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3311 OTHER SPECIALIZED UTILITY ACCOUNTING PRACTICES
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FLOW-THROUGH ACCOUNTING ASSUMING DECREASE IN CUSTOMER RATES Income Statement Revenue Depreciation Other expenses Income before taxes Federal income taxes: Payable currently (34% $48) Deferred Total Net income $948 (200) (600) $148 16 $ 16 $132 Tax Return $948 (300) (600) $ 48 16 Timing Difference $100 $100
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Exhibit 339 Illustration of ow-through accounting with a decrease in rates
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The comparison of the normalization and ow-through concepts in Exhibit 3310 illustrates that operating income continues to be $132 under both methods and that the $52 of savings in revenue requirement in Year 1 due to ow-through is offset by $52 of higher rates in Year 3 For simplicity, this example ignores the rate base reducing effects of deferred taxes The comparison illustrates the principal argument for normalization that revenues are at a level, or normal, amount, whereas revenue varies greatly under ow-through Advocates of normalization note that normalization distributes income tax expense to time periods, and therefore to customