
23 96
60 225
41 129
31 125
26 90
20 93
41 140
29 99
20 95
34 123
31 130
18 106
26 103
34 97


115%
166
134
104
102
103
98
173
123
125
95
94
130
99
96
117
125
105
102
97


Based on Richard Walker, "The Capital Cost of Utility
Construction," Arthur Andersen Chronicle, Vol. 31, No.
4 (September 1971), p. 34.


"Source:


29

capitalized IDC has become a very significant part of the utility indus-

try's total reported earnings.

The problem is even more severe for many individual companies.

Table 4 shows the percentage of earnings per share represented for 20

selected companies. The portion of earnings represented by IDC credits

ranges from 17 percent all the way up to 60 percent. And the situation

continues to worsen as indicated by the increase in the average IDC to



TABLE 4

RELATIONSHIP OF INTEREST DURING CONSTRUCTION TO EARNINGS
AND DIVIDENDS FOR SELECTED UTILITY COMPANIES' IN 1970*


B C D E F

Dividends as a
3r Share % of Column B


Other T


Earnings Pe
Interest All


:otal
Net


Column A
as a % of
Column C


During Const.
~(IDC) Income

$.82
.81
.24
.74
.80
.57
.50
.95
.86
.56
.34
.30
.48
.70
.33
.67
.57
.42
.38
.68


(non-IDC)
Income

$1.48
.75
1.14
1.68
2.15
1.73
1.65
.62
1.26
1.27
.97
1.18
.68
1.71
1.34
1.30
1.27
1.87
1.11
1.32


Company

No. 1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20


Income

$2.30
1.56
1.38
2.42
2.95
2.30
2.15
1.57
2.12
1.83
1.31
1.48
1.16
2.41
1.67
1.97
1.84
2.29
1.49
2.00


Common Preferred









earnings ratio for the industry.

These non-cash earnings may also cause firms to be unable to meet

their preferred and common stock dividends. Although earnings per share

(EPS) are unaffected by IDC,2 more shares of stock will be outstanding

when construction is partially equity financed. In addition, part of the

earnings are now in the form of IDC credits. Companies may find that

they are unable to earn adequate cash income from operating revenues to

cover the payment of cash dividends on preferred and common stock. This

could seriously impair the ability of these companies to raise sufficient

capital for construction to satisfy public demand. The severity of this

problem is illustrated by columns E and F of Table 4 above.

For these reasons, investors may value IDC earnings, and the value

of the company in general, less highly than when IDC credits are not

present. To the extent that this is true, a company with large IDC

credits will have to offer a higher return on its common equity to have

securities as attractive as those of firms which do not capitalize IDC.

This results in a higher overall cost of capital and, thus, higher costs

for consumers.



Issues Relating to Method RB

There are also several issues relating to method RB which are impor-

tant and should be considered. One writer has argued that since we are

currently facing increasing costs in the production of utility services,



The impact of IDC on EPS is often misunderstood. For a thorough
discussion of this subject, see R. E. Frazer and R. C. Ranson, "Is
Interest During Construction 'Funny Money'?", Public Utilities Fortnight-
ly, Vol. 90, No. 13 (December 21, 1972), pp. 20-27.






31

.using method RB is preferable because it results in higher prices ini-

tially.2 These higher prices more accurately reflect the current trend

which may serve as a signal to consumers who can plan their expenditures

accordingly.

Method RB includes CWIP in the rate base as investments are made.

If these investments are being made continually throughout the construc-

tion period, which is usually the case, the rate base changes continual-

ly. A changing rate base may require changing utility rates if a fair

return on CWIP is to be assured. This would require a rapid rate adjust-

ment process. With the usual regulatory lag, the actual compensation

ultimately received by investors may be insufficient.

Finally, with method RB, rates may increase at a time when no new

services are being provided. Given the political nature of regulation,

raising rates as this method requires may be difficult. With the in-

creasing costs of construction and the lengthening construction periods

faced by most utilities, this problem could be severe.



su mary

This chapter has provided a brief but fairly complete introduction

to the issues involved in providing a return on CWIP. Two conclusions

were reached early in the discussion. First, it was shown that investors

must be compensated for funds allocated to CWIP. Second, current regula-

tory procedures require that the provision of a return on CWIP must be

considered separately. We also discussed the reasons construction ac-




-r01son, Charles E., "Interest Charged Construction: Economic,
Financial, and Regulatory Aspects," Public Utilities Fortnig~htly, Vol. 88,
No. 4 (August 19, 1971), pp. 31-32.







32

counting has generated so much interest in recent years. We then exam-

ined the two basic construction accounting methods which form the basis

for the evaluation presented in later chapters. The final section in-

troduced a number of problems which have evolved mainly from the use of

capitalized IDC. These problems are important in that they provide some

framework around which the alternatives are evaluated. Subsequent chap-

ters explore these issues more thoroughly and further define the specific

alternatives for providing a return on CWIP.








CHAPTER 3

THE PROTOTYPE FIRMS


Chapter 2 introduced the two basic methods for providing a return on

construction work in progress (CWIP). By altering and combining these

two basic methods, several additional methods for providing a return on

CWIP are available. These alternatives require different accounting pro-

cedures which are explained in considerable detail using a simplified set

of assumptions. Once the reader has become familiar with the alterna-

tives, a more complex model is developed, and the results of both models

are examined. These limited results are sufficient to demonstrate that

the different alternatives will produce different results.

Depreciation policy also influences many of the variables which are

examined in the analysis of the firms. Thus, we also differentiate be-

tween straight line depreciation accounting and two procedures for hand-

ling accelerated depreciation. In effect, 15 prototype firms are estab-

lished which are analyzed in subsequent chapters.



Derivation of the Alternative Firms

A number of suggestions have been made which represent variations on

the two basic methods. Figure 1 illustrates the derivation of six alter-

native firms from the two basic methods and the mnemonic symbols that

will be used when referring to each of the firms.' The derivation of

these firms is presented below.



IIt seems most useful to think of a number of similar firms which
differ only in the method chosen for handling the return on CWIP. Thus,
rather than speak of alternative methods for providing a return on CWIP,
we shall speak of alternative firms which employ these methods.

















Capitalize
IDC


Include CWIP in
the Rate Base


.locate


RB RB-IDC RB-%IDC-ITB


IDC IDC-ITB-G


IDC-ITB-N


FIGURE 1


DERIVATION OF ALTERNATIVE FIRMS









Firm RB

Firm RB employs one of the two basic methods for providing a return

on CWIP. This firm includes the full amount of CHIP in the rate base

and, therefore, theoretically earns the same rate of return on CWIP as

is earned on used and useful assets. There is no capitalization of IDC,

and, thus, only the actual dollar investments are included in CWIP and,

eventually, the rate base.



Firm RB-IDC

Like Firm RB, Firm RB-IDC includes CWIP in the rate base and earns

a rate of return on CWIP equivalent to the rate of return on used and

useful assets. However, this firm also capitalizes IDC at the gross

rate and includes IDC "above the line" for rate making purposes. "Above

the line" means that IDc: is included as a part of operating income for

the purposes of determining the revenues required to provide an adequate

return on the rate base. For example, if net operating income of $1,000

were required to provide the allowed rate of return on the rate base and

the amount of IDC was $200, then only $800, rather than $1,000, would

have to be generated from the firm's customers. This does not provide a

double return on CWIP, since the income generated in the form of IDC re-

duces what must be generated through customer revenues.



Firm RB-%IDC-ITB

Like the previous two firms, this firm includes CWIP in the rate



'The term "gross," as used in connection with the IDC rate, means
that IDC is capitalized at the before-tax cost of capital, however de-
termined. The "net" rate is the after-tax cost of capital.







36

base and earns a rate of return on CWILP equivalent to the rate of return

on used and useful assets. This firm also capitalizes IDC and, like

Firm RB-IDC, includes capitalized IDC above the line. However, this

firm capitalizes IDC at a very low rate, at a rate equal to the debt

component of the IDC rate. For example, if CWIP were financed equally

by debt and equity, and the interest rate was 8 percent, then the debt

component of the IDC rate would be 4 percent (8 percent x .5). This

figure would be the rate at which IDC is computed. But Firm RB-%IDC-ITB

also allocates the interest-tax benefit (ITB) which results from con-

struction. Table 5 illustrates the origin of the interest-tax benefit.

Part A of Table 5 shows the income statement of a firm which has no CWIP.

Assets are $1,000, financed equally by debt and equity, with debt requir-

ing 8 percent interest and equity earning a 12 percent return. Part B

shows the same firm with $100 of CWIP, financed equally by debt and



TABLE 5

ILLUSTRATION OF THE INTEREST-TAX BENEFIT


Income Statements
A B
Firm With Firm With
No Construction Construction

Revenues $410.00 $410.00
Operating Expenses
(including depreciation) $250.00 $250.00
Taxes 60.00 58.00
Interest-Tax Benefit* -0- 310.00 2.00 310.00
Net Operating Income $100.00 $100.00
IDC 10.00
Adjusted NOI $110.00
Interest Expense 40.00 44.00
Net Income 1-99122 A Afri

*Normally the interest-tax benefit is simply a debit to the income
tax expense. It is shown this way merely for emphasis.










equity. With increased debt due to construction, interest payments have

risen $4, and as the tax calculation reveals, taxes are $2 less. Since

nothing else changed in the example, the reduction in taxes must be

caused by construction. It can be argued that this tax saving, which is

caused by the interest payments on funds borrowed to finance construc-

tion, should be allocated (credited) to the CWIP account. Since the tax

saving results from the construction program, it should be used to reduce

the cost of construction. The effect of the procedures followed by this

firm is to capitalize IDC at an effective rate equivalent to the after-

tax cost of debt times the debt ratio, or 2 percent for the example used

above. The return on CWIP financed by debt is provided by IDC credits,

while the return on CWIP financed by equity is generated from operating

revenues.

The first basic method and two variations on it have yielded three

alternative firms. These firms have significant differences which will

become more clear when each firm is fully illustrated using the single

asset model. The final three firms discussed in this section derive

from the procedure whereby IDC is capitalized as a means of providing a

return on CWIP.



Firm IDC

Firm IDC includes no CWlP in the rate base, but computes IDC on CWIP

at the "gross"3 IDC rate. This imputed amount is the only means by which

a return is provided on CWIP. IDC also becomes a part of the cost of the

asset and is, therefore, included in CWIP, The most difficult and still


As defined in footnote 2.







38

unresolved question which arises for this and the next two firms is the

rate at which to capitalize IDC.



IDC rate. From the viewpoint of the stockholders, the IDC rate is

a crucial issue for Firms IDC, IDC-ITB-G, and IDC-ITB-N. In these firms

the amount of capitalized IDC is the only return investors receive.

Firms RB, RB-IDC, and RB-%IDC-ITB include CWIP in the rate base, and in

doing so earn a rate of return on CWlP equal to the rate of return earn-

ed on used and useful assets. For these firms the amount of IDC reduces

merely the amount of revenues which must be generated through customer

payments. Therefore, the IDC rate is crucial mainly to Firms IDC,

IDC-ITB-G, and IDC-ITB-N, for the rate at which IDC is computed deter-

nines the rate of return earned on CWIP. If IDC is computed at a rate

of 10 percent of CWIP, investors earn a rate of return of 10 percent on

CWIP.

The IDC rate is important for another reason. The proper rate is

necessary to accurately reflect the cost of the plant under construction.

IDC becomes part of the base upon which future rates are determined and

is part of the base to be depreciated and charged against future reve-

nues.

As indicated in Chapter 2, regulators have allowed a rate of return

on CWIP large enough to cover debt payments on funds borrowed for con-

struction and to provide some return on equity funds invested in con-

struction. However, they have not systematically specified, in theory,

what the rate of return on equity funds allocated to construction should

be. There are two systematic approaches to determining the IDC rate.

Both approaches have considerable merit, and both implicitly assume that

the construction program does not alter the riskiness of the entire in-









vestment.

One approach to determining the IDC rate is to use the current, or

marginal, cost of capital. The current cost of capital is computed as

the weighted average cost of those funds used specifically for construc-

tion. The cost of debt sources is the effective interest rate, and the

cost of equity sources is the equity rate of return allowed on used and

useful assets. Assuming the firm's currently allowed rate of return pro-

vides the proper return to investors before construction, then the re-

turn for funds invested in CWIP should be set at the marginal cost of

those funds. The marginal rate may be above or below the currently al-

lowed rate of return, but in either case the return would be just suffi-

clent to meet the debt payments and provide a return to equity holders

at the specified rate.4 At some future time when the sources of capital

used to finance CWIP are included in the determination of the allowed

rate, the rate of return on CWIP should be set equal to the rate allowed

on used and useful assets. This approach requires the assumption that

the sources of capital used for construction can be segregated for the

purposes of determining the marginal cost of capital. For many firms

this would be a difficult and arbitrary process. Thus, a more practical

approach may be necessary.

Another approach is to set the IDC rate equal to the average cost

of capital for the firm, or the allowed rate of return on used and use-

ful assets. From a practical standpoint, this approach has considerable



Current conditions make it likely that the marginal cost will ex-
ceed the allowed rate of return for a utility in a net investment rate
base jurisdiction. This is because the embedded cost rates of senior
security capital may well be below those in current capital markets.
However, should rates begin falling, marginal costs could be below em-
bedded cDSts.







40

merit. Regulatory bodies would not be burdened with specifying two

rates, one for used and useful assets and another for CWIP. The same

rate would apply to CWIP as well as used and useful assets. Also, firms

would not have to be able to identify the sources of capital used for

construction, thereby eliminating a possible source of conflict between

management and regulators. However, one disadvantage of this approach is

that the rate of return on CWIP would be incorrect when the current cost

of capital differed from the embedded cost. This situation could be rem-

edied by initiating rate hearings if the difference in cost rates became

serious.

There appears to be no justification for a rate which does not pro-

vide a return to equity holders equal to the rate of return earned on

used and useful assets. If regulators allow 12 percent for equity hold-

ers for investment in used and useful assets, it would be difficult to

justify a lower rate of return for that portion of CWIP financed by eq-

uity. Using the allowed rate of return on used and useful assets as the

IDC rate has two advantages. First, it requires no additional work for

regulators or management. Second, this amount is the return effectively

provided for firms which include CWIP in the rate base. Use of the al-

lowed rate provides consistency among the different methods for providing

a return on CWIP. However, firms should be able to petition for rate

changes any time the marginal cost of capital increases the embedded cost

of capital.

For the illustrations in this chapter, the IDC rate is set equal to

the allowed rate of return on used and useful assets.s This equality



In the simplified examples used in this chapter, the costs of debt
and equity are constant, making the marginal cost and the embedded cost
the same.







41

makes the firms which only capitalize IDC comparable to the firms which

include CWIP in the rate base for the analysis provided later. The last

two firms, which are variations of Firm IDC, are discussed next.



Firm IDC-ITB-G

Firm IDC-ITB-G follows the same procedures as Firm IDC but also al-

locates the ITB. The arguments brought out earlier regarding the ITB

apply here as well. It can be argued that since IDC is used to place the

burden of construction on those who benefit from it, any saving which re-

sults from construction should be passed on to those who bear the cost.

The allocation of the ITB makes the effective IDC rate lower for this

firm than for Firm IDC.



Firm IDC-ITB-N

Firm IDC-ITB-N is similar to the previous firm except that the net

rate for capitalizing IDC is used. The ITB is automatically allocated

to CWIP since by using the net rate, it is never added into the construc-

tion cost. The tax saving is listed on the income statement under other

income as an income tax credit.

The two basic methods and the variations of them have yielded five

firms which employ different methods for providing a return on CWIP.

Table 6 summarizes the key differences between these firms. It is the

different formulas for the variables shown in this table which create the

differences in revenues, taxes, profits, and the other variables. These

formulas will be useful when the procedures followed by each firm are

presented in detail. But first it will be helpful to think of the firm

from the perspective described below.









TABLE 6

SUMMARY OF THE KEY DIFFERENCES BETWEEN THE FIRMS


RB RB-IDC RB-%IDC-ITB IDC IDC-ITB-G'

Construction Work in
Progress Included
in the Rate Base Yes Yes Yes No No
Rate for Computing
Interest During
Construction' IDC-1 IDC-2 IDC-3 IDC-2 IDC-2
Rate for Computing the
Interest-Tax
Benefits ITB-1 ITB-1 ITB-2 ITB-1 ITB-2
Revenue Requirements4 RR-1 RR-2 RR-2 RR-1 RR-1

Notes_: 1. As demonstrated later, the last two firms pro-
duce identical results and it is only necessary
to consider one of them.
2. IDC Rate Formulas
IDC-1: zero (do not capitalize IDC)
IDC-2: (debt ratio x interest rate) + (1.0 debt
ratio) x equity rate
IDC-3: debt ratio x interest rate
3. ITB Rate Formulas
ITB-1: zero (do not allocate the ITB)
ITB-2: debt ratio x interest rate x tax rate
(allocate the ITB)
4. Formulas for Revenue Requirements
RR-l: Firms which include IDC below the line for
rate making purposes:
1/1 TX [DBK + AIR x RB) + ITB TX (DTX + INT)]
RR-2: Firms which include IDC above the line for
rate making purposes:
1/1 Tx [DBK + (AR x RB) IDC + ITB TX (DTX
+ INT)]
where DBK = book depreciation, AR =- allowed rate of
return, RB = rate base, ITB = interest-tax benefit, IDC
= interest during construction, DTX = tax depreciation,
and INT = interest expense.


The Firm as an Aggregation of Assets


To facilitate the explanation of the alternative procedures for

providing a return on funds invested in CWIP, it is useful to think of

the firm as an aggregation of numerous individual assets, or "'units of

plant." Every unit of plant must be financed, and they all generate







43

revenues, depreciation, and output over their useful lives. In every

case a unit of plant constructed by the firm goes through a cycle of

construction and then depreciation.

Table 7, which depicts the growth of a hypothetical firm over a

three-year period, is founded on the following two assumptions: 1) The

firm has no construction work in progress prior to the first year shown

and 2) each asset requires an investment of $100 during each year of its

construction period. In the first year, construction is initiated on

four assets, A, B, C, and D. The first asset (A) requires two years for

construction and has a useful life of four years. The other three as-

sets (B, C, and D) begun in year one have construction periods of two,

three, and four years, and useful lives of six, eight, and ten years,

respectively. With an investment of $100 required for each asset, the



TABLE 7

LIFE CYCLES OF ASSETS FOR A FIRM
OVER A THREE-YEAR PERIOD OF GROWTH


Assets Years
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16

A C C DDD D
B C CD DD D DD
C CC CD DD DD DD D
D C C C C D D D D D D D D D D
E C CD DD D
F C CD DD DD D
G C C C D D D D D D D D
H C C C D D D D D D D D)
I C C C C D D D D D D D D D D
J C C DD DD DD
K C C C D D D D D D D D
L C C C C D D D D D D D D D D

Notes: 1. The "C's" represent the years in which the asset
is under construction and costs are being incurred.
2. The "D's" represent the years in which deprecia-
tion occurs and inflows accrue.









total investment for year one is $400.

In the second year, construction is begun on five additional assets.

These assets have construction periods and useful lives similar to those

assets begun in year one. Thus, nine assets are under construction in

year two. With a $100 investment required for each asset, the total in-

vestment for year two is $900. At the end of year two, the amount of

CWIP accumulated in each asset begun in year one is $200, and the amount

of CWIP accumulated in each asset begun in year two is $100. The total

amount of CHIP at the end of year two is $1,300.6

At the beginning of the third year, construction begins on three

additional assets. At the same time, two of the assets begun in year one

are completed and go on line. This leaves ten assets still under con-

struction in year three, and will again require an additional investment

of $100 for each of them. Thus, the total investment outlay for the year

is $1,000. The two remaining assets under construction from year one

each represent $300 of accumulated CWIP, while each asset begun in year

two represents $200 of accumulated CHIP, and each asset begun in year

three represents $100 of accumulated CWIP. Therefore, the total CWIP at

the end of year three is $1,900. The $200 invested in each of the com-

pleted assets begun in year one is now included in the rate base and no

longer represents CWIP.

This hypothetical example was designed to illustrate the indepen-

dence of each asset. As the preceding discussion revealed, to determine

the total CWIP for the firm as a whole, it is only necessary to aggregate,



bEhroughout this illustration we ignore IDC since it would compli-
cate the example and add nothing to the point we are trying to make. The
procedures for dealing with IDC are explained later.






45

or sum, the amounts of CWIP associated with each asset. Similarly, the

total investment required by the firm in any period is simply the sum of

the investments required for each asset. Though not illustrated, this

independence also holds for items such as depreciation and maintenance

costs. More importantly, for regulated companies, this independence

exists for items such as revenues and IDC. Thus, to determine the value

of any of these variables for the firm, it is only necessary to sum the

value of the variables for each of the individual assets. Given this in-

dependence of assets, the procedures followed by the various firms can be

illustrated using a single asset. Consequently, to get a complete pic-

ture of each firm, a single asset which goes through the complete cycle

of construction and depreciation is all that is necessary.



Illustration of the Alternative Firms
With the Single Asset Model

Using the single asset model greatly simplifies the explanation of

the alternatives and should allow the reader to more easily follow the

presentation. The illustrations which follow consist of a series of

beginning and ending balance sheets and income statements for selected

years during the asset's life cycle. These illustrations require a num-

ber of assumptions.



General Assumptions

1. On January 1, 1971, each firm is incorporated and as-
signed a group of customers for whom it must provide
service beginning January 1, 1973. The service re-
quirement for each firm is identical, and service must
be provided for four years, from January 1, 1973 to
December 31, 1976.

2. Customers may be billed beginning January 1, 1971,
depending on the requirements of the individual firm.







46

3. The construction period is two years, from January
1, 1971 to December 31, 1972. A total investment
of $200 is required for each firm to complete
construction. Half of the investment is made on
January 1, 1971, and half on January 1, 1972.

4. The depreciable life is four years, and the de-
preciation policy followed is straight line. Cash
generated by depreciation is used to retire debt
and equity in equal proportions.

5. Revenues are based on the rate base at the beginning
of the year,

6. The return on equity is determined on equity held
at the beginning of each year. The return on equity
is always 12 percent. Equity holdings may be in-
creased or reduced with no flotation costs.

7. Operating expenses for each firm are identical
and, therefore, omitted from the income statements.

8. All profits are paid out in dividends.

9. The capital structure is always maintained at 50
percent debt and 50 percent equity.

10. The interest rate on all debt is 8 percent. Debt
may be increased or reduced at no cost, other than
the interest expense.

11. The average cost of capital is 10 percent, which is
also the allowed rate of return. The gross IDC rate
is 10 percent, and the net rate is 8 percent.

12. The tax rate is 50 percent. IDC is not taxable in-
come.

These assumptions result in firms with identical commitments, finan-

cial requirements, and service requirements. They differ only in the

method of providing a return on CWIP. For each firm, beginning and end-

ing balance sheets and income stateadnts are provided for 1971, 1972,

1973, and 1976. The first two years represent the construction period,

the third year is the year the asset goes on line, and 1976 is the last

year of the useful life of the asset. Nothing uniquely significant oc-

curs during 1974 and 1975; consequently, the data for these years are







47

not provided. The important procedures followed by each firm are fully

revealed in the years for which data are presented. For each year, the

beginning balance sheet, income statement, and ending balance sheet are

discussed and significant changes noted. The objective is to illustrate

the complete cycle of an asset and show how the different policies of

each firm are reflected in the balance sheets and income statements.

By the end of 1976, the asset constructed by each firm during 1971-1972

is fully depreciated, the service requirement has been fulfilled, and the

cycle is complete.



Firm RB

Firm RB invests $100 at the beginning of 1971, as shown in the bal-

ance sheet for January 1, 1971, in Table 8. Since Firm RB includes CWIP

in the rate base, the firm has a base upon which operating revenues may

be earned. The customers of Firm RB begin making utility payments in

1971, though service has not yet begun. This simplified example illus-

trates that, under the procedures followed by Firm RB, current customers

must pay part of the cost of an asset from which they do not currently

benefit. As the income statement shows, sufficient operating revenues

must be generated to cover taxes, interest, and profit. Net operating

income (NOI), as always, is 10 percent of the rate base. The balance

sheet at the end of the year is the same as the balance sheet at the be-

ginning of the year.

In 1972, another $100 is invested, financed equally by debt and

equity, raising CWIP to $200. The full $200 is included in the rate

base, and sufficient revenues must be generated to cover interest, taxes,

and profit. As the income statement for 1972 shows, NOI is 10 percent of









TABLE 8

SINGLE ASSET
BALANCE SHEETS AND INCOME STATEMENTS FOR FIRM RB


1971
Invest $100 for Construction


1972
Invest $100 for Construction


Balance Sheet
1/1/72


Balance Sheet


$200.00 Debt
Equity
$200 00 Total Liab.


Income Statement
Year Ending 12/31/72


$100.00
100.00
$200 00


CHIP

Total Assets


$100.00 Debt
Equity
S100.00 Total Liab.


$ 50.00
50.00
S100.00


CWlP

Total Assets


Income Statement
Year Ending 12/31/71


Revenues
Depreciation
Taxes

Interest Expense
Net Income


$32.00



8.00
$12.00


Revenues
Depreciation
Taxes
NOI
Interest: Expense
Net Income


$16.00

6.00
$10.00
4.00
f_6_00


-0-
12.00


-0_
6.00


Balance Sheet
12/31/71


Balance Sheet
12/31/72


$100.00 Debt
Equity
$100 00 Total Liab.


$ 50.00
50.00
$100.00


CWIP


$200.00 Debt
Equity
$2000 Total Liab.


