Email This Author Comment On Article About The Author More Articles By This Author

To the relief of most unregulated generating companies, accounting authorities have once again decided not to implement proposed accounting standards that would require power plants to account and report expensed and capitalized costs on a component-level basis. The industry opposed these standards because they would:

• Introduce significant new administrative costs to identify and track the hundreds of components that make up a power plant as distinct fixed assets.
• Disallow accruing costs in advance for replacing major maintenance components, which could mean that these multi-million dollar costs would have to be expensed in a single year.

What most in the industry failed to recognize is that a component-level approach can also be used to show that unregulated power plants have a useful life as long—or even longer—than that demonstrated by regulated plants—i.e. over 45 years for fossil-fired plants and over 100 years for hydroelectric generating plants. Because the large majority of unregulated generating companies use a depreciable life that is significantly less, such an increase—which reduces the annual rate of depreciation—would increase book income by $10-to-$20 million a year or more. While this does not increase cash, it does increase earnings per share, which improves stock valuation. This article explains why the decision to not impose component-level accounting puts unregulated generating companies in a position to use this approach as a way to increase plant depreciable life—while at the same time—avoiding the two major disadvantages listed above. In short, how you can both have your cake and eat it too. The discussion draws on what has been learned over the course of conducting the series of depreciable life studies and industry surveys listed at the end of the article. Publicly available accounting standards and related information used in the article are listed as footnotes. The discussion is organized according to the following topics:

1. Component level accounting status and prospects
2. Alternative strategies for defining components
3. Implications of alternative strategies
4. Implications of other accounting standards and requirements

Component-Level Accounting Status and Prospects
The American Institute of Certified Public Accountants (AICPA) met with representatives of the Financial Accounting Standards Board (FASB) on April 14 to determine if new component-level accounting standards for all property, plant, and equipment (PP&E), which includes electric generating plants, should be approved. The standards, which would have been effective for fiscal years after December 15, 2004, are based on an Exposure Draft of a proposed Statement of Position (SOP) previously issued by the AICPA Accounting Standards Executive Committee (AcSEC).¹ They were developed to establish a more consistent basis for accounting and disclosure issues related to PP&E costs and services. As stated in the SOP:

“Diversity in accounting for those kinds of costs has been widely observed. Some entities capitalize certain of those expenditures whereas others charge expenditures for similar items to expense as incurred. Also, some entities group, or “batch,” and capitalize certain expenditures that would ordinarily be charged to expense as incurred.”

FASB gave the following reasons for not approving the SOP:²

• The timing, given the current environment and demands already placed on the financial reporting system.
• Lack of convergence with existing International Accounting Standards Board (IASB) guidance, which is regarded as “highly desirable for such a far-reaching change in accounting”.
• Disagreement with particular requirements including the latitude allowed in defining components and a provision that would not allow PP&E replacements to be capitalized unless they were previously designated as separate components.

While no further action is planned, the Board indicated that the AcSEC work would be retained for use in connection with any future convergence of efforts with the IASB related to PP&E. Because the problem of diversity in PP&E accounting remains, it is likely that it will be addressed at some time in the future. Until such time, unregulated generating companies will not be required to apply a component-level method but there is nothing preventing them from doing so, where it is to their advantage. A FASB representative has confirmed that there is nothing in the SOP that is inconsistent with existing accounting standards used in Transactive Management studies. Alternative Strategies for Defining Plant Components
As observed by FASB, the SOP would give companies considerable latitude in determining the level at which components are defined—i.e., as a major system, major component, or subcomponent. It specified that a component can be defined as a depreciable fixed asset if it:

1. Is a tangible part or portion of PP&E that can be separately identified as a capital asset;
2. Has a separate expected useful life;
3. Provides economic benefit for more than one year;
4. Can be identified at the time of acquisition or construction;
5. Cost more than a “reasonable threshold”, which does not include costs incurred for normal, recurring, and periodic replacement of minor items.

