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18.3 Allowance for funds used during construction
Publication date: 22 Nov 2023
us Utilities guide
Constructing utility plant takes time, potentially resulting in the incurrence of significant carrying costs in advance of when the facilities are ready for use and included in allowable costs for ratemaking purposes. In most cases, a regulated utility does not earn a return on assets under construction to cover financing costs incurred during the construction period. Therefore, regulators typically allow utilities to capitalize an allowance for funds used during construction (AFUDC) for future recovery. ASC 980-835-30-1 requires capitalization of AFUDC if the regulated utility’s regulator provides for its recovery. The primary difference between AFUDC and interest capitalized under ASC 835 is that AFUDC includes a component for equity funds. If AFUDC is capitalized, the regulated utility should record a corresponding increase in pre-tax income for the component for equity funds. See UP 18.3.4 for information on financial statement presentation of AFUDC.
See UP 19.2.2 for further information on income tax considerations related to the equity portion of AFUDC.
Question UP 18-1
If a regulator does not permit recovery of AFUDC, does it result in a disallowance of utility plant?
If a regulator does not permit recovery of AFUDC, does it result in a disallowance of utility plant?
PwC response
No. As discussed in ASC 980-340-55-2, a regulator may permit recovery of an incurred cost without providing for any return (such as for a plant prior to completion and inclusion of the plant in rate base). The regulator’s decision not to provide a return on an incurred cost does not impact the regulated utility’s ability to record the underlying asset, except in the limited case of abandoned plants (see UP 18.7.1). Consistent with this guidance, a regulator’s decision to deny recovery of AFUDC does not result in a disallowance or any adjustment to the carrying value of the plant under construction.
18.3.1 Criteria for capitalization of allowance for funds used during construction
In accordance with ASC 980-835-25-1 and 30-1, AFUDC should be capitalized only during periods of construction and only if it is probable that the regulated utility will receive subsequent recovery through the ratemaking process. Any amounts that are not probable of recovery should not be capitalized. Furthermore, pursuant to ASC 980-835-25-2, if AFUDC is not capitalized because future recovery through rates is not probable, the regulated utility should not alternatively capitalize interest cost under ASC 835-20, Interest – Capitalization of Interest.
Regulated entities capitalizing AFUDC should regularly monitor the status of construction and ensure capitalization of AFUDC at the allowed rate continues to be appropriate. If completion of construction for which AFUDC is being capitalized is no longer probable, or where there is or is expected to be a plant disallowance by the regulator, the regulated utility should evaluate whether previously capitalized amounts should be written off and whether it should cease capitalizing AFUDC. In addition, when construction in progress is permitted in rate base, specific requirements regarding the capitalization of AFUDC may apply (see UP 18.4). Considerations regarding the capitalization of AFUDC during construction are addressed in ASC 980-835-25-2 through 25-4 and summarized in Figure UP 18-1.
Figure UP 18-1
Recognition of allowance for funds used during construction
Recognition of allowance for funds used during construction
Status of construction |
Impact on AFUDC |
Completion of the plant and recovery of all construction costs is probable
|
|
Completion of the plant is reasonably possible but no longer probable
|
|
Disallowance of plant costs is reasonably possible
|
|
Plant is probable of being abandoned or all or a portion being disallowed
|
|
Example UP 18-1 illustrates the accounting for AFUDC when it is reasonably possible that a portion of the plant costs will be disallowed.
EXAMPLE UP 18-1
Application of AFUDC — cap on amount of AFUDC imposed by the regulator
Application of AFUDC — cap on amount of AFUDC imposed by the regulator
On July 1, 20X1, Rosemary Electric & Gas Company (REG) began construction of the Camellia Generating Station, a 575 MW natural gas-fired power plant. The total cost of construction is budgeted at $500 million. Construction is scheduled for completion in June 20X7. REG obtains an order from its regulator that:
- Approves recovery of construction costs up to $500 million, subject to prudency review
- Allows AFUDC on the cost of construction, at REG’s approved cost of capital (both debt and equity components)
- Orders REG to include the Camellia power plant in its rate base in its first general rate case subsequent to the plant being placed in service
REG starts capitalizing AFUDC. In 20X3, management determines that the total cost of construction will be $600 million. Management discusses the expected cost overruns with the regulator; however, the regulator does not change the cap on construction costs permitted for recovery, subject to further evaluation in the next general rate case.
Should REG continue to capitalize AFUDC for amounts that exceed the original $500 million once it determines that the cost of construction will exceed the cap approved by the regulator?
Analysis
As a result of the cap, REG determines that recovery of AFUDC is not probable on any construction costs incurred in excess of $500 million. REG should continue to record AFUDC on expenditures up to $500 million; however, no AFUDC should be applied on amounts in excess of the cap. In addition, REG will need to assess whether a disallowance should be recorded on construction costs in excess of the cap. See UP 18.7.2 for further information on accounting for disallowances of recently completed plant.
18.3.2 Deferral of shareholder return outside the construction period
Due to the timing of rate case filings, regulators may allow a regulated utility to recover a carrying cost (including both debt and equity return, similar to AFUDC) on the value of plant placed in service from the commercial operation date to the effective date of inclusion of the plant in rates charged to customers. A regulated utility may also request other similar arrangements to compensate it for delays in including significant capital projects in rate base.
ASC 980-340-25-5 through 25-6 clarify that regulated utilities applying ASC 980 are not permitted to capitalize the cost of equity, except while a plant is under construction.
