Electric utilities' accounting for construction work in progress the effects of alternative methods on the financial statements, utility rates and market to book ratio

Electric utilities account for funds used during construction usually by one of three methods or combinations of these methods: 1. They capitalize an allowance for funds used during construction (AFUDC) which is added to the construction work in progress (CWIP) investment and recognize an unrealized AFUDC income for a like amount. This income is realized in cash over the useful life of the asset by way of depreciation and rate base increment. 2. They include CWIP in the rate base and receive a current cash return for construction funds. 3. They include CWIP in the rate base but have an offsetting AFUDC credit to revenue requirements. This study consists of three parts: 1. A computer simulation of two alternative methods of accounting for CWIP. 2. Security market research on the effects on the cost of capital. 3. Current industry practices and regulatory policy surveys. The two polar methods, AFUDC capitalization and rate base inclusion are simulated under moderate growth assumptions employing a deterministic model. The lead-in period of the simulation provides a realistic vintage of assets with prior capitalized AFUDC. The 25-year simulation compares identical firms which differ only in CWIP treatment. The firm which includes CWIP in the rate base could be compared with one which has switched methods from AFUDC capitalization. The simulation shows the effects of the CWIP accounting treatment on rate base, utility rates, operating and net income, cash flows, internally generated funds and interest coverage. The effects of AFUDC on normalized accounting are also considered. The hybrid method of including CWIP in the rate base with offsetting AFUDC credits to revenue requirements is modeled for the first time in the literature. The current cash return and the AFUDC return with various assumptions about the allowed rate of return and the AFUDC rate are derived. The compounding of prior AFUDC when this method is employed is fully explored. The security market research consists of multiple regression analysis and price/earnings trends. The effect of CWIP accounting on the price/book ratio of 100 electric utilities was ascertained employing a linear model. The price/book effect was translated into effect on cost of capital. In addition, an attempt was made to determine if a threshold amount of AFUDC/earnings is necessary before cost of capital is affected. The trend of price/earnings ratios for two groups of electric utilities ranked on AFUDC/earnings is tracked for 1960-1975. Extensive surveys of the electric utility industry and state public service commissions were run. Accounting practices, methods used to determine the amount of CWIP to include in the rate base, treatments of interest tax benefits and prior AFUDC, and the AFUDC effect on financing are covered. A comparison is made of industry practices with commissions' stated policy.