In aiming to make financial statements more meaningful, will FASB instead make them indecipherable?
By mid-summer, a total of 123 companies had cranked out some 574 pages of comments, detailing exactly what they thought of the accounting rules proposed by the Financial Accounting Standards Board to cover the closure or removal of certain long-lived assets. %n1%n The FASB's"Exposure Draft," issued early last year, had requested comments on eight issues. The respondents answered as requested, but also raised a host of new questions.
The proposed financial accounting standards pertain to nuclear plant decommissioning and other similar legal obligations. If adopted, the standards would alter the accounting and depreciation practices of all utilities.
The FASB had launched the project on the heels of suggestions both by the Securities and Exchange Commission and the Edison Electric Institute. The SEC had posed that decontamination of nuclear facilities denotes an environmental obligation that should be recorded as a liability. With that position somewhat at odds with the typical utility practice of providing for nuclear plant decommissioning through depreciation and trust funds, the EEI in February 1994 had asked the FASB to address accounting practice costs incurred to decontaminate nuclear facilities and for other similar obligations. FASB responded with its exposure draft. By its terms, the proposal would cover not just nuclear decommissioning, but a broad range of activities, including closure of landfills or hazardous waste storage facilities, plus dismantlement and removal of offshore and gas production facilities. In general, it would cover all unavoidable obligations (both legal and constructive) incurred in the normal operation of a long-lived asset and that are incurred early in the life of an asset and mature at closure or removal.
Among other points, the FASB exposure draft would require utilities and other businesses to record estimated future costs for certain covered obligations (costs incurred early in the asset life) as liabilities on their balance sheets, discounted to present value. This liability treatment would sever much of the link between cost recognition and asset use, leading to a backloading of costs and greater financial disclosure for utilities than is now customary. Other obligations not qualifying for liability treatment would be depreciated up to the amount of salvage proceeds and the remainder expensed (cash treatment). Thus, the FASB proposal promised to impose significant changes in accounting practice for electric and gas utilities, whose assets tend to produce removal costs much higher than salvage value. %n2%n
Overall, the comments seemed negative. Most agreed, however, that the financial obligations addressed in the standards should qualify as "liabilities" and that additional guidance would prove useful. Considerable disagreement arose concerning the appropriate treatment of such obligations for financial reporting.
Of course, the board had said it intended to make financial statements more meaningful. But the mismatch with asset usage or revenue generation that would stem from the exposure draft would prevent this from happening. The letters prove that many believe the exposure draft will produce indecipherable, and perhaps misleading, financial statements. Many responses said the draft would not reflect accurate estimates of the amount and timing of future closure or removal expenditures. This situation does not stem directly from treating these obligations as liabilities; instead, it arises from the disparity between balance sheet treatment at discounted present value under liability treatment versus zero value under cash treatment.
The position of utilities and industrials appears well taken that current accounting practice creates a better match between costs and use of assets. It will be a shame if insistence on balance sheet treatment at different costs (present value for liability treatment; zero value for cash treatment) damages the validity of financial statements.
The board had asked whether others saw a need for additional guidance regarding obligations or assets. The response was an overwhelming yes. Accountants, in particular, expressed this need. Some additional comments were:
• Spent Fuel. Utilities requested clarification that temporary, spent-fuel storage costs qualified for liability treatment; %n3%n
• Indefinite Life. Utilities and industrials wanted to clarify that the standards would not apply to removal of components of asset groups for which life is indefinite, such as electric and gas transmission and distribution systems and quarries;
• Abandoned Plant; Losses. Utilities expressed need for guidance on application of SFAS 90; accountants for SFAS 121;
• Asset Impairment. Several letters requested clarification intended to keep liability treatment from triggering large-asset-impairment write-offs;
• Technological Advances. Some need guidance on handling future technological advances, and facilities for which the depreciable lives may be much different from the expected timing of satisfying the obligation, such as for facilities on leased sites; and
• Land Reclamation. Utilities and industrials pointed out that the most significant obligations for mine reclamation and landfills are not incurred early in life.
In general, the proposed standard likely applies to every asset. Removal or closure costs must receive either liability treatment or cash treatment. The board's deliberations in response to the comments reinforce this interpretation.
Many facilities exist for which the depreciable life is significantly different from when the obligation would be satisfied. Liability treatment for such facilities will complicate fixed-asset and depreciation accounting for all businesses.