Excerpt from ASC 980-340-25-5
If specified criteria are met, paragraph 980-340-25-1 requires capitalization of an incurred cost that would otherwise be charged to expense. An allowance for earnings on shareholders’ investment is not an incurred cost that would otherwise be charged to expense. Accordingly, such an allowance shall not be capitalized pursuant to that paragraph.
Consistent with this guidance, although a regulator may permit a utility to recover the “cost” of equity in rates, the regulated utility should not capitalize the equity component or otherwise record a regulatory asset for financial reporting purposes, regardless of whether future recovery is probable. The equity component should not be recognized until it is collected through rates. However, if recovery is probable, it would be permissible to defer debt-only carrying costs as a regulatory asset. Any debt-related amounts capitalized under this type of arrangement should be classified as a regulatory asset, not as part of the utility plant balance. Furthermore, the regulated utility should base the amount deferred on its actual interest costs incurred associated with that plant or capital project. It would not be appropriate to base the deferral amount on the regulated utility’s hypothetical capital structure.
Examples UP 18-2 and UP 18-3 illustrate the capitalization of debt-only carrying costs.
EXAMPLE UP 18-2
Recovery of carrying costs — acquisition financed through debt issuance
Recovery of carrying costs — acquisition financed through debt issuance
On February 1, 20X1, Rosemary Electric & Gas Company (REG) acquires a 300 MW combined-cycle natural gas-fired electric generation plant for $250 million. The next general rate case is not expected until 20X3; therefore, REG petitions for and receives approval from its regulator to:
- Defer operating and maintenance expense, depreciation, taxes, and cost of capital invested in rate base beginning with the filing date of the petition and ending with the effective date of new rates from the 20X3 general rate proceeding
- Defer monthly carrying costs on the deferred costs at its approved rate of return of 10% until amortization begins
- Recover the deferred amounts over the three-year period commencing the earlier of January 1, 20X2, or the effective date of implementation of new rates from the general rate case
REG has a rate order permitting it to recover its carrying costs as well as operating costs for the new plant until the plant is included in rates. The approved carrying cost of 10% includes an equity component. REG’s weighted-average debt cost is 6.5%. The acquisition of this facility was financed through issuance of new debt with financing cost of 5%.
How should REG account for its carrying costs during the period from receipt of its rate order until the implementation of new rates?
Analysis
For financial reporting purposes, REG should defer only the carrying cost related to the cost of debt used to finance the plant (5% in the example). Although the regulator approved recovery of REG’s full cost of capital, in accordance with ASC 980-340-25-5 through 25-6, REG is not permitted to defer equity carrying costs because the plant is not under construction (where deferral of equity carrying costs would be permitted as part of AFUDC). The regulated utility should record deferral of debt cost as a regulatory asset separate from utility plant.
EXAMPLE UP 18-3
Recovery of carrying costs — acquisition financed through general funds
Recovery of carrying costs — acquisition financed through general funds
Assume the same facts as Example 18-2, except that REG financed acquisition of the new facility through its general funds.
How should REG account for its carrying costs during the period from receipt of its rate order until the implementation of new rates?
Analysis
Similar to the analysis in Example 18-2, REG would not be permitted to defer its equity-related carrying costs. Furthermore, because acquisition of the facility was financed through general funds, REG would need to estimate the amount of debt costs associated with the acquisition. One approach to determining the amount to defer is to multiply the carrying value of the facility by its weighted-average cost of debt. The rate used to calculate the amount deferred should be updated periodically. In addition, amounts deferred should be recorded in a regulatory asset separate from utility plant.
18.3.3 Capitalization of interest on a regulated equity method investee
ASC 835-20-15-6(e) and 55-3 provide guidance on the investor’s accounting for capitalized interest related to an investment in a regulated investee that the investor accounts for under the equity method. In accordance with this guidance, a reporting entity that holds an investment in a regulated utility and accounts for its investment under the equity method is not permitted to capitalize interest on its investment. Rather, the regulated investee would capitalize AFUDC during the construction period, which would be recognized indirectly by the investor in its income statement through its equity method earnings.
18.3.4 Presentation and disclosure of allowance for funds used during construction
There are specific disclosure considerations for AFUDC as discussed below.
18.3.4.1 Balance sheet
ASC 980-360-25-1 specifies that AFUDC should be capitalized “as part of the acquisition cost of the related asset.” Consistent with this guidance, AFUDC should be recorded as part of utility plant and not as a separate regulatory asset.
18.3.4.2 Income statement
ASC 980-835-45-1 provides guidance for the income statement classification of AFUDC, indicating that it may be an item of other income, a reduction of interest expense, or both (i.e., the debt component reported as a reduction of interest expense and the equity component included in other income).
18.3.4.3 Statement of cash flows
ASC 230 does not address the classification of AFUDC. However, it does specify that capitalized interest on property, plant, and equipment is a cash outflow from investing activities:
Excerpt from ASC 230-10-45-13
All of the following are cash outflows for investing activities:
…
(c) Payments at the time of purchase or soon before or after purchase to acquire property, plant, and equipment and other productive assets, including interest capitalized as part of the cost of those assets.
Consistent with this guidance, the debt portion of AFUDC should be classified within investing activities in the statement of cash flows. Similar to the debt component, the equity portion of AFUDC is a noncash increase to net income in the income statement. However, the capitalization of the cost of equity arises due to regulated accounting and is not covered by the guidance for capitalized interest. Therefore, the equity portion of AFUDC should be reported as a noncash adjustment to net income (i.e., a reduction of operating cash flows).
18.3.4.4 Disclosure
ASC 980-340-50-3 requires disclosure of any allowance on shareholder investment capitalized for ratemaking purposes but not recognized for financial reporting.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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