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Evolution or Revolution? Dismantling the FASB Standard on Decommissioning Costs

Fortnightly Magazine - May 15 1996

expense component will grow with time as the discount period shrinks. For example, the liability amount for an obligation maturing in 40 years with 5-percent annual cost escalation and a 6.5-percent discount rate would run only about one-half of the current cost required to satisfy the obligation. By the 40th year, the annual increase in the liability amount recorded as an expense would run nearly 12 times the amount recorded during year one.

Cash Treatment. Costs not requiring liability treatment would receive cash treatment. The FASB proposal would allow companies to incorporate cost of removal into depreciation only to the extent that it offsets salvage, with any excess cost of removal recorded as an expense at the time of expenditure. Thus, the net salvage reflected in depreciation rates and expenses could never fall below zero.

Cash treatment involves even more backloading than liability treatment, making it even more important to determine which obligations qualify for which accounting treatment.

Reporting Income. A company that implements the proposed standard would record the move as a change in accounting principle, reporting income for the difference between cost of removal previously recognized as an expense and the amount that would have been reported if the standard had been effective when the closure or removal obligations were incurred. (The effects of the change would include a reversal of the cost-of-removal portion of the existing accumulated provision for depreciation.)

Backloading Implications

The predicted backloading of cost of removal under the proposed FASB statement distinctly contrasts with current utility practice. This backloading stems from the use of discounting, and is

sensitive to the relationship between the present-value discount rate that will apply under the FASB statement, and the escalation rate in both cost of removal and the earnings rates for trust funds for nuclear decontamination or decommissioning. Backloading differs from the lifetime usage patterns of depreciable utility assets, whereby usage typically decreases or remain relatively constant (see sidebar, "Timing Differences").

The three Tables summarize estimates of the initial effect of applying the proposed standard. These estimates rely upon data developed during depreciation studies and reflect simplifying assumptions that may not be suitable for financial reporting. Nuclear generating units are excluded for those electric utilities that have them. The averages are unweighted. The calculations assume either 1) that all closure or removal costs qualify for liability treatment, or 2) that none do (thus requiring cash treatment).

Table 1 shows the obligation for cost of removal as a percentage of depreciable plant balances recorded at original cost. The much wider range of the total obligations for gas distribution utilities (LDCs) demonstrates the influence of capitalizing labor as a cost of replacement assets rather than as a cost of removal (a practice more common for gas utilities than for electrics). However, the range and higher average obligation for gas utilities becomes more like that of the electrics after discounting, because of the generally longer lives of gas property.

Table 2 shows the estimated reserve and pretax income effects as percentages of the accumulated provisions for depreciation. The percentage income change for cash