- 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.
- Introduce significant new administrative costs to identify and track the hundreds of components that make up a power plant as distinct fixed assets.
- Serve as the basis for determining the period of time over which power plants can be depreciated, which for most companies can increase book income $10-to-$20 million or more a year.
For regulated companies, these standards can be used to support testimony before state regulatory commissions regarding the period of time over which investments in new plants should be recovered. Even though accounting requirements for regulated companies differ, there is still merit in seeking capital recovery for new plant investments that are based on the generally accepted accounting principles (GAAP).
The following discussion, which is a follow-up to any article written on this same topic in June 2004 (see reference 1 below), begins by reviewing recent FASB actions in the context of a long-standing effort to bring more consistency to PP&E accounting by introducing a component-level approach. This is followed by a discussion of the implications of these actions for unregulated and regulated companies based on the issues identified above. The final section provides a concluding summary.
Accounting Authority Actions and Background
On March 8 the Financial Accounting Standards Board (FASB) met to consider whether to undertake a project to provide guidance on the accounting for planned major maintenance activities (PMMA) associated with PP&A. The meeting was in response to an Accounting Standards Executive Committee (AcSEC) letter dated July 21, 2004, that asked the Board to consider several issues that it believed should be addressed in a FASB Staff Position (FSP) or other short-term project. The AcSEC also encouraged the Board to undertake a broad agenda project on the accounting for PP&E. (See references 2 and 3.) The AcSEC's recommendations were initially considered in February 2005 when the Board directed the staff to further research the accounting for PMMA as a basis for refining the scope of any project the Board may chose to undertake. (See reference 4.)
The AcSEC request followed a decision by FASB in April 2004 to object to AcSEC's issuing a final Statement of Position (SOP), Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment. (See the Energy Pulse article in reference 1.) The SOP would have established requirements for a component-level accounting and reporting method for depreciating a PP&E asset’s original construction cost and for expensing and capitalizing maintenance costs incurred during the asset’s in-service stage. It was developed to address the inconsistency that currently prevails in the accounting and disclosure of 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.”
Despite these needs, FASB concluded that the SOP should not be approved because:
- 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.
The actions taken in March represent FASB’s attempt to address the prevailing diversity in PP&E accounting and reporting but within a more limited scope than what was proposed by the AcSEC. In choosing this course of action the Board again expressed its concern that a more ambitious and complex project could detract from the priority of items on the Board’s agenda.
In determining its actions, the Board considered prevailing guidelines for PMMA as established in American Institute of Certified Public Accountants (AICPA) Industry Audit Guide, Audits of Airlines (Airline Guide) and the IASB International Accounting Standard (IAS) 16, Property, Plant and Equipment.
The Airline Guide currently permits four alternative methods of accounting for PMMA, which are widely used in other industries:
- The Direct Expense Method—expense major maintenance costs as incurred.
- The Built-In Overhaul Method—segregate costs by those that are depreciated and those that require overhaul at periodic intervals. For example, the estimated cost of the airframe and engines are amortized to the date of the initial overhaul and then the initial overhaul is capitalized and amortized to the next overhaul, at which point the cycle continues.
- The Deferral Method—capitalize the actual cost of each overhaul and amortize these costs over the number of years until the next overhaul.
- The Accrual Method—estimate the cost of the pending overhaul and accrue them based on an hourly rate over the years prior to the year in which the overhaul is completed. At that time, actual costs incurred for the overhaul are charged to the total amount accrued and any deficiencies are charged as an expense and any excess recorded as a credit.
IAS 16 provides the following guidance on the accounting for maintenance or servicing costs:
- Costs should be recognized in profit or loss as incurred—i.e., expensed.
- Costs for replacing an individual part of PP&E should be capitalized if they are likely to result in future economic benefits and the costs can be measured reliably.
- Major inspection costs should be treated as an asset and capitalized if they meet recognition criteria defined in the Standard.
The minutes of the Board meeting reveal a number of considerations that will likely shape future PP&E standards. The staff research confirmed the AcSEC finding that there is significant diversity in how companies define and account for planned major maintenance activities and that all four of the methods are widely used. The Board’s primary concern is the need to disallow the accrual-in-advance method because it creates liabilities for items that do not meet the accounting standards’ definition of a liability. Moreover, the Securities and Exchange Commission (SEC) has determined that this method should be eliminated and that it will take independent action if accounting authorities do not eliminate it. Some members also want to eliminate the Deferral Method while others support the Built-In Overhaul Method.