The following three levels bracket the range of options for a power plant. Level 1, Plant Systems: At the highest level, capitalized components could be defined as the 8-to-10 major systems that comprise a power plant. For a combined cycle plant, this would include: (1) the combustion turbine facility, (2) heat recovery steam generator (HRSG), (3) steam turbine facility, (4) flue gas control system, (5) the switchyard, (6) water facility, (7) buildings (as a single category), (8) the yard, and (9) piping systems. Level 2, System Major Components: At the next level, major systems could be broken down by the major types of equipment and materials that make up each. This would typically result in from 5-to-7 components for each major system. For example, the combustion turbine facility would break down into the combustion turbine generator, main power transformer, supporting structure (forms, rebar, concrete, and structural steel), system piping, and instrumentation and controls. The result would be about 45-to-63 capitalized components for a combined cycle plant. Level 3, Major Component Inventory Items: At the lowest level, each of the Level 2 components would be broken down further into their respective line-item components as identified in an inventory management system (such as SAP) or—for plants originally built by a regulated utility—Federal Energy Regulatory Commission (FERC) accounting useful life units. This approach would result in from 100-to-200 components identified as distinct fixed assets. Implications of Alternative Strategies
I initially assessed the tradeoffs associated with each of the above approaches in anticipation of the Board approving component-level accounting standards in the April meeting. Alternative strategies were assessed based on four considerations:

1. Can the capital cost basis be readily determined?
2. What are the implications with regard to annual maintenance costs charged to expense?
3. What are the implications with regard to plant depreciable life, value, and book income?
4. What is the level of effort and cost associated with initially establishing and subsequently implementing the method chosen?

The following provides the results of that analysis to show how unregulated generating companies can apply a component-level approach to increase the period of time over which plants are depreciated—i.e., places emphasis on consideration 3. It retains the other three considerations to show how this can be done in a manner that anticipates the introduction of component-level requirements at some future date. That is, if provisions of the SOP are used in preparing a new standard, a transition to such requirements will be easier to accommodate. In this regard, it is worth noting that disallowing the practice of accruing costs in advance would likely be one of the provisions included in any such standard given that the Securities and Exchange Commission (SEC) discourages this practice. Level 3, Major Component Inventory Items
Even though this approach has been rendered largely irrelevant by the Board decision, it is worth including because it represents the most prevalent industry view of how component-level accounting would be implemented. This, in turn, explains industry opposition to the standards. In working with clients and conducting surveys I found that every company that has either considered or actually developed a policy and process for implementing component-level accounting has used this approach. One reason is that SAP-type inventory management systems make the needed information readily available—i.e., consideration 1. A second more significant reason is that by capitalizing components, annual maintenance costs charged to expense are reduced—i.e., consideration 2. This is because, the lower the level at which components are identified, the greater the opportunity to spread component replacement costs over a number of years based on their respective useful life. The downside of this is approach is that it results in a depreciable life for the plant as a whole that has the fewest number of years relative to the other, higher-level strategies—i.e., consideration 3. As discussed below, in the other approaches, line-item inventory items are a “consumable” part of a major component or major system. Thus upgrading or replacing them, is treated as an expense. This, in turn, allows major components and systems to have an extended life that is based on the ongoing replacement of original components. However, in the Level 3 approach, depreciation is based on the design life or original plant components, which for the large majority of components ranges between 3-to-30 years. The other disadvantage is the cost of the process that would have to be put in place for fixed asset accounting at such a detailed level for each plant—consideration 4. This would include not only the cost of adjusting the pre-component-accounting basis, but subsequently tracking the actual life and replacement costs of the hundreds of components that make up each plant. Clearly this is the worst approach in terms of increasing plant depreciable life and in anticipating that component-level accounting will eventually be required. Level 1, Major Systems
At the other extreme, the Level 1 strategy would represent the fewest number of components and the pros and cons are generally the reverse of Level 3. It would be the best in terms of yielding the longest period of depreciable life (consideration 3) and being the least cost to establish and maintain (consideration 4). It would be the worst with regard to the level of annual maintenance costs charged to expense (consideration 2). With regard to consideration 1, it should not be difficult to obtain the original cost basis for major systems from accounting records used for tax-based depreciation or—for newer plants—from Engineering, Procurement, and Construction (EPC) contracts and related records. This strategy maximizes opportunities for replacing and upgrading the major components and materials that comprise each system. Because such costs are expensed, system service life projections can be based on the ongoing replacement of original plant major components—the steam turbine, the combustion gas turbine, the boiler, switchgear, the HRSG, etc. It is for this very reason, however, most companies would not consider it a viable strategy—at least “as is”. Charging the replacement costs of major components as an expense in a single year would be prohibitive. Thus it is the best approach for increasing plant depreciable life but would likely be modified if new requirements were introduced in the future. It is also a good starting point for implementing a combination strategy, which has elements of both the Level 2 and Level 3 approaches. Systems such as the combustion turbine facility and steam turbine facility, which represent a significant percent of original cost as well as ongoing maintenance costs, could be broken down to a major component and subcomponent level. Other major systems could be left at the total systems level where they represent a relatively small percent of original plant costs, are inexpensive to maintain, and are comprised of common materials and equipment. This includes systems such as the switchyard, flue gas control system, yard, and buildings. For example the yard is comprised largely of civil and structural materials that have a life of 85-to-100 years and are relatively low cost to maintain. Level 2, Major Components
This approach is the best in terms of meeting all four of the considerations listed above. It is therefore the best approach to increase depreciation in a way that anticipates that component-level accounting will eventually be required. Prior to new standards being introduced, it would only be necessary to use this approach for a single plant that is representative of other plants using the same technology—i.e., a prototype plant. Provided that maintenance practices can be shown to be uniformly applied, all of the plants could be depreciated over the projected life of such prototype plants. If new standards are introduced, the prototype plant component breakdown structure and service life projections could be applied to the original construction cost of each plant to project their respective depreciable life. With regard to consideration 1, original component cost data can be compiled from EPC contract records, tax records, or the same inventory management systems used for Level 3. It is also good with regard to consideration 3. Implementing component-level accounting applying the Level 2 strategy would yield a depreciable life of over 45 years for fossil-fired plants, over 50 years for wind generating turbines, and over 100 years for hydro plants. With the exception of wind turbines, which are a relatively new technology, this is generally comparable to the period of time these plants actually operate. Although large, high pressure fluidized bed plants and combined cycle plants also represent new technologies, outside of the power block, supporting balance of plant systems are the same as conventional fossil-fired boiler plants. It is also good with regard to implementation costs—consideration 4—particularly if some systems are kept on a total system basis as suggested above. With this combined approach, the number of components could be kept to about 40. Although this approach also has drawbacks with regard to expensing the replacement of original plant components—consideration 2—this can be addressed by identifying high maintenance cost combustion and steam turbine sections as fixed assets. To determine the impact on overall plant depreciable life, I completed a sensitivity analysis that broke the original construction cost of an F-Frame combined cycle plant into its major components. Using the results of our research on major component extended service life, I projected an overall plant life of 50 years. Next, I assigned a cost of $25 million and a 4-year life to combustion turbine major maintenance components—i.e., identified these as a separate fixed asset. This changed the overall plant depreciable life to 45 years. If actual data were used, useful life would likely be longer because the plant data used was for a two-train combined cycle plant whereas the $25 million capital cost would be more consistent with a six-train plant (i.e., six sets of replacement components). Implications of Other Accounting Standards and Requirements
It is important to recognize that the forgoing discussion is limited to applying component-level accounting as a basis for projecting the physical, or technological, life of a power plant. In my experience, getting third parties such as a company’s independent public accountants and the SEC, to agree to an unregulated plant economic life comparable to that of regulated plants, requires a number of related efforts. First it is necessary to demonstrate that, with the emergence of unregulated power markets in the late 1990s, there became a new and distinct basis for projecting the life of the merchant plants selling power in these markets. Up to that time, unregulated plants were largely limited to plants selling power under a power purchase agreement and were depreciated over a period of time comparable to such agreements—i.e., about 25 years. For plants selling power into competitive markets—currently or after existing power purchase agreements expire—it is necessary to show that they can be reasonably expected to remain economically viable over a projected physical life of 45 years or more. This, in turn, raises a number of questions that must be addressed:

• Could the carrying costs associated with an extended useful life cause plants to become economically impaired—i.e., will cash generated over this life be enough to cover such costs?³
• Will such economic viability be affected by the future introduction of advanced power generating technologies that are more efficient and lower cost?
• Will future federal energy and environmental programs impact the technological or economic viability of technologies under study?
• Will future trends in the cost of fuel allow plants to remain competitive?

In addition to providing the research and analysis to address such questions, it is also necessary to demonstrate that conclusions in such areas are consistent with what plant owners use in there day-to-day planning and financial analysis. Also, the governance and accounting transparency requirements of the Sarbanes-Oxley Act apply if a change in depreciation accounting results in a significant change in book income. Although such a change does not affect cash, the change in income affects the earnings per share of publicly traded stock, which in turn, affects the market value of stock. It is therefore prudent for companies to ensure that the component-level accounting process is fully integrated with the policies and practices that govern internal controls and that any accounting changes that have a material impact of stock valuation are approved by its board of directors. ¹Accounting Standards Executive Committee (AcSEC) Statement of Position (SOP) entitled “Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment” dated June 29, 2001 ² Financial Accounting Standards Board Minutes of the AcSEC April 14, 2004 Board Meeting, April 21, 2004. ³Accounting requirements are defined in the Statement of Financial Accounting Standards (SFAS) No. 144 Accounting for the Impairment or Disposal of Long-Lived Assets, October 3, 2001.