for closure or removal of long-lived assets
will bring costs out into the open.
But is it rational?
On February 7, 1996, the Financial Accounting Standards Board (FASB) issued for comment an "Exposure Draft" of a new proposed statement of financial accounting standards pertaining to nuclear plant decommissioning and other similar legal obligations, both for regulated utilities and unregulated firms. The proposed new standard, Proposed Statement of Financial Accounting Standards, Accounting for Certain Liabilities Related to Closure or Removal of Long-Lived Assets, would apply to fiscal years beginning after December 15, 1996. The comment period ends May 31, 1996.
If approved as drafted, the new accounting standard will pose important questions for utilities, both in its interpretation and its likely effects on accounting and depreciation practices.
s Depreciation Practice. Current treatment, as a component of depreciation, would no longer apply exclusively. The new
standard would affect the "group concept" of depreciation commonly practiced by utilities.
s Accounting Methods. Future accounting treatment would depend on whether the cost qualifies under the new standard either as a "liability" or a cash "expense."
s Backloading. Either way (liability or cash expense), the new standard will create a significant backloading of costs for covered obligations.
s Disclosure. The new standard will likely attract attention both from regulators and investors, as it will require utilities to identify and disclose certain future obligations.
The FASB launched the project on the heels of suggestions both by the Securities and Exchange Commission (SEC) and the Edison Electric Institute (EEI). More than two years ago, the SEC suggested that decontamination of nuclear facilities represents 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 asked the FASB to consider a project to address accounting practice for costs related to the obligation to decontaminate nuclear facilities and other similar obligations. In April 1994, the Financial Accounting Standards Advisory Council discussed whether the FASB should address nuclear decommissioning costs in particular and removal costs in general, or whether it should take on a much broader project to examine the whole gamut of environmental remediation.
Eventually, the FASB chose a middle ground, addressing a broad range of closure and removal obligations, not just those for nuclear facility decontamination. By its terms, the exposure draft would cover obligations for a range of activities that include closure of landfills or hazardous waste storage facilities, or dismantlement and removal of offshore oil and gas production facilities.1 In general, it would cover obligations that satisfy all of the following three characteristics:
s Normal Operation. Incurred in the acquisition, construction, development, or early operation of a long-lived asset.
s Mature at Closure. Related to the closure or removal of a long-lived asset; cannot be satisfied until cessation of operation or use.
s Unavoidable. Cannot realistically be avoided if the asset is operated for its intended use.2
Thus, the proposed standard would not cover obligations related to general environmental remediation that might arise from "improper operation," such as "unintentional environmental discharges or industrial accidents."3 However, the proposal would cover both legal and "constructive" obligations (em i.e., those obligations that the firm has "little or no discretion to avoid," such as when the actions or representations of management have "directly influenced the reasonable expectations or actions of those outside" the firm.4
The obligations and costs addressed by the exposure draft include those that the Uniform Systems of Accounts promulgated by utility regulators define as the cost of removal of depreciable assets. Cost of removal in this context is a generic term that refers to the costs incurred to remove or safely abandon facilities, not for purely physical removal. The proposed standard would establish financial reporting practices for cost of removal that differ from existing utility accounting practices, which are based primarily upon regulatory requirements. These differing practices will require more timely periodic information about these costs and, in the absence of conforming changes to regulatory practices, maintenance of separate records for purposes of financial reporting and regulatory accounting and disclosure of differences between the two.
The effects of the proposed standard should prove quite significant for electric and gas utilities, as their assets produce much more cost of removal than salvage. This fact is true even for underground facilities that are usually abandoned in place, because safely doing so involves costs that are large relative to the original cost of the facilities. Further, the proposed standard carries significant implications as to how well the recording of depreciation-related asset costs will reflect asset usage or consumption. Implementation for obligations that qualify for liability treatment should prove more straightforward for companies that practice the "item concept" of depreciation than for regulated entities that are required to practice the "group concept."
New Accounting Treatment
The proposed standard requires either of two treatments: 1) a liability, or 2) a current cash expense. Under the first treatment, the company would record costs as liabilities and capitalize an equal amount as a component of the depreciable balance. Costs that do not qualify for liability treatment would be recorded as expenses when they occur, to the extent the costs exceed salvage proceeds. (Utilities currently treat the costs of such obligations as a component of depreciation for both financial reporting and regulatory accounting purposes.)