Both the staff and several Board members expressed the view that the best approach would allow for capitalizing maintenance costs that meet IAS guidelines and expensing all other costs. An IASB member that participated in the meeting pointed out that any such solution without a componentized approach couldn’t fully converge with IAS 16. The Board affirmed its goal of FASB standards converging with IAS standards, which is consistent with a Memorandum of Understanding signed by the two boards in 2002. (See reference 6.)
After considering the foregoing, the Board voted to:
1. Issue guidance in the form of an FSP to eliminate the accrue-in-advance method of accounting for planned major maintenance activities;
2. Address transition guidance at a future Board meeting.
The staff was asked to provide the Board with a recommendation on transition guidance after researching the practicability of accounting for the adoption of the provisions in the FSP as a change in accounting principle with retrospective application.
Implications for Unregulated Power Generating Companies
The only negative implications with regard to the three areas that effect unregulated companies identified at the beginning of this article are pending actions to disallow accruing major maintenance costs in advance. This year the Board will likely act on staff recommendations to issue a new standard to prevent the use of the Accrual Method beginning in 2007 that will require retrospective application. Some companies have used this method to avoid having to record the cost of major maintenance outages in a single year. These costs can be over $10 million for large, multi-train combined cycle plants where hot gas path replacement components for a single train cost several million dollars. Such an impact can still be avoided, however, by treating costly components as a capital item, which would still be allowed under any new PMMA standards. Companies could also use the Built-In Overhaul Method, which the FASB staff research found to have much wider application than the airline industry and some FASB members favor.
With regard to the other two issues listed above, the limited scope of the Board’s effort to address PP&E accounting indicates no near-term plans to establish standards that mandate component-level accounting. This means that unregulated companies will not be required to put into place an administrative process to identify and track component-level costs, which many had feared would be very costly. However, there will be nothing preventing companies from using a component-level approach to estimate the useful life of plants as a basis for determining the period of time over which they should be depreciated. This is perhaps the most important outcome because it gives unregulated companies an opportunity to depreciate plants over a time period that reflects the technological and economic life of these assets in a deregulated market.
Transactive Management, Inc. (TMI) depreciable life studies and industry surveys conducted over the past nine years have found that the majority of companies are undervaluing generating assets by depreciating them over periods that are too short. (See the Energy Pulse article in reference 7.) There are two primary reasons for this. First, it reflects the continuing practice of basing plant depreciable life on the duration of long-term power purchase agreements, which began with the rise of independent power producers (IPPs) some two decades ago and persists into the merchant plant era. Second, it reflects the overly conservative accounting that followed in the wake of the Enron collapse, plant overbuilding, and related financial problems.
Most companies depreciate plants over a period of 40 years or less which is significantly less than what TMI studies have found their depreciable life to be, which for newer plants is:
- 50 years for combined-cycle plants
- 50 years for combustion fluidized bed plants fueled by waste or pulverized coal
- 55 years for conventional boiler coal-fired plants
- Over 100 years (or through the end of the current license period and an additional 40-year license period) for hydroelectric generating systems
The approach used to determine unregulated plant depreciable life is based on a system-by-system component-level technological life analysis that meets or exceeds the component-level accounting requirements that would have been established by the proposed AcSEC standard. This approach is also consistent with requirements defined in IAS 16 that will likely serve as the point of departure for any broader PP&E accounting and reporting standards eventually established by FASB.
In a recent study, I applied steps recommended by proposed AcSEC guidelines for retrospective application of component-level accounting to determine the remaining life of supercritical boiler coal-fired plants that came on-line in the late 1960s and early 1970s. I found that, even though some of these plants were almost 40 years old, ongoing capital improvements would allow a remaining useful life of at least 30 more years. This outcome, which represents the first TMI assessment of older baseload plants with an established maintenance history, indicates that conclusions regarding the life of newer plants may, in fact, be conservative.
Implications for Regulated Power Generating Companies
As discussed at the beginning of this article, regulated company PP&E accounting is based on regulatory accounting guidelines. However, as publicly traded companies, accounting practices still must conform to fiduciary standards and what is generally regarded as accepted accounting practices. While I am not aware of any example of an independently own utility using generally accepted accounting principles as a rationale for seeking capital recovery for new plant investments, I offer the following suggestions to promote thinking in this regard.