Present Value Discounting
The industrials appeared to favor the use of current cost in the treatment of liabilities (em i.e., cost of removal predicted at today's prices. The group labeled "others" (see sidebar) favored FASB's proposal to discount costs to present value, using a risk-free rate. Utilities were split. Accountants showed some support for current cost treatment.
In my opinion, the call by industrials for the use of current costs instead of present-value discounting should not appear surprising, since petroleum producers utilize SFAS 19 in this manner for closure of oil and gas fields.
If industry is to convince the FASB to switch from present value discounting to current cost, it may choose from one of two methods to keep costs up to date: 1) Update current costs ratably over remaining life, or 2) adopt the inflation rate as a discount rate. The first method would backload costs even more than FASB's proposed discounting. The second method, however, would reduce the extent of backloading and eliminate the need to predict when the liability will be satisfied.
Utilities and others favored cost estimates that consider near-term technological advances. Accountants did not; industrials were split. Some suggested that FASB should not limit consideration only to near-term technological advances.
As I see it, the draft could undermine the typical position of the regulators that depreciation rates should reflect currently available technology. Every proposal I have seen to reflect future technology in electric and gas utility depreciation has produced decreased rates. I believe that the accountants have good reason to be concerned about whether estimates are accurate or can be audited if they reflect future advances in technology.
Accountants and others favored the use of a risk-free discount rate. Regulators did not. Utilities and industrials were split. Those that disagreed favored a higher rate.
The task of setting an appropriate discount rate to estimate present value of liabilities enjoys the well-deserved reputation of being a difficult aspect of asset valuation. The degree of backloading in annuity calculations is a function of the magnitude of the discount rate, so those favoring a rate higher than the risk-free rate are proposing to increase the mismatch between asset usage and the recording of that usage for assets qualifying for liability treatment.
In its deliberations since the comments on the exposure draft, the board has reaffirmed its decision to require a risk-free rate.
External Trust Funds
Contrary to FASB's proposal, utilities and industrials favored the idea of applying trust funds as an offset against the obligation under liability treatment. Accountants did not, and others were split. Utilities stated that an offset for nuclear decommissioning funds appeared consistent with accounting treatment under SFAS 87 and 106.
While it appears logical to use cash flows from dedicated trust funds to offset closure or removal expenditures, the board apparently intends to disallow this claim.
Corresponding Capital Account
FASB's proposal requires businesses to recognize a capital account corresponding to the liability for the cost of closure or removal. Overall, those commenting tended to favor this approach. Accountants, others and some utilities favored capitalization as a cost of the asset. Regulators and most utilities favored capitalization as an intangible or deferred debit. Industrials were split. Several utilities and regulators stated that capitalization as a cost of the asset would increase property taxes.
Recorded liability amounts should carry a negative value, so that value increases should not occur as a result of liability treatment. However, increases may happen as a consequence of how ad valorem tax values are derived, suggesting faulty derivation methods.
Faulty derivation methods notwithstanding, the board should think hard about the validity of treating a liability in a way that could increase ad valorem tax values, as value increases are the reverse of economic reality.
Most respondents agreed the proposed disclosures under liability treatment were excessive (em especially the current and future costs and inflation rate. They showed concern that users of financial statements might not understand the multiple amounts (three or four) for the same obligation. Some suggested the disclosures would prove confusing and onerous (em dissuading voluntary disclosure of constructive obligations by requiring admission of enforceable obligations not legally binding.
In this case, disclosure overload lies at cross-purposes with the efforts of the accounting profession to find ways to get stockholders to read annual reports. The overload appears largely the product of the board's insistence on recording closure or removal costs at present value. This situation could be averted by maintaining existing approaches for these costs that are understood, such as use of depreciation by utilities and SFAS 19 by petroleum companies.
With the exception of the others group, the comments gave nearly universal support for a delay of one year or more. Some suggested a delay until field tests are conducted or until completion of the board's current project examining accounting measurements based on present value of future cash flows. These respondents said any effort to revise depreciation practices should be part of a complete review of depreciation issues.
In my view, the board should remain sensitive to the fact that the respondents with the best understanding of implementation requirements were the most vocal concerning the need to delay implementation. However, even with these suggested delays, implementation would occur well before the modified or new software could be prepared to carry out the changes.
