AFUDC - Compliance or Non-Compliance

The allowance for funds used during construction (“AFUDC”) rate calculation is the Federal Energy Regulatory Commission’s (“FERC” or “Commission”) long-standing regulation that permits a regulated electric or gas utility to earn a return on the construction costs of utility plant during the period of construction. AFUDC is not an innocuous accounting provision to ignore as it can represent a material percentage of capitalized construction costs that will ultimately impact rate base and depreciation in the cost of service rate for electric and gas utility companies. As such, we briefly discuss certain provisions of AFUDC, the importance of compliance, and practical advice to ensure compliance as an electric or gas utility company or a stakeholder to cost of service rates. The AFUDC rate is determined annually and applied on a monthly basis to eligible construction costs to determine the amount of AFUDC that is a capitalized as a cost of construction and recovered through rates once the utility plant is placed in service. While the Commission’s AFUDC rules are numerous, they are not complex and have been in place for more than 40 years without any significant modification. Yet there has historically been repeated noncompliance on the accounting for AFUDC. Generally, noncompliance comes from failure to properly capture all sources of financing in computing the AFUDC rate, which includes all amounts of short-term debt, long-term debt, and equity financing. AFUDC noncompliance also frequently comes from failure to appropriately utilize or compute the cost rates associated with debt and equity financing and failure to seek Commission waiver to depart from Commission’s AFUDC rules. AFUDC compliance has been an area of emphasis to the Commission for decades as the Commission’s Office of Enforcement has publicly noted an AFUDC compliance focus through its public audit reports and Annual Report on Enforcement. An example of AFUDC noncompliance and the material impact of it became evident in the Commission’s November 8, 2017 delegated audit report in Docket No. FA15-16-000 and the related December 17, 2020 Order on Paper Hearing affirming the contested audit finding on AFUDC, which resulted in approximately $50 million overstatement of AFUDC. In terms of impact, noncompliance with AFUDC may result in corrections to prior periods and could result in material reductions to plant balances, reductions to current period earnings, and potential refunds. Accordingly, it is paramount that regulated electric and gas utility companies and the stakeholders subject to utility cost-of-service rates thoroughly understand and evaluate compliance with AFUDC to ensure FERC-jurisdictional rates are just and reasonable. Fundamental aspects to the Commission’s AFUDC regulations include the following:

• The Commission’s AFUDC rules and regulations include: (1) 18 C.F.R. Part 101, Electric Plant Instruction No. 3(17) and 18 C.F.R. Part 201, Gas Plant Instruction No. 3(17); Order No. 561 (57 FPC 608 (1977) and Order No. 561-A (59 FPC 1340 (1977); Accounting Release AR-5, Capitalization of Allowance for Funds Used During Construction; and Accounting Guidance in FERC Docket No. AI93-5-000, Accounting for Income Taxes.
• The AFUDC rate is established at the beginning of each year and it sets the maximum AFUDC rate allowed to be used to capitalized construction costs.
• The AFUDC cannot exceed the overall rate of return applied to rate base.
• Short-term debt is considered the first source of funds for construction.
• The AFUDC rate is computed using all sources of capital available to the utility. The intended use of capital is not a factor in determining the AFUDC rate. As such, specific short-term debt or long-term debt proceeds not intended for construction activities cannot be excluded from the AFUDC rate computation.
• The AFUDC rate formula utilizes monthly estimates for short-term debt and construction cost, which must be compared to actual amounts at year end to determine if a material deviation results. A material deviation occurs if the AFUDC rate computed with estimates exceeds by up to 25-basis points the rate that would be derived from actual experience. Where a material deviation exists, capitalized AFUDC accruals should be adjusted.
• To utilize an alternative AFUDC rate methodology that produces a higher AFUDC rate than the Commission’s prescribed rate, an electric or gas utility must obtain a waiver from the Commission.
• AFUDC capitalization begins when capital expenditures for the project have been incurred and activities that are necessary to get the construction project ready for its intended use are in progress. Capitalization of AFUDC stops when the facilities have been tested and are placed in, or ready for, service.
• Federal income tax regulations do not allow the capitalized portion of AFUDC associated with equity financing (AFUDC Equity) as an income tax deduction in the tax return of an electric or gas utility company. However, AFUDC Equity is a part of depreciation expense for utilities for financial reporting purposes. FERC accounting guidance in Docket No. AI93-5-000 specifies that the difference between the federal income tax and financial reporting treatment of AFUDC Equity is recorded as a deferred income tax liability with an offsetting regulatory asset. For ratemaking purposes, the Equity AFUDC deferred tax liability is generally a specified adjustment in the computation of the income tax allowance.

For regulated electric or gas utility companies, how sure are you that your company is compliant? Are you following a “historical” accounting practice for AFUDC but not sure if it is fully compliant? As noted above, the AFUDC rules are numerous and at times can be complex if there are different AFUDC requirements for retail rate regulation. Here are some tips to help navigate through the Commission’s AFUDC regulatory requirements:

For stakeholders that are currently under cost of service rates with electric and gas utility companies, it is important not to overlook risks of material overstatements of capitalized AFUDC. Prior period errors in AFUDC could result in refunds, decrease rate base, and decrease depreciation expenses. Additionally, ensuring AFUDC is properly computed will ensure future rates are not overstated. A full review of AFUDC compliance typically requires more resources than practical for most stakeholders. However, there are some helpful tips to identify potential material errors without a strain on resources.

Know the factors that have the greatest impact on capitalized AFUDC. For example, the failure to use all short-term debt in the AFUDC rate computation and failure to identify material deviations in excess of 25 basis points could result in significant AFUDC errors.

Engage in established tariff and ratemaking processes to evaluate AFUDC compliance. For example, engage in the annual information exchange process required in the tariff protocols of wholesale electric formula rates. Additionally, consider intervening in accounting filings seeking Commission waiver of select AFUDC requirements by electric and gas utility companies to ensure your concerns are heard and interests are protected

Utilize industry experts in the Commission’s AFUDC accounting and ratemaking requirements to help you assess the risk of material noncompliance, engage in discovery, and communicate any AFUDC concerns identified with the utility and Commission, as appropriate.

When noncompliance is discovered, seek refunds and take appropriate measures to ensure that the noncompliance ceases.

For more information or to comment on this article, please contact: