Enhancing Effectiveness of Plant and Depreciation Accounting APPA Business and Finance Workshop Jacksonville, Florida September 22, 2004

Presenters Mindy Willis – Director of Accounting Services, Orlando Utilities Commission Tom Unke, Partner, Virchow, Krause & Company, LLP

Session Background Public Utilities are increasingly seeing higher expectations from regulators and stakeholders to ensure that methods to report and account for plant construction is done accurately. As utility plant assets mature and unplanned replacement project costs increase, public utilities face increased rate pressure.

Inconsistencies with accounting treatment have continued to persist over the years. Tolerance levels for accuracy and the increased fiduciary expectations over utility assets have prompted serious assessments of current utility practices.

Simple facts for all public power utilities Utility plant in service represents one of the largest assets owned by city government. Utility plant is the basis for determine just and reasonable rates.

What are the problems? Insufficient standard industry guidance to determine when capitalization or expense recognition is appropriate. Sins of the past. Ambiguous capitalization of construction and single mass assets make it extremely difficult to properly reflect retirements. Changes in technology and software have both changed the manner in which construction costs can be accounted for and the life of originally recorded assets.

What are the problems, continued Technology changes allow utilities to become increasingly accurate for plant accounting, but the process utilities follow to accumulate and track construction hasn’t The introduction of new utility services (i.e. telcom) creates more challenges relative to plant accounting, cost allocation and retirement accounting.

Session’s objective To interactively share experiences of Orlando Utilities Commission and Virchow Krause relative to plant accounting, depreciation recognition and generally accepted utility plant industry practices. To provide a reference source for your utility to use when making enhancements to existing systems.

Discussion topics Retirement accounting –how to retire an asset that isn’t a specified retirement unit Technology spending –how and when to capitalize Depreciation accruals –what are reasonable rates and do you need a depreciation study to ensure your rates are reasonable Capitalization Policies –what is reasonable and makes sense for your utility

I. Retirement Accounting Broad capitalizations in previous years makes retirements extremely difficult. Inadequate communications of retired assets from operations staff makes retirements extremely difficult Given depreciation methods such as individual or group/class asset depreciation, utilities usually do not properly reflect asset retirements properly.

Broad Capitalizations First, implement a strategy to fix the issue going forward –Establish a method to determine manageable cost pools when unitizing assets upon project completion and if your assets values tend to very large, work with the engineers to establish retirement units that focus on identifiable units –Try to stay away from non-mass units titled “2004 substation project”. Try for: Arthur road buss bar; Arthur road fuse link, etc. –Focus on allocating costs to units that have similar useful lives. This will increase the probability of not having to make partial retirements.

Broad Capitalizations Next, determine applicability to implement changes/reclasses to asset records that are readily available (10 years for large non-mass projects). Manage changes for information that is available and develop a policy for addressing partial retirements systematically….but don’t feel a requirement to reinvent property records beyond a set number of years. Remember, this process will eventually fix itself by implementing a new process now.

Focus on established unit of property policies to assist with work order closings. The majority of public power utilities do not use unit of property accounting. Units of property help provide employees the ability to determine if maintenance or replacement has occurred.

Inadequate Communications for Retirements Implement work order authorization/opening procedures that require a good project description including inquiring on whether or not the project is a new addition or replacement. Upon project completion, require closing procedure to ensure there is proper capitalization detail for future retirements. Have plant accounting personnel also look for other signs of retirements such as salvage or cost of removal activity.

Retirement entries Many utilities feel that not making retirements is just not that important since most entities assume a fully depreciated asset upon retirement. With mass units such as poles, wire, URD, etc this is typically allowable since group based depreciation allows for the assumption of fully depreciated assets. This is because depreciation studies are meant to compensate through increasing or decreasing depreciation rates in future studies.

Retirement Entries However, non-mass assets accounted for using a individual unit method of asset tracking typically will result in a recognition of a gain or loss upon retirement. If assets have existing book value, loss should be recognized through the income statement upon retirement. Overall, the exclusion of retirements could misstate your net investment in plant.

II. Technology Spending What about systems planning costs before development occurs? What to do with in-house development costs and the development of utility- owned intellectual property? How to account for the costs of hardware when hardware costs fall below your capitalization limits.

System planning costs before development Costs associated with investigating alternatives should be expensed as these costs do not enhance the future asset – they help you make a better decision All costs incurred up to the time of final project selection should be expensed including travel and site visits

Dealing with large planning investments for technology Some states have allowed deferral of costs for future rate recovery if current rates are not sufficient to cover the costs. For those implementing FAS #71, options for deferral may be available assuming they meet FAS #71 criteria.

In-house development costs In-house development typically begins upon the formal approval for the project and a project leader has been assigned to control project. Capitalize all direct costs associated with development. This process differs greatly among utilities.

In-house development costs, cont. Utility A – Capitalize only direct costs. Utility B – Capitalize labor costs and indirect costs up to a cap. Utility C – Only programming costs and related loadings.

In-house development Auditors have a responsibility to determine reasonableness and ensure materially correct financial statement presentation. All of the previous examples should be allowable for external auditors.

Hardware investment accounting options When hardware that, on a per unit basis falls below your capitalization criteria, is purchased in bulk the assets may be capitalized as a group asset. Regardless of whether or not the hardware assets are capitalized, these assets should still be tracked for control purposes

Hardware investment accounting Calls to several large utilities (including IOUs) provided differing aspects of capitalization. The majority do capitalize assets as classes of costs if the joint purchase is over a certain dollar limit. Most also acknowledged that it will eventually be problematic for future retirements, however.

III. Depreciation Accruals Many public power utilities use either a composite depreciation rate or individual FERC account rates that usually haven’t been modified for quite some time. Are they reasonable? Do they serve as an accurate reflection of your surviving utility assets.

First the facts on depreciation Depreciation is an arbitrary allocation of a plant investment’s cost over the service life of the particular asset. The assertion being obtained is properly matching the cost of the asset with the revenue being generated by the asset being in service. Of course, the “arbitrary allocation” is based on professional judgement.

Depreciation is an estimate Depreciation is and will always be an estimate. However, that is not a sufficient reason to assume your existing rates are reasonable. All utilities need to provide reasonable assurance that due diligence has been invested to deem your existing rates are reflective of professional judgment placed upon the service life of your assets.

Where do I start? Look to your regional neighbors including IOU’s to determine if they have had studies completed. You may need to look regionally since weather and other climate conditions may impact the lives of assets. Some states require IOUs to complete these studies every five years.

Other options Conduct a depreciation study of your assets. Please understand the commitment you will be making to complete a depreciation study…

Depreciation Studies Analyzes addition and retirement histories of assets and asset classes to determine the average surviving life of assets. Creation of survivor curves allows for the mathematical calculation of average service life. Average service life equates to defendable depreciation accruals for your utility.

Depreciation studies, cont. Several methods exist but most use the same general principles. Importance of understanding your limitations is critical. –Existing plant ledger –Retirement methodology –Accuracy of existing assets listing.

IV. Capitalization Policies Capitalization Policies determine thresholds for when assets need to be capitalized to the statement of net assets. They typically do not determine if your utility should track the asset in your fixed asset system.

Capitalization vs. Asset control Asset control is as critical to your utility as the recording of assets. For example, assets susceptible to misappropriation should always be managed within your system. However, they may not be capitalized with a depreciable value. Why? Administrative feasibility is easier while still promoting accountability over the control of the asset.

Capitalization Policy considerations Differences for type of assets. Overriding criteria given risk of misappropriation. Consideration of materiality and administration to manage to assets once capitalized.

How to make positive change. Suggestions…

Continuous Improvement Suggestions Obtain buy-in Commit to an evolution not a revolution Make changes in the confines that engineers and linemen will never be accountants Sell the value for making change Perform a serious evaluation of your plant accounting process Try to give something to get a lot in return.

Obtaining buy-in to create value Educate management and engineers as to how utility plant is accounted Post information memos on internal webs Demonstrate impact of depreciation on rates and how unplanned retirements can effect current year operations

Commit to an evolution not a revolution Start slowly and always continue to educate Highlight things to remember during the budget process Inquire regularly with management on approved projects to ensure costs are accounted for properly in the beginning

Evaluate your plant accounting process Many problems for retirements and depreciation come from inadequate plant accounting procedures. Garbage in…..

Give a little to get a lot Change is easier when a trade-off can be achieved. The perception of change means more work. Clearly provide an opportunity to reduce work for the team members that you are asking to do things differently.

Reference Sources Depreciation rates benchmarks from selected utilities.