$100.00
100.00
$200 00


Total Assets


Total Assets









TABLE 8 (Continued)


1973


Balance Sheet
1/1/73


Balance Sheet
1/1/76


Debt $100.00
Equity 100.00

Total Liab. $200 00


200.00
150.00


Debt $25.00
Equity 25.00

Total Liab. $50 00


Oper. Plant
Depreciation
Net Plant
Total Assets


200.00
-0-
$200.00
$20 0 0


Oper. Plant
Depreciation
Net Plant
Total Assets


$50.00
(50 00


Income Statement
Year Ending 12/31/73


Income Statement
Year Ending 12/31/76


Revenues
Depreciation
Taxes
NOI
Interest Expense
Net Income


$82.00

62.00
$20.00
8.00
$12.00


Revenues
Depreciation
Taxes
_NoI
Interest Expense
Net Income


$58.00

53.00
$ 5.00
2.00
& 3 00


50.00
3.00


50.00
12.00


Balance Sheet
12/31/76


Balance Sheet
12/31/73


Oper. Plant 200.00
Depreciation 200.00

Total sets


Debt
Equity

Total Liab.


$-0-
-0-


200.00
50.00


Debt $ 75.00
Equity 75.00

Total Liab. $150.00


Oper. Plant
Depreciation

Nota~lAssets









the rate base. Customers are again required to make payments in 1972

though service has still not begun. The balance sheet at the end of 1972

is unchanged.

At the beginning of 1973, the asset which had been under construc-

tion goes on line. The balance sheet for January 1, 1973 no longer lists

the assets as CWIP, but as operating plant. The rate base is unchanged

since the investment, as CWIP, was included before, and, as operating

plant, is included in the rate base now. The income statement for 1973

indicates that sufficient revenues must be generated to cover not only

taxes, interest and profits, but depreciation as well. NOI is again 10

percent of the rate base. The balance sheet at the end of 1973 includes

some depreciation which accumulates over the life of the asset. Debt and

equity are reduced as the net asset value falls.

By the start of 1976, accumulated depreciation has reduced the net

plant to $50, which is also the rate base. Debt and equity are both $25.

The income statement is generated as usual, with NOI 10 percent of the

rate base. By the end of 1976, the asset is fully depreciated, and the

cycle is complete.



Firm RB-IDC

Firm RB-IDC, like Firm RB, includes CWIP in the rate base, but also

capitalizes IDC at the gross rate of 10 percent. The amount of IDC is

then included above the line for rate making purposes. Since IDC is in-

cluded above the line, adjusted net operating income, rather than net

operating income, must always be 10 percent of the rate base. In 1971,

$100 is invested in construction, which is financed equally by debt and









equity. As shown in Table 9,7 IDC is calculated as 10 percent of CHIP,

or $10, Since adjusted NOI must be equal to 10 percent of the rate base,

NOI must be zero. With NOI zero, profits, for tax purposes (i.e., ex-

cluding IDC), are minus $4, or a $4 loss. Consequently, taxes are minus

$4, or a $4 credit, and revenues are minus $4.8 At the end of 1971, the

$10 of IDC is added to CWIP and debt and equity are both $5 larger.

Table 10 illustrates the "T-accounts" which help explain what actually

occurs with the creation of IDC. First, IDC is credited to other income

and simultaneously added to CWIP as a construction expense. Next, $4 in

cash is used to pay the interest expense and another $6 in cash is used

to pay dividends. Finally, $10 in cash is raised by increasing debt and

equity by $5 each to meet the $10 cash expenditure for interest and divi-

dends. All the T-accounts balance, and the balance sheet at the end of

1971 is as shown in Table 9. Similar transactions occur in every in-

stance in which IDC is capitalized.

At the beginning of 1972, another $100 is invested in construction.

The rate base is now $210, so that adjusted NOI must be $21. IDC is cal-

culated as 10 percent of CWIP, or $21 and, therefore, NOI is again zero.

For tax purposes, an $8.40 loss results, since IDC is not taxable in-

come. An $8.40 tax credit is incurred, making revenues minus $8.40 for

1972. At the end of 1972, IDC is added to CWIP and debt and equity are

again increased.



Table 9 shows the balance sheets and income statements for Firm
RB-IDC and Firm IDC. As explained after the discussion of Firm IDC, the
results for these two firms are identical, and Table 9 is used for the
illustration of both firms.

8In a more realistic situation with an on-going firm, revenues
would be $4.00 less, rather than negative. Also, taxes would simply be
lower, rather than having a credit,









TABLE 9


SINGLE ASSET
BALANCE SHEETS AND INCOME STATEMENTS FOR FIRMS RB-IDC AND IDC


1971
Invest $100 for Construction


1972
Invest $100 for Construction


Balance Sheet


Balance Sheet
1/1/72


CWIP

Total Assets


$100.00 Debt
Equity
$100.00 Total Liab.

Income Statement
Year Ending 12/31/71


$ 50.00
50.00
$100_00





-$4.00

-4.00
-0-
10.00
$10.00
4.00
$_ALER


Debt $105.00
Equity 105.00

Total Liab. $210 00


CWIP
IDC
Total
Total


200.00
10.00
CWIP
Assets


$210.00
$210 00


Income Statement
Year Ending 12/31/73


Revenues
Depreciation
Taxes
Net Oper. Income (NOI)
IDC
Adjusted NOI
Interest Exp~ense
Net Income


Revenues
Depreciation
Taxes
NOI
IDC
Adjusted NOI
Interest Expense
Net Income


-$8,40

-8.40
-0-
21.00
21.00
8.40
$12.60


-0-
-4.00


-0-
-8.40


Balance Sheet
12/31/71


Balance Sheet
12/31/72


CWIP
IDC
Total
Total


100.00
10.00
CWIP
Assets


Debt $ 55.00
Equity 55.00

Total Liab. )]JE X)


CWIP
IDC
Total
Total


200.00
31.00
CWIP
Assets


Debt
Equity
$2]31L.00
$231 00 Total Liab,


$115.50
115.50

$231 00


$110.00
$110.00
- --- -





TABLE 9 (Continued)


1976


Balance Sheet
1/1/73


Balance Sheet
1/1/76


Oper. Plant
Depreciation
Net Plant
Total Assets


231.00
-0-
$231.00
$231.00


Debt $115.50
Equity 115.50

Total Liab. $231.00


Oper. Plant
Depreciation
Net Plant
Total Assets


231.a00
173.25
$57.75
$57.75


Debt $28.875
Equity 28.875

Total Liab. $57.75


Income Statement
Year Ending 12/31/73


Income Statement
Year Ending 12/31/76


Revenues
Depreciation
Taxes

LDC
Adjusted NOI
Internst Expense


$102.46



-0-
$ 23.10
9. '





$ 86.625
86.625

$ 7 .2


Revenues
Depreciation
Taxes


AD usted NOI
IntelnsomExpense


$74.74

68.96 V


$..8


57.75
21.61


57.75
11.21


Balance Sheet
12/31/73


Balance Sheet
12/31/76


Oper. Plant
Depreciation
Net Plant
Total Assets


231.00 Debt
57.75 Equity
$173.25
$173.25 Total Liab.


Oper. Plant 231.00
Depreciation 231.00
Net Plant
Total Assets


Debt
Equity
$-0-
$-O- Total Liab.


$-0-

$-0-
















Other Income Dividend Interest
(IDC) CWIP CashExesEpee

10 (1) (1) 10 (4)(5 :5 4 (3)2)(36(2



DebtEut










At the beginning of 1973, the asset goes on line with a book value

of $231. This amount is higher than the book value of the asset of Firm

RB by the amount of accumulated IDC. The income statement is derived in

the usual manner, with one exception. For tax purposes, depreciation is

calculated only on the net-of-IDC value of the asset, or $200. To allow

the IDC part of the asset to be depreciated for tax calculations would

make the IDC income of 1971 and 1972 tax free. This procedure would pro-

vide unjustifiable benefits to firms which capitalize IDC. The tax cal-

culation for Firm RB-IDC for 1973 is illustrated below:


TABLE 10

T-ACCOUNTS FOR FIRM RB-IDC FOR 1971
TRANSACTIONS REGARDING IDC


$102.46

59.24
$ 43.22
$ 1.11


Revenues
Depreciation
Interest Expense
Taxable Income
Taxes @ 50 percent


50.00*
9.24


*Book Value
Less Accumulated IDC


$231.00
31.00
$200.00 over four years equals
'$ 50.00 per year









Straight line depreciation, for tax purposes, is $50 per year, not $57.75,

which is book depreciation. This procedure for calculating taxes is used

for all firms which capitalize IDC. The income statement for 1973 shows

that adjusted NOI is 10 percent of the rate base. The balance sheet at

the end of 1973 reveals that net plant is reduced by accumulated deprecia-

tion as it accrues over the life of the asset. Debt and equity are corres-

pondingly reduced.

At the beginning of 1976 net plant is $57.75, as is the rate base.

Debt and equity have been periodically reduced, corresponding to the net

value of the asset. The income statement is derived as usual, with NOI

10 percent of the rate base. The final balance sheet shows the asset

fully depreciated, and the cycle is complete.



Firm RB-%IDC-ITB

Firm RB-%IDC-ITB also includes CWIP in the rate base. Like Firm

RB-IDC, this firm capitalizes IDC and includes it above the line. This

again requires that adjusted NOI be equal to 10 percent of the rate base.

Firm RB-%IDC-ITB differs from Firm RB-IDC in two important respects.

First, Firm RB-%IDC-ITB calculates IDC at a lower rate of 4 percent.

Second, the ITB is allocated to the CWIP account. In 1971 the firm in-

vests $100 in construction, as shown in Table 11. As shown in the income

statement, IDC is computed at 4 percent. Since adjusted NOI is 10 per-

cent of the rate base, of $10, NOI must be $6. With taxes of $4 and the

ITB of $2, revenues are $12. This firm, like Firm RB, requires its cus-

tomers to make payments in 1971, even though service has not yet begun.









TABLE 11


SINGLE ASSET
BALANCE SHEETS AND INCOME STATEMENTS FOR FIRM RB-IDC-ITB


1971
Invest $100 for Construction


1972
Invest $100 for Construction


Balance Sheet


Balance Sheet
1/1/72


CWIP

Total Assets


$100.00 Debt
Equity
$100 00 Total Liab

Income Statement
Year Ending 12/31/71


$ 50.00
50.00
$100,00


CHIP
IDC
Total
Total


200.00
2.00
CWIP
Assets


Debt $101.00
Equity 101.00

Total Liab. $202.00


$202.00
$202.00


Income Statement
Year Ending 12/31/72


Revenues
Depreciation
Taxes
ITB
NOI
IDC
Adjusted NOI
Interest Expense
Net Income


$12.00


6.00
$ 6.00
4.00
$10.00
4.00
$ 6.00


$24.24


12.12
$12.12
8.08
$20.20
8.08
$12.12





$103.02
103.02

$206.04


Revenues
Depreciation
Taxes
ITB
NOI
IDC
Adjusted NOI
Interest Expense
Net Income


-0-
4.00
2.00


-0-
8.08
4.04


Balance Sheet
12/31/71


Balance Sheet
12/31/72


CWIP 100.00
IDC 2.00
Total CWIP
Total Assets


$ 51.00
51.00

$102.00


Debt
Equity

Total Liab.


CWIP 200.00
IDC 6.04
Total CWIP
Total Assets


Debt
Equity

Total Liab.


$206.04
4206.04


$102.00
$102.00





TABLE 11 (Continued)


Balance Sheet
1/1/73


Balance Sheet
1/1/76


Oper, Plant 206.04
Depreciation -0-
Net Plant $206.04
Total Assets $206 0


Debt $103.02
Equity 103.02

Total Liab. $20604


Oper. Plant
Depreciation
Net Plant
Total Assets


206.04
154.53
$51.51
$5 .5


Debt $25.755
Equity 25.755

Total Liab. $5 .51


Income Statement
Year Ending 12/31/73


Income Statement
Year Ending 12/31/76


Revenues
Depreciation
Taxes
ITB
NOI
IDC
Adjusted NOI
Interest Expense
Net Income


$85.98


65.38
$20.60
-0-
$20.60
8.24
$12 36


Revenues
Depreciation
Taxes
ITB
NOI
IDC
Adjusted NOI
Interest Expense
Net Income


$61.26


56.11
$ 5.15
-0-
$ 5.15
2.06
}_3 09


51.51
13.87
-0-


51.51
4.60
-0-


Balance Sheet
12/31/73


Balance Sheet
12/31/76


Oper. Plant
Depreciation
Net Plant
Total Assets


206.04 Debt
51.51 Equity
$154.53
$154.53_ Total Liab.


$ 77.265
77.265

$154.53


Oper. Plant 206.04
Depreciation 206.04
Net Plant
Total Assets


Debt
Equity
$-0-
$-0- Total Liab.


$-0-
-0-







58

The payments required are not as large as those required by Firm RB since

some IDC is capitalized and included in earnings. The balance sheet at

the end of 1971 reveals that IDC is added to CWIP and the ITB has also

been credited to CWIP. With IDC of $4 and an ITB of $2, the net addition

to CWIP is $2. Consequently, debt and equity are increased by $1 each.

At the beginning of 1972, another $100 is invested in construction.

The rate base is now $202, and adjusted NOI is 10 percent of this, or

$20.20. As shown, revenues are again positive, requiring customers to

make payments in 1972 even though service has not yet begun. IDC is cal-

culated at 4 percent, and the ITB is allocated to CWIP. Rather than the

CWIP increasing by the total IDC of $8.08, the allocation of the ITB of

$4.04 makes the net increase in CWIP only $4.04. As a result, debt and

equity are increased by $2.02 each.

In 1973 the asset goes on line and depreciation begins. The book

value of the asset is greater than for Firm RB since some IDC is capital-

ized, but the book value is less than for Firm RB-IDC since IDC is

capitalized at a lower rate. The rate base is $206.04, NOI is $20.60,

and there is no IDC or ITB since CWIP is now zero. Depreciation, for

tax purposes, is determined as explained earlier. The balance sheet at

the end of 1973 shows the net value of the asset being reduced by de-

preciation. Debt and equity are reduced correspondingly.

By the start of 1976, the net plant has been reduced substantially

by accumulated depreciation. Adjusted NOI is 10 percent of the rate base,

and there is no IDC or ITB. By the end of 1976, the asset is fully de-

preciated and the cycle is complete.









Firm IDC

Firm IDC does not include any part of CWIP in the rate base, but

capitalizes IDC at the gross rate as a means of providing a return on

funds invested in CWIP. Given this procedure, NOI must always be equal

to 10 percent of the rate base. In 1971, $100 is invested in construction

as shown in Table 9.9 The rate base is equal to zero, since CWIP is

excluded from the rate base. With NOT equal to 10 percent of the rate

base, or zero, and IDC being non-taxable, profits, for tax purposes, are

minus $4. Taxes are also minus $4, or a $4 credit, and, therefore, rev-

enues are minus $4. At the end of 1971, IDC has been added to CHIP and

debt and equity have beenl increased.

In 1972 another $100 is invested in construction. The rate base is

still zero, making NOI zero. IDC is 10 percent of CWIP, or $21, but not

taxable income. For tax purposes, profits are minus $8.40, and the tax

credit for 1972 is $8.40. IDC is again added to CWIP, and debt and equity

have both been increased by $10.50. For both 1971 and 1972, the customers

of Firm IDC are not required to make any utility payments. The total re-

turn to funds allocated to CWIP is provided by the IDC credit.

In 1973, the asset goes on line and the rate base is $231. The book

value of the asset for Firm IDC is higher than the book value for Firm RB

by the amount of accumulated IDC. The income statement for 1973 reveals

that NOI is 10 percent of the rate base and IDC is zero. Here again, as

with earlier firms, depreciation, for tax purposes, is allowed only on the

net-of-IDC cost of the asset. Depreciation accrues this year, and by the

end of 1973 the net plant has been reduced. Debt and equity are reduced



As noted earlier, Table 9 illustrates the results for Firm RB-IDC
and Firm IDC.









accordingly.

As with the other firms, by 1976 the net plant has been reduced by

accumulated depreciation. NOI is 10 percent of the rate base, and IDC is

zero. By the end of 1976, the asset is fully depreciated and the cycle

for the asset of Firm IDC is complete.

As mentioned earlier, Firms RB-IDC and IDC produce identical re-

sults. This is only true, however, when the IDC rate is equal to the al-

lowed rate of return on used and useful assets, as is true in the illus-

trations of this chapter. Any difference between the IDC rate and the

allowed rate will produce different results for the two firms. This is

illustrated in Table 12, where the IDC rate for Firm RB-IDC is now 8 per-

cent rather than the original 10 percent. Using the data for 1971, Table

12 shows that taxes and revenues now differ for the two firms. Both are

still providing a 12 percent return on equity. Firm RB-IDC still has an

adjusted NOI equal to 10 percent of the rate base, but $8 is in the form

of IDC credits and $2 is generated from revenues after taxes. Previous-

ly, the entire $10 was in the form of IDC credits. While the two firms

produced identical results for the assumptions specified earlier, the two

firms could produce quite different results under different assumptions.



Firm IDC-ITBlo

In addition to capitalizing interest at the gross IDC rate, Firm

IDC-ITB allocates the interest-tax benefit to the construction account.


"Thug the_ accounting procedures_ differ slightly Firms IDC-ITB-G

and IDC-ITB-N produce identical results. This is illustrated in the ap-
pendix to the chapter. Therefore, we shall deal only with Firm IDC-ITB-
G, and it will be referred to as Firm IDC-ITB in the remainder of this
paper.









TABLE 12

COMPARISON OF RESULTS WHEN THE RATE FOR COMPUTING IDC
DIFFERS FROM THE ALLOWED RATE OF RETURN FOR FIRM RB-IDC


Firm RB-IDC Firm IDC

Allowed Rate 10% 10%
IDC Rate 8% 10%


Income Statement
Year Ending 12/31/71

Revenues $ -0- -$ 4.00
Depreciation -0- -0-
Taxes -2.00 -2.00 -4.00 -4.00
NOI 2.00 -0-
IDC 8.00 10.00
Adjusted NOI 10.00 10.00
Interest Expense 4.00 4.00
Net Income $ JE.000 $ 6.00




In 1971, $100 is invested in construction and is financed equally by debt

and equity. Table 13 shows that NOI is 10 percent of the rate base,

which is zero since CWIP is excluded from the rate base. IDC is calcu-

lated as 10 percent of CHIP, and the ITB is allocated as illustrated in

the income statement. Taxable income is -$4.00, which makes taxes -$2.00.

Adding the ITB to the tax expense makes net taxes zero and thus, revenues

are zero also. The ending balance sheet shows that $10 of IDC has been

added to CWIP, which, with the ITB allocation of $2, makes the net addi-

tion to CWIP $8. Debt and equity are both increased by $4.

In 1972, another $100 is invested in construction. The rate base is

still zero, making NOI zero. IDC is again computed as 10 percent of CWIP

and the ITB is allocated to the income statement. Taxable income is

-$8.32, which makes taxes -$4.16. The allocation of the ITB of $4.16

makes net taxes zera and again revenues are zero. The procedures followed












SINGLE ASSET
BALANCE SHEETS AND INCOME STATEMENTS FOR FIRM IDC-ITB


TABLE 13


1971
Invest $100 for Construction


1972
Invest $100 for Construction


Balance Sheet


Balance Sheet
1/1/72


CWIP

Total Assets


$100.00 Debt
Equity
$100 00 Total Liab.

Income Statement
Year Ending 12/31/71


$ 50.00
50.00
$100.00


CWIP 200.00
IDC 8.00
Total CWIP
Total Assets


Debt $104.00
Equity 104.00

Total Liab. $208 00


$208.00
(208 00


Income Statement
Year Ending 12/31/72


Revenues
Depreciation
Taxes
ITB
NOI
IDC
Adjusted NOI
Interest Expense
Net Income


$ -0-


-0-
-0-
10.00
$10.00
4.00
$ 6.00


-0-
(2.00)
2.00


Revenues
Depreciation
Taxes
ITB
NOI
IDC
Adjusted NOI
Interest Expense
Net Income


$ -0-


-0-
-0--
20.80
$20.80
8.32
$12.


-0-
(4.16)


Balance Sheet
12/31/71


Balance Sheet
12/31/72


CWIP 100.00
IDC 8.00
Total CWlP
Total Assets


Debt $ 54.00
Equity 54.00

Total Liab. $108.00


CWlP 200.00
IDC 24.64
Total CWIP
Total Assets


$112.32
112.32

$224.64


Debt
Equity
$224.64
$224.64 Total Liab.


$108.00
$108 00









TABLE 13 (Continued)


1976


Balance Sheet
1/1/76


Balance Sheet
1/1/73


$112.32
112.32







$98.26


75.80
$22.46
-0-
$22.46
8.99
$1 .7




$ 84,24
84,24

$18 4


Oper. Plant
Depreciation
Net Plant
Total Assets


224.64
168.48
$56.16
$5 6 1


Debt $28.08
Equity 28.08

Total Liab. $56 16


Oper. Plant 224
Depreciation
Net Plant
Total Assets


.64 Debt
-0- Equity
$224 64
$ 24 64 Total Liab.


Income Statement
Year Ending 12/31/76


Income Statement
Year Ending 12/31/73


Revenues
Depreciation
Taxes
ITS
NOI
IDC
Adjusted NOI
Interest Expense
Net Income


$71.31


65.69
$ 5.62
-0-
$ 5.62
2.25
( 3 7


Revenues
Depreciation
Taxes
ITB
NOI
IDC
Adjusted NOI
Interest Expense
Net Income


56.16
9.53
-0-


56.16
19.64
-0-


Balance Sheet
12/31/76


Balance Sheet
12/31/73


Oper. Plant 224.64
Depreciation 224.64
Net Plant
Total Assets


Debt
Equity

Total Liab*


$-0-
-0-

$-0-


224.64 Debt
56.16 Equity
$168.48
$168_48 Total Liab.


Oper. Plant
Depreciation
Net Plant
Total Assets


$-0-
$ 0









by Firm IDC-ITB do not require customers to make payments during the

1971-1972 period. The entire return for funds invested in CWIP is pro-

vided by IDC credits. The ending balance sheet shows that IDC has been

added to CWIP and the ITB has been credited to CWIP, making the net addi-

tion $16.64. Debt and equity increase by $8.32 each.

When the asset goes on line in 1973, the book value of the asset for

Firm IDC-ITB is less than for Firm IDC since a smaller net amount of IDC

was added to CWIP. The rate base is now $224.64, and NOI is 10 percent

of the rate base, or $22.46. Depreciation begins this year and, for tax

purposes, is computed on the book value of the asset, excluding accumu-

lated IDC. The balance sheet at the end of 1973 shows the declining

value of net plant as depreciation accumulates.

By the beginning of 1976, net plant has been reduced to $56.16, due

to .accumulated depreciation. NOI is again 10 percent of the rate base.

By the end of 1976, the asset is fully depreciated and the cycle is again

complete.



While the explanation of the procedures followed by each firm re-

quires only a single asset model, the evaluation of the different methods

for providing a return on CWIP requires that the firm as a whole be

examined. It is the cumulative effects of rapid, fluctuating growth

which create problems. In the next section, another model is briefly

described which is somewhat more realistic and begins to demonstrate these

cumulative effects.



The Continuous Growth Model

The continuous growth model is simply an extension of the single as-









set model. Most of the assumptions of the single asset model are re-

tained, but a few modifications are required. First, the service re-

quirement, which is identical for all firms, is such that capacity must

be expanded by a constant amount. After the first two years, an asset

similar to the asset in the single asset model must go on line each year.

This assumption requires construction to begin on a new asset each year.

With a two-year construction period, an investment of $200 must be made

in each year after 1971, while the first year still requires only a $100

investment. Of the $200, $100 is allocated to the construction of an

asset begun in the previous year, and $100 is allocated to the construc-

tion of an asset begun in the current year. This process is assumed to

go on indefinitely.

Another major change is that the funds generated by depreciation are

now used to maintain the asset at full use and value. The maintenance

cost of each asset is $50 per year, w~thich is the same for each firm.

This change means that the "IDC part" of the asset is depreciated and

"retired" over the asset life. An example should make this result clear.

The book value of an asset, excluding IDC, is $200. Thus, over four

years, depreciation, excluding IDC, is $50. The book value of an asset

for each firm differs, depending on the amount of IDC capitalized. Using

Firm 1DC for the illustration, an asset has a book value of $231, $31 of

which is IDC. Book depreciation, calculated on $231, is $57.75 each

year. Of the $57.75, $50 is used to maintain the full usefulness of the

asset and $7.75 is depreciated and "r-etired." The funds generated by

depreciated IDC are used to reduce debt and equity in proportion to the

debt ratio. At the end of four years, an asset maintained in this way

will have a book value of $200, rather than $231, since $7.75 per year,









or $31 over four years, is written off. The part which is written off

is always the amount of accumulated IDC for each firm. This procedure

allows the rate base to be maintained, without altering the comparability

of the various firms.

The final modification for the continuous growth model specifies

that each firm begins with an asset base of $1,000, rather than zero.

Thus, each firm has a beginning rate base of $1,000.

As demonstrated earlier, the firm can be viewed as an aggregation

of assets. This model illustrates the impact of adding a series of sin-

gle assets, similar to the asset in the single asset model, to an exist-

ing firm. This model is one step closer to the more complex computer

nodel which is described in the next chapter. Since the procedures fol-

lowed by each firm were adequately demonstrated by the single asset

model, only the results are presented for this model.



Examination of the Results

This section reviews the results of the two models with respect to

two variables, revenues and times-interest-earned ratios. The single

asset model indicates how the variables change over the complete life

cycle of a single asset. The continuous growth model illustrates the

cumulative effects on each variable of adding a series of such assets to

an existing firm. Each model provides unique insights into the various

methods for providing a return on funds invested in CWIP.


The Sinele Asset Model Results


Revenues. The single asset model best illustrates two facts re-










garding the revenues generated by each firm. First, the revenues re-

quired over a complete life cycle indicate the cost to the customer of

the procedures followed by each firm. Second, revenues indicate the

timing of payments required by each firm, since the service requirement

(or customer group size) is the same for all firms. Table 14 shows the

revenues required by each firm over the life cycle. Of particular in-

terest to customers is the overall cost they incur under the procedures

followed by each firm. Since the timing of payments differs for each

firm, it is necessary to compare the net present value (NPV) of the

revenue requirements of each firm." As Table 14 reveals, the NPV of

revenue requirements for each firm is identical. This equivalence means

that the cost to the customers is the same over a complete life cycle.

Consequently, the importance of cost considerations in evaluating the



TABLE 14

REVENUE REQUIREMENTS
SINGLE ASSET MODEL


Year Firm
RB RB-IDC RB-%IDC-ITB IDC IDC-ITB

1971 16.00 -4.00 12.00 -4.00 -0-
1972 32.00 -8.40 24.24 -8.40 -0-
1973 82.00 102.46 85.98 102.46 98.26
1974 74.00 93.22 77.74 93.22 89.28
1975 66.00 83.98 69.50 83.98 80.29
1976 58.00 74.74 61.26 74.74 71.31

Net Present Value of Revenue Requirements at 8 Percent

243.20 243.20 243.20 243.20 243.20




The rate used to discount the stream of revenues is the net (af-
ter-tax) rate of return. The allowed after-tax rate' is 8 percent in
these illustrations.









firms is secondary. The timing of payments, cash flows, and other vari-

ables become more important.

The timing of payments is important to individual customers. Cur-

rent customers want to pay only for those assets which benefit them. Two

of the firms examined, Firms RB and RB-%IDC-ITB, require customers to

nake payments during the construction period. In an on-going firm, this

result means that current customers pay part of the cost of assets which

are not currently used to their benefit. On the other hand, Firms RB-

IDC and IDC both show negative revenues during the construction period.

In an on-going firm, present customers would be receiving a benefit from

construction. This benefit results from the failure to allocate the tax

savings, or ITB. This reduces revenues currently required, which bene-

fits present customers, and raises the revenues required in later years,

to the detriment of future customers. Firm IDC-ITB, which capitalizes

IDC and allocates the ITB, has revenues of zero during construction.

This result means that present customers pay no part of the cost of as-

sets that are to be used in the future. Firm IDC-ITB is the only firm

which fully reflects the exact capital costs of construction in the cost

.of the asset.

Figure 2 is a graph of the revenue requirements of each firm from

the single asset model. Firm RB produces the least extreme changes in

revenue requirements. During construction revenues for Firm RB are the

highest, and after construction they are the lowest. Firm RB-%IDC-ITB,

which capitalizes a small amount of IDC, produces slightly more extreme,

results. Firm IDC-ITB, which, in effect, capitalizes IDC at the net

rate, produces still more extreme results. Finally, Firms RB-IDC and

IDC, which capitalize the most IDC, produce the widest fluctuations .in
















Revenue
Requirements
($)


IDC
IDC-ITB

RB-%IDC-ITB
RB


1971 1972 1973 1974 1975 1976

Year







FIGURE 2

REVENUE REQUIREMENTS: SINGLE ASSET MODEL









revenue requirements. In general, the more IDC capitalized, the greater

the fluctuation in revenue requirements. The importance of this fluctua-

tion depends on many other factors, particularly demand and other cost

considerations. At this point, we merely recognize this fluctuation,

leaving its evaluation to subsequent discussions.



Times-Interes t-Earned Ratios.1 2 In addition to indicating the cov-

erage of interest charges, the times-interest-earned ratio provides a

rough indication of cash flow. Table 15 summarizes these ratios for each

firm in each year. Figure 3, which graphs these ratios, indicates that

they respond in a manner similar to revenues. Firm RB has a constant

coverage ratio. Firm RB-%IDC-ITB, which capitalizes a small amount of

IDC, has relatively lower ratios during construction and somewhat higher

ratios after construction. Firm IDC-ITB, which capitalizes more IDC, has

more widely fluctuating ratios before and after construction, while Firms

RB-IDC and IDC have ratios which fluctuate the most. Like revenues, the

fluctuation increases as the amount of capitalized IDC increases. This

fluctuation results from the fact that during construction, cash revenues

are replaced by IDC credits, in a proportion of two-to-one. That is, for

every dollar of IDC, revenues can be reduced by two dollars, since IDC is

not taxable. After construction, or during the asset's useful life, an

opposite effect occurs. The larger rate base of the firms which capi-

talize IDC cause larger cash flows relative to interest payments and the'

ratios are higher. Consequently, for the single asset model, more IDC



"Times-interest-earned is calculated as the ratio of income before
taxes to interest charges. Since IDC is not cash income, it is excluded
from the calculation of the coverage ratio.






















Times-
Interest-
Earned
Ratios


8.0
IDC

7.0 r //IDC-ITB

6.0


5.0 -RB-%IDC-ITB


4.0 R


3.0

2.0


1.0




-1.0
1971 1972 1973 1974 1975 1976
Year











FIGURE 3


TIMES-INTEREST-EARNED RATIOS: SINGLE ASSET MODEL









TABLE 15

TIMES-INTEREST-EARNED
SINGLE ASSET MODEL


Year ; Firm
RB RB-IDC RB-IDC-ITB IDC IDC-ITB

1971 4.00 -1.00 3.00 -1.00 -0-
1972 4.00 -1.00 3.00 -1.00 -0-
1973 4.00 4.84 4.18 4.84 4.69
1974 4.00 5.12 4.24 5.12 4.91
1975 4.00 5.68 4.37 5.68 5.37
1976 4.00 7.35 4.73 7.35 6.74




during construction makes the times-interest-earned ratios relatively

low during construction and relatively high after construction ends.

The examination of these two variables has revealed that the larger

the amount of IDC, the greater is the fluctuation in both revenues and

times-interest-earned ratios. These results, particularly for the period

after construction, are somewhat exaggerated by the use of a short de-

preciable life. They are further exaggerated by the absence of continued

construction and growth. The results for the continuous growth model,

though still not entirely realistic, more accurately depict what might

be found in the real world.



Continuous Growth Model Results



Revenues. Table 16 summarizes the revenues generated in the con-

tinuous growth model, and Figure 4 illustrates them graphically.- The

pattern during the initial construction period resembles the pattern

established in the single asset model. Also like the single asset model

results, Firm RB has the highest revenues initially but the lowest later


















Revenue
Requirements
($)

1000 ~


IDC
IDC-ITB
RB-%IDC-ITB
RB


900




800


700




600




500


IDC-ITB
IDC


400 0


1lillilli
'71 '72 '73 '74 '75 '76 '77 '78 Year







FIGURE 4

REVENUE REQUIREMENTS: CONTINUOUS GROWTH MODEL









TABLE 16

REVENUES
CONTINUOUS GROWTH MODEL


Year Firm
RB RB-IDC RB-IDC-ITB IDC IDC-ITB

1970 410.00 410.00 410.00 410.00 410.00
1971 426.00 406.00 422.00 406.00 410.00
1972 458.00 397.60 446.24 397.60 410.00
1973 540.00 500.06 532.23 500.06 508.26
1974 622.00 601.28 617.97 601.28 605.54
1975 704.00 701.26 703.47 701.26 701.83
1976 786.00 800.00 788.74 800.00 797.14
1977 868.00 882.00 870.74 882.00 879.14
1978 950.00 964.00 952.74 964.00 961.14




on. The other firms follow the same relative pattern. But with con-

tinued investment, the shifts in relative position are less extreme and

take longer to occur. Once a full cycle has been completed, by 1976,

the annual increase in revenues is $82 for all firms. This constant in-

crease in revenues is due to the pattern of constant growth specified in

the assumptions.



Times-Interest-Earned Ratios. Table 17 summarizes the times-

interest-earned ratios, which are graphed in Figure 5. Firm RB still

has a constant ratio of income to interest charges. The ratios for each

of the other firms decline during the first two years in proportion to

the amount of IDC capitalized by each. The ratios for these firms then

begin to rise and asymtotically approach the level of Firm RB as the

percentage of .CWIP to other assets falls. That is, as the percentage of

CWIP to other assets falls, IDC as a percentage of earnings falls, and

times-interes t-earned ratios approach the level of Firm RB, where no IDC























Times-
Interest-
Earned
Ratios


RB

RBD) -ITB

IDC













IIIII 1ll
'71 '72 173 '74 '75 '76 '77 '78
Year












FIGURE 5


75 ~


3.50

3.25


3.00


TIMES-INTEREST-EARNED RATIOS: CONTINUOUS GROWTH MODEL









TABLE 17

TIMES-INTEREST-EARNED
CONTINUOUS GROWTH MODEL


Year Firm
RB RB-IDC RB-IDC-ITB IDC IDC-ITB

1970 4.00 4.00 4.00 4.00 4.00
1971 4.00 3.55 3.91 3.55 3.64
1972 4.00 2.82 3.77 2.82 3.06
1973 4.00 3.12 3.82 3.12 3.30
1974 4.00 3.34 3.87 3.34 3.47
1975 4.00 3.51 3.90 3.51 3.61
1976 4.00 3.65 3.93 3.65 3.72
1977 4.00 3.68 3.93 3.68 3.74
1978 4.00 3.70 3.94 3.70 3.76




is capitalized.