The same component-level approach used to determine the depreciable life of unregulated plants can also be used to define the period of time over which regulated companies should be allowed to recover their investments in new plants. The first step in projecting a plant’s technological life is to estimate the life of each component in a system-by-system breakdown of plant construction cost. Estimates are based on a common component service life table that groups components according to their operating environment (e.g., high energy), standard industrial classification (SIC) category, and accounting treatment (i.e., capitalized or expensed) and assigns a life to each grouping.
These estimates are applied to calculate the life of each system and the overall plant based on the percent of total plant construction cost represented by each component. Thus overall plant life, which represents the appropriate period of capital investment recovery, is ultimately based on component life. Component life, in turn, is based on whether or not costs incurred for replacing or upgrading original plant components are capitalized or expensed. If they are capitalized, the assigned life is based on the actual life of replaced components or the design life of the replacement components. If they are expensed, the assigned life must consider the additional life—beyond original component life—allowed by the replacement. This “service life”—which is component design life as extended by ongoing maintenance including replacements and upgrades—is significantly longer than component design life. The common component service life table used in TMI studies uses service life for all components with the exception of components such as the distributed control system, which becomes technologically obsolete before it wears out.
Regulated companies can use this same approach to determine the period of time over which new plant investments should be recovered—but with one significant difference. The life assigned to each component is based on original component design life rather than component service life. This is because what state regulators initially approve as “used and useful” for capital recovery in rate base is the new plant—i.e., the sum total of original components. The resulting period for new plant investment recovery would be about 25 years for most power generating technologies. This is because, with the exception of structural components, components have a design life of 5-to-30 years.
Even if it is not politically feasible for a state regulatory commission to approve a 25-year capital investment recovery, which could cause an unacceptable increase in electrical rates, there are still advantages to presenting this approach in rate cases. A corollary to the argument justifying recovery based on component design life is that achieving a plant life beyond the life of original components requires a high standard of maintenance care to ensure efficient operations over the number of years approved for capital recovery. In seeking recovery of maintenance costs in subsequent rate cases, companies can frame their requests in terms of the high standard of maintenance care necessary to operate the plant over its full operating life, as defined by the capital recovery period.
As in the depreciable life studies of unregulated plants, which must be reviewed and approved by independent public accountants and at times the SEC, the analysis is supported by references to accounting standards. Such arguments are particularly persuasive with the passage of the Sarbanes-Oxley Act, which introduces strict governance and accounting transparency requirements. As publicly traded companies, regulated power generating companies must meet such fiduciary standards.
A particular benefit of this approach for power generating companies with both regulated and unregulated assets is that it puts depreciation recovery and regulated capital recovery on a consistent analytical basis. Thus if the same type of plant is built for regulated and unregulated businesses, a depreciable life of 50 years for the regulated plant is consistent with a capital recovery period of 25 years for the regulated plant.
Summary and Conclusions
On balance, the outcome of FASB actions in March is favorable for both unregulated and regulated power generating companies. For unregulated companies, any downside from pending actions to disallow the Accrual Method can be addressed by capitalizing major maintenance expenses. More importantly, new PMMA standards will continue to allow the use of a component-level approach to determining the depreciable life of plants, while not introducing the administrative burden of accounting for PP&E costs at the component level. For regulated companies, the evolving PP&E accounting standards can be used to support arguments before state regulatory commissions for a rate of recovery in new plant investment based on the design life of original plant components, which in most states would mean a much more rapid recovery of new plant capital investment. Where this is not politically feasible, GAAP and Sarbanes-Oxley requirements can be used to support full recovery of maintenance cost during the plant in-service stage consistent with a clearly defined standard of maintenance care.
1. Plant Component-Level Accounting—Having Your Cake and Eating It Too, Ray Mischkot, Energy Pulse, June 16, 2004
2. Minutes of March 8, 2006, Board Meeting—Planned Major Maintenance Activities Agenda Request, March 14, 2006
3. Board Meeting Handout, Planned Major Maintenance Activities, March 8, 2006
4. Minutes of the February 2, 2005 Board Meeting, February 8, 2005
5. International Accounting Standard 16, Property, Plant and Equipment, International Accounting Standards Board, undated
6. Memorandum of Understanding, “The Norwalk Agreement”, September 18, 2002
7. Are You Undervaluing Your Unregulated Generating Assets?, Ray Mischkot, Energy Pulse, August 24, 2005