Liability Treatment. Under liability treatment, the company would recognize the obligation as it occurs (at construction, for most utility property). However, it would recognize the liability at the inservice date, and record the liability on a present-value basis using a risk-free discount rate (see sidebar, "Liability Treatment"). For new property, however, the company would also capitalize an amount equal to the liability on the balance sheet as a component of the depreciable investment. Thus, in a manner somewhat the equivalent of sinking fund depreciation, the new liability treatment will create two expense
components: 1) pro rata depreciation, which remains constant; and 2) the liability, discounted to present value.
Importantly, liability treatment will tend to cause a backloading of expenses, because the liability 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.)
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 treatment appears as a mirror image of the change in reserve, because the only application adjustment is the reversal of the cost-of-removal portion of the existing accumulated provision for depreciation.
Table 3 compares depreciation-related expenses to depreciation amounts that reflect existing depreciation rates. These estimates indicate that, on average, the new FASB statement should produce different effects on depreciation-related expenses for electric and gas utilities: 1) liability treatment (em a small increase for electrics, a small decrease for gas; and 2) cash treatment (em a small decrease for electrics, a substantial decrease for gas.
However, the ranges demonstrate that some companies could face substantial changes. The cash treatment increases are somewhat understated, and the decreases somewhat overstated, because the estimates do not include amounts for expending any excess cost of removal that may be incurred during any one period.
Under the proposed standard, companies must expect to modify recorded construction costs, acquisitions costs, or liability amounts whenever circumstances dictate. Financial reporting needs would dictate making the studies to determine whether modifications are needed more frequently than has historically been necessary for regulatory purposes to test the continued validity of depreciation rates. Site-specific demolition cost estimates may be required for some types of assets because past experience may be lacking or may prove inadequate.
Other Transition Issues
Nuclear Trust Funds. Many utilities use trust funds for all aspects of nuclear decommissioning. However, trust-fund contributions are determined through an annuity calculation (em that procedure differs from the present-value calculation specified in the exposure draft. Thus, after-tax fund earnings and discount rates will vary. Also, the current contribution amounts to nuclear trust funds will diverge from the recorded depreciation-related expenses, and the market value of existing trust funds will vary from the recorded liability amounts.
For property other than nuclear generating plants, the extent of differences arising under the proposed standard will depend upon whether the costs qualify for liability treatment, and the extent to which removal or abandonment obligations have been reflected in depreciation in the past.
Reserve Adjustments. Table 3 suggests that, on average, the regulatory backloading for electric and gas distribution companies is about the same as liability treatment backloading, but that regulatory backloading is less than cash treatment backloading. However, unique circumstances and accounting practices cause substantial variations from the averages for individual companies. Moreover, electric and gas utilities may find it necessary to reverse some portion of their existing accumulated depreciation. The Table thus suggests substantial reserve adjustments for some companies.
Asset Groups. Because utilities typically follow the group concept in depreciation practice, assigning an averaged useful life across large groups of related properties, they may find it appropriate to adopt the same type of simplification in assigning cost-of-removal obligations under the proposed statement.
A typical electric utility (excluding nuclear facilities) will employ 15 or more depreciable asset groups with a large cost of removal relative to original cost. A typical gas local distribution company (LDC) will have five or more such groups. The number of asset inservice years reflected in each group will reach 50 or more. Thus, for costs that require liability treatment, the calculations will likely prove extensive and complex.
The actual pace of property retirements adds to the problem. Under the group concept, regulators typically use depreciation rates that assume that all assets in a group retire at an age equal to the average life and all normal retirements are recorded as fully depreciated. The intent is that early and late retirements will eventually offset each other. However, in practice, utility property is commonly much younger than its average life, and utilities typically retire items at an average dollar age less than average asset life. One-fourth to one-third of the average life is typical for electric transmission and distribution property; one-third to one-half for gas LDC property. This situation may complicate the adjustments required upon initial application of the FASB standard, and upon periodic reassessments of recorded liabilities.
Flaws and Blessings
As a depreciation specialist, I view positively any sign that the proposed statement from FASB will increase understanding of removal or abandonment obligations for utility assets. However, I see the proposal as flawed, because removal or abandonment obligations will be recorded in a manner inconsistent with the usage of the underlying assets. The exposure draft claims that its handling of cost of removal is systematic and rational. But if handling the depreciable investment, salvage, capitalized closure or removal amounts, and cost of removal offsetting salvage proceeds on a straight-line basis is "systematic and rational," as defined by the American Institute of Certified Public Accountants (AICPA), then how can backloading the rest of cost of removal also be systematic or rational?
