(January 2011) Gold Mine or Fool’s Gold?: Debt is recorded on the right side of the balance sheet in recognition that it’s a source of capital, but users of financial statements...
An Indicator of Fairness
Ratable treatment of removal costs through depreciation should be favored.
maturity at the maximum frequency that occurs at a retire- ment age equal to the average service life. With no growth or cost escalation, the average age of the retirements of an ongoing mature property group stays at this maximum frequency point and at the age equal to the average service life. This causes the relationships for the scenario without growth and cost escalation, i.e., equality (see Figure 2) .
This scenario is helpful for understanding the significance of property group maturity, but isn’t realistic, because life isn’t constant and growth and cost-escalation occur. Therefore, increasing maturity causes the age of retirements to climb the frequency curve (see Figure 1) , but growth and cost escalation keep it from reaching an age equal to the average service life, which prevents the equality of the ages and amounts. Growth and cost escalation cause the relationships (see Figure 2) for the scenario with growth and cost escalation, i.e., inequality.
The concerns expressed in regulatory proceedings for current removal cost accruals being larger than the amounts currently being expended, place the blame on incorrectly reflecting the cost escalation. These concerns are misplaced, partly because they are limited only to this relationship, and partly because this situation is the natural consequence of growth, cost escalation, and accrual accounting. There are two aspects to concerns for the influence of cost escalation on removal costs—the rate of escalation and the period of time over which it occurs. The concern expressed is about the rate of escalation, which is the wrong concern, because: 1) depreciation analysts addressed such concerns long ago by recognizing the past rate as being the best estimate of the future rate; and 2) the influence of the period of time is greater than is the influence of the rate. The correct concern is about the period of time for escalation, but is never expressed, because the response demonstrates that depreciation rates should be increased.
Alternative treatments of removal costs have different impacts on regulated entities, ratepayers, and the economic viability of service territories. Therefore, it’s important to understand these impacts. Seven treatment scenarios are addressed here: 1) ratable accrual through straight-line depreciation; 2) recognition of cost escalation as it occurs; 3) liability (SFAS 143) treatment; 4) external funding with constant fund contributions; 5) expensing when incurred; 6) five-year amortization after being expended (generally known as the Pennsylvania method); and 7) capitalizing as a cost of the replacement asset. Straight-line depreciation matches the recording of removal costs with the pattern of usage of the associated asset, and the other scenarios defer to varying degrees the recording of these costs. The analysis is from the standpoint of the ratepayer, as it discloses what ratepayers would pay for service over the asset life under rate-base regulation (cost of service that includes return on rate base as a cost) for each scenario.
The analysis demonstrates that the impact of removal costs on ratepayers varies directly with the extent of the deferral in recording such costs, and is based on $1 of removal cost, useful lives of 40