The examination of the results of both models has revealed that sig-

nificant differences will result for each firm. The simplified models

examined in this chapter were designed to illustrate the various firms

and provide some insight into the results which might be expected. The

final section of this chapter adds another degree of realism before the

full computer simulation model is examined in the next chapter.



Depreciation Policies

Under the assumptions specified earlier, the firms examined followed

a straight line depreciation policy. While some firms use a straight

line depreciation policy for both book and tax purposes, the majority of

utility companies use some form of accelerated depreciation for tax pur-

poses. The benefits of accelerated depreciation can be handled by two

basic accounting procedures. Under the flow through method, the tax

savings which occur early are flowed through to reported profits. Under






77

the normalization method, the savings are not included in reported prof-

its but are segregated in a reserve for deferred taxes. Arguments have

been made for both procedures, and both are widely used.l The importance

of depreciation policy to this study stems mainly from the differences in

the patterns of cash flow which result. Since the timing of cash flows

differs due to depreciation policy,' and also differs depending on the

policy followed for providing a return on CWIP, it will be useful to

examine whether these factors are compounding and create a serious cash

flow problem or, perhaps, are offsetting and minimize any potential cash

flow problem. Consequently, the combination of three depreciation poli-

cies with the five methods for providing a return on CWIP produces 15

firms which are analyzed using the computer simulation model.



summary

This chapter explained each of the various methods for providing a

return on funds invested in CWIP. This was done using the single asset

model, which was shown to be sufficient for the purpose of illustrating

these procedures. In addition to the single asset model, a continuous

growth model was presented, and the impact on revenues and times-interest-

earned ratios was examined for each firm. The results indicated that

significant differences between the various firms could be expected. The

last section indicated that different depreciation policies are followed

by firms, and these have different impacts on variables of interest to



Brigham, E. F. and J. L. Pappas, Liberalized Depreciation and the
Cost of Capital, 1970 MSU Public Utilities Studies, MSU, 1970, pp. 1-2 and
113-115.

"Ibid, Chapter 4.






78

this study. The result of this chapter is to suggest 15 prototype firms

which are to be analyzed by the computer simulation model.
















APPENDIX


As pointed out in Chapter 3, Firms IDC-ITB-G and IDC-ITB-N produce

identical results and, therefore, only one of these firms needs to be

analyzed. This is demonstrated below using the values of the gross and

net IDC rates as specified for the single asset model.

To illustrate the equality of these two firms, Table 18 outlines the

accounting treatment, the income statement effects, and the effect on the

construction account, of IDC and the ITB. Part A of Table 18 illustrates

the accounting treatment. For Firm IDC-ITB-G, construction is debited 10

percent and IDC income is correspondingly credited 10 percent. For the

ITB, income tax expense is debited 2 percent,' and the construction ac-

count is credited 2 percent. For Firm IDC-ITB-N, construction is debited

at the net rate of 8 percent and IDC income is credited 8 percent. The

income tax expense is again debited 2 percent, but for Firm IDC-ITB-N,

the offsetting transaction is a 2 percent credit to income taxes, listed

under other income.

Part B of Table 18 shows the income statement effects. Income taxes

are raised by 2 percent for both firms as illustrated by the accounting

transactions. For Firm IDC-ITB-G, other income is raised 10 percent due

to the IDC credit of 10 percent making net income 8 percent. Firm IDC-

ITB-N raises other income by 10 percent also, but only 8 percent is IDC



"The income statements shown in Tables 10 and 13 of Chapter 3 list
the ITB separately from the income tax expense. This is done merely to
emphasize the ITB.










TABLE 18

ILLUSTRATION OF THE EFFECTS OF IDC AND THE ITB
FOR FIRMS IDC-ITB-G AND IDC-ITB-N




(A)
Accounting Treatment

Firm IDC-ITB-G

Debit Construction 10 Percent
Credit IDC Income 10 Percent
Debit Income Tax Expense 2 Percent
Credit Construction 2 Percent


Firm IDC-ITB-N
Debit Construction (Net) 8 Percent
Credit IDC Income 8 Percent
Debit Income Tax Expense 2 Percent
Credit Income Taxes-0ther Income 2 Percent


(B)
Income Statement

Firm IDC-ITB-G Firm IDC-ITB-N

Income Tax 2 Percent 2 Percent
Other Income
IDC 10 Percent 8 Percent
Income Tax Credit 2 Percent
Total 10 Percent 10 Percent
Net Income 8 Percent 8 Percent


(C)
Construction Account

Firm IDC-ITB-G Firm IDC-ITB-N

Construction Cost
IDC 10 Percent 8 Percent
Income Tax Credit (2 Percent)-
Net IDC Cost 8 Percent 8 Percent






81


income while the other 2 percent is in the form of an income tax credit.

Net income is again 8 percent, the same for both firms.

Looking next to the construction account, Part C shows that the cost

of construction for both firms rises by 8 percent. For Firm IDC-ITB-G,

IDC of 10 percent is added to construction, but the allocation of the 2

percent tax credit makes the net addition 8 percent. Firm IDC-ITB-N only

adds IDC of 8 percent to the construction account, making the net increase

the same for both firms.

As shown, the net addition to the income statement is 8 percent for

both firms, as is the net addition to the construction account. Thus,

both firms produce the same net results, making it necessary to examine

only one of them.















CHAPTER 4

THE SIMULATION MODEL


The models of the previous chapter are too simplified to provide

the kind of information necessary to evaluate the alternatives. A more

realistic model which tracks the effects of the alternatives over an ex-

tended period is too cumbersome to deal with manually. Consequently, a

computer simulation model is used which provides the necessary realism

and flexibility for a thorough analysis.

The validity of the results and the conclusions subsequently drawn

are directly related to the assumptions used in the development of the

model. Rather than simply list the assumptions, this chapter provides a

broad overview of the computer model, allowing the assumptions to be dis-

cussed as they arise. The chapter itself is primarily a verbal descrip-

tion of the model, with the important equations provided in Appendix A.

The first discussion examines some of the important considerations

designed to assure that the model is both realistic and valid. Along

with the assumptions, the input variables determine the usefulness of the

results. The discussion of the input options illustrates the flexibility

and range allowed in evaluating the alternatives. The output variables

are quite numerous and indicate the measures of performance to be used in

the analysis. Appendix B is the result of efforts to validate the model,

and Appendix C provides a listing of the actual computer program.









General Features of the Model

This section discusses four important features of the simulation

model. The model incorporates a start-up period which~is necessary to

avoid cycling and unrealistic beginning values. Another important as-

pect is the establishment of the proper timing of events to avoid a "re-

turn lag" or a built-in construction period. It is also crucial that

investment is determined in a manner which maintains the comparability of

the firms. Finally, and perhaps the most important aspect, is the model-

ing of the construction program. The realism of this feature greatly

affects the usefulness and validity of the model.



The Start-Up Period

The model has been designed to allow a start-up period of 100 years.

The start-up period assumes a construction period of zero,' which re-

sults in all firms beginning with the same initial values. The only dif-

ference in the firms at the beginning of the first year of interest is

that the normalizing firms have a reserve for deferred taxes included in

their capital structure. With depreciation being reinvested each year,

the start-up period minimizes the cycling that would otherwise be sig-

nificant. The initial 100 years also allows the cumulative reserve for

deferred taxes to be established, rather than unrealistically starting it

at zero. Beginning in the first year of interest, the construction ac-

tivities generally assume non-zero construction periods, and this change

causes the differences in firms. With respect to providing a return on

CWIP, a construction period of zero would produce identical results for



This is equivalent to saying that all facilities are purchased on
a turn-key basis throughout the start-up period.






84

all firms since there would not be any construction work in progress.

Having a start-up period eliminates some potential problems and

makes the model more realistic, thereby improving the quality of the re-

sults. Establishing the proper timing of events is also crucial to a

realistic model.



Timing

All of the stock variables represent either~ beginning-of-period

values or end-of-period values. Beginning-of-period values always re-

flect the investment made during the period. That is, all investment is

made at the beginning of each period. End-of-period values reflect all

the changes which occurred during the period, particularly with respect

to the flow variables associated with the income statement. While flow

variables represent flows which occur throughout the period, these are

accounted for at the end of each period, and, for convenience, may be

referred to as end-of-period values. Thus, we focus on two points in

time in each period, the beginning of the period and the end of the

period. With regard to the computation of such variables as interest,

rate of return on equity, rate base, and others, beginning-of-period

values are used. Since investments are made at the beginning of the

period, there is no "return" lag built into the model. That is, all

funds invested receive a full return from the moment of their commitment.



The Determination of Investment

Having assured that investments receive a full return, it is neces-

sary to examine the procedure which determines the size of the investment

made by the firms in each period. The amount of investment must be the




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