As of mid-summer, however, the board had not yet issued a revised exposure draft or final standard, or even released a time line for future actions. Thus, any final adoption of the FASB proposal must necessarily be delayed at least by one year beyond the original plan, which had targeted fiscal years beginning after Dec. 15, 1996.
Other topics drew more responses, beyond the eight issues on which the FASB had asked for direct comment, showing the following concerns:
• Constructive Obligations. Definition thought to be too broad or too vague, affecting the reliability of estimates and financial statements (accountants, in particular).
• Overall Consistency. Conflicts seen with EITF 93-5 on environmental liabilities, %n4%n SFAS 87 and 106, Rule 4-10 of SEC Regulation S-X, and the definition of reliability %n5%n contained in Statement of Concepts 2.
s Accretion (liability treatment). That recording accretion as interest under liability treatment would damage validity of financial ratios; that accretion should be recorded instead as depreciation or operating expense (industrials, mostly). Or that FASB should segregate depreciation of the corresponding asset amount from normal depreciation under liability treatment.
• Income Volatility. Under liability treatment, with constant revisions of cost estimates as plans change for future use of assets. (Utilities feared that different approaches for nuclear decommissioning (em annuity calculations for funding, present-value calculations for financial statements (em would create short-term volatility.)
• Unforeseen Circumstances. Under liability treatment, these might be confused with a contingency reserve, which cannot be recorded as a liability under SFAS 5 (accountants).
• Matching Principle. That the FASB draft would disrupt the matching of revenues and asset consumption or product production that stems from the current practice of using depreciation and SFAS 19 for the obligations. (Especially the utilities and industrials, regarding obligations already recorded for mines and oil and gas fields.) %n6%n
The FASB had addressed the definition of "constructive obligations" prior to issuing the exposure draft, deciding not to offer a strict definition. However, it has since expressed an intent to provide some additional guidance.
Without a strict definition, companies would enjoy considerable flexibility in deciding between liability and cash treatment. This choice may become obvious when liability treatment involves acceptance of the legal implications of declared unavoidable obligations and extensive implementation efforts, while cash treatment does not. Other benefits of cash treatment (em higher earnings or lower revenue requirements and the ability to control when costs are recorded (em may also influence decisions. However, regulated entities will need to balance the advantages of cash treatment against an important risk. They may have trouble recovering from customers any costs for which recording is deferred.
Some alleged they were blindsided by the expansion of scope beyond nuclear decommissioning. One letter claimed a lack of due process. Many others saw inconsistencies with current practices that provide more meaningful financial statements, i.e., depreciation (by the utilities), and SFAS 19 (by the industrials). In general, however, one should not be surprised that the FASB would encounter difficulty in keeping such a radical change in accounting practices consistent with other standards and pronouncements.
I believe the board should heed concerns that liability treatment will not provide information useful for making business and economic decisions, because this fear suggests the proposal is not reflective of economic circumstances.
It also appears that reporting entities will have to deal with depreciable lives that will differ from the useful lives over which occur the accretion of liability. The obligations of nonregulated entities will undoubtedly be satisfied later than the conservative depreciable lives typically adopted to reduce or eliminate recording of losses and differences between book and tax depreciation. With the exception of replacement of transmission and distribution system components, regulated entities are unlikely to remove facilities when they are closed. Therefore, the depreciable lives of these facilities would be less than the lives used to calculate liability and accretion amounts.
Income volatility stems from the mismatch of revenues with use or consumption of assets. Regulated entities should be able to mitigate income volatility by application of SFAS 71, by recording regulatory assets and recognizing liabilities for differences between financial accounting and regulatory accounting treatment.
As for contingencies, confusion may exist between a reserve, on one hand, and the legitimate and necessary component of engineering estimates, on the other. Contingencies in estimates recognize the costs of activities that will occur, but which are handled in composite rather than as specific line items. Such contingencies are appropriate for inclusion in engineering estimates, and should not be excluded for accounting purposes under liability treatment.
Lastly, the concerns seen about matching revenues with asset use highlight three important aspects of the FASB's exposure draft: 1) backloading of the liability accretion, which stems from discounting under liability treatment, 2) more extensive backloading, from cash treatment, and 3) closure or removal activities that occur after the end of depreciable or actual asset lives.
The backloading inherent in the annuity calculation to be used for discounting under liability treatment can be illustrated by an obligation maturing in 40 years with 5-percent annual cost escalation and a 6.5-percent discount rate. The liability amount would be 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 be nearly 12 times the amount recorded during year one. Of course, cash treatment is even more severely backloaded. This backloading is much different from the typical constant or decreasing pattern of usage of utility assets.
Utilities have long been confronted with proposals for backloading the recording of the usage of high-cost facilities, such as power plants. To their credit, regulators have usually denied such proposals, because of the resulting deferral in recording the costs until the facilities are old and unlikely to be productive. Now sanctioning this backloading for some of these costs for financial reporting can be expected to expand the extent of backloading for regulatory accounting, and proposals to do so have already begun. t
John S. Ferguson is a former principal of Deloitte & Touche LLP, and a frequent contributor to
PUBLIC UTILITIES FORTNIGHTLY.
Utilities: American Electric Power Service Corp.; Ameritech Corp.; Arizona Public Service Co.; Arkansas Public Service Co.; Baltimore Gas and Electric Co.; Basin Electric Power Co-op.; Brooklyn Union; Carolina Power and Light Co.; Cilcorp Inc.; Commonwealth Edison Co.; Consolidated Edison Co. of New York, Inc.; Consumers Power Co.; Detroit Edison Co.; Duke Power Co.; Entergy Corp.; FPL Group Inc.; Kentucky Utilities Co.; Long Island Lighting Co.; Lower Colorado River Authority; New England Electric System; New York Power Authority; New York State Electric & Gas Corp.; Niagara Mohawk Power Corp.; Northeast Utilities System; Ohio Edison Co.; Ontario Hydro; PacifiCorp; PanEnergy Corp; PECO Energy Co.; Piedmont Municipal Power Agency; Public Service Enterprise Group Inc.; Salt River Project; Sonat Inc.; South Carolina Company Services; Southern Company Services Inc.; Texas Utilities Co.; TransCanada PipeLines Ltd.; Virginia Electric and Power Co.; Williams Companies Inc. (Associations include: American Gas Asso.; Edison Electric Institute; National Rural Electric Co-op. Asso.; Interstate Natural Gas Asso. of America; United States Telephone Asso.)
Regulators: Colorado Pub. Utils. Comm'n; Florida Pub. Serv. Comm'n; Kansas Corp. Comm'n; Missouri Pub. Serv. Comm'n; Montana Pub. Serv. Comm'n; New York State Dept. of Pub. Serv.; Ohio Pub. Utils. Comm'n; South Carolina Pub. Serv. Comm'n; West Va. Pub. Serv. Comm'n; Wisconsin Pub. Serv. Comm'n; Wyoming Pub. Serv. Comm'n.
Industrials: Mostly extractive-type industries. Some of the larger respondents include: Chevron Corp.; Ciba-Geigy Corp.; Exxon Corp.; General Electric Co.; Mobil Corp.; Shell Oil Co.; USX Corp; and 3M.
Accountants: Arthur Anderson LLP; Coopers & Lybrand LLP; Deloitte & Touche LLP; Ernst & Young LLP; Price Waterhouse LLP. (Associations include: American Accounting Asso.; Maryland Asso. of CPAs; New York State Society of CPAs.)
Others: Individuals, lenders and associations of financial executives and security analysts, including, for example, Chase Manhattan Corp. and National Westminster Bank..R2
1Exposure Draft, Proposed Statement of Financial Accounting Standards, Accounting for Certain Liabilities Related to Closure or Removal of Long-Lived Assets, No. 158-B, Feb. 7, 1996.
2For more details, see, "Evolution or Revolution? Dismantling the FASB Standard on Decommissioning Costs," PUBLIC UTILITIES FORTNIGHTLY, May 15, 1996, p. 16.
3The proposed standards would require either of two treatments: 1) Liability, in which the company would recognize the obligation as it occurs (at construction, for most utility properties); or 2) Cash, which would cover all costs not requiring liability treatment and allow companies to incorporate removal costs into depreciation only to the extent that it offsets salvage.
4That discounting should be applied only when the "aggregate amount of the obligation and the amount and timing of the cash payments for that site are fixed or reliably determinable."
5"The quality of information that assures that information is reasonably free from error and bias and faithfully represents what it purports to represent."
6Some regulators took the opposite approach. They showed concern that the board would limit their flexibility in deciding when costs could be reflected in tariffs.
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