A National Association of Regulatory Utility Commissioners publication, Public Utility Depreciation Practices, offers an eloquent argument for using traditional accrual accounting for cost of removal:
"The intent of the present concept (accrual of original cost and net salvage over the life of an asset) is to allocate the net cost of an asset to annual accounting periods, making due allowance for the net salvage, positive or negative, that will be obtained when the asset is retired. This concept carries with it the thought that ownership of property entails the responsibility for its ultimate abandonment or removal. Hence if current users of the property benefit from its use, they should pay their pro rata share of the costs involved in the abandonment or removal of the property."
[This treatment of salvage appears in harmony with generally accepted accounting practices and tends to remove from the income statement fluctuations caused by erratic, although necessary, abandonment and uneconomical removal operations. It also adds the advantage that current consumers will pay a fair share, even though estimated, of the costs associated with the property devoted to their service. (author's explanation)]
Financial accounting would be well served by the regulatory matching concept known as intergenerational customer equity, whereby all asset costs (including those for the eventual abandonment or removal of the facilities from which they take service) are borne by the generation of customers causing the costs to be incurred. While this regulatory concept is too often more words than deeds, providing the best possible consumption/recording match should be no less important than providing the best possible service/cost match.
The simplest solution would come from specifying that the AICPA definition referred to in the exposure draft should mean net salvage (em not gross salvage (em thereby requiring that all cost of removal is handled on a straight-line basis through depreciation. Nevertheless, the last column in Table 3 suggests that this solution would cause substantial increases in utility depreciation provisions. Regulators probably would not allow utilities to charge increases to customers.
A more limited solution would match only the investment component of depreciation to asset consumption. Both salvage and cost of removal would be handled through present value calculations. But this solution would add an interesting twist: The new calculations would lead to frontloaded salvage.
One last alternative would
allow any company practicing group-concept depreciation to employ an annuity calculation (sinking-fund depreciation) for all cost of removal or for the cost of removal of assets that qualify for liability treatment. This approach would produce a backloading of depreciation expenses similar to the pattern of depreciation-related expenses under liability treatment, and should also involve most of the exposure draft disclosures. In the past the FASB has looked unfavorably upon sinking-fund depreciation, but its current proposal (em which produces backloading in a manner similar to a sinking fund (em may denote a change of heart.
In any case, the proposed standard is more revolution than evolution. I question whether this revolution will produce more meaningful financial statements. t
John S. Ferguson is a former principal of Deloitte & Touche, LLP, and a frequent contributor to PUBLIC UTILITIES FORTNIGHTLY.
The exposure draft defines obligations that qualify for liability treatment:
Cost. For such obligations, the company would record the cost as a liability (em i.e., cost of removal preducted for the future date when the cost will be incurred. (For new property, the company would also capitalize an equal amount on the balance sheet as a component of the depreciable investment.)
Discounting. The company must discount the liability using a risk-free rate (the rate on a U.S. Government bond with a maturity similar to that of the obligation). This rate is determined as of the date the assets are placed in service. (A composite rate for all asset vintages may prove more practical for assets existing at the time the proposed standard is adopted.)
These liabilities carry strict disclosure requirements: The company must update the liability: 1) by recalculating the estimated future cost as circumstances change, and 2) by recalculating the liability's present value, applying the constant, risk-free discount rate determined at the inservice date.
By contrast, under current utility practice, the typical depreciation disclosure would describe only a composite depreciation rate, plus a statement that cost of removal is recorded in accumulated provision for depreciation.
Systematic and Rational?
Q. If approved, will the new FASB standard create a regulatory asset totrack timing differences in recognition of cost of removal?
A. The answer may depend upon the AICPA definition of "depreciation" and "salvage."
Regulatory Accounting. Treats cost of removal as component of depreciation, under rules and definitions from American Institute of Certified Public Accountants (AICPA) and Uniform System of Accounts: Depreciation denotes "loss in service value"; service value means "difference between original cost and net salvage value"; net salvage value is "salvage value of property less the cost of removal." AICPA describes depreciation as a "systematic and rational" process of allocation.
FASB Standard. As proposed, however, the FASB statement would discount, and thus backload, cost of removal under its liability treatment (cash treatment makes backloading even worse). This backloading lies at odds with typical usage patterns (constant or declining) for energy utility property.
Rationalization. The exposure draft would reconcile this conflict by claiming that the term salvage, as used in the AICPA definition of "depreciation," denotes only "gross salvage," without offset for cost of removal.
*The exposure draft acknowledges the problem: "The amounts charged to customers for costs of closure or removal may differ from the expense recognized in accordance with this Statement" (Exposure Draft, para. 22, pp. 6-7).
1 Exposure 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, para. 6, p. 2 (Financial Accounting Standards Board).
2 Id., para. 4, p. 2.
3 Id., para. 5, p. 2.
4 Id., para. 7, pp. 2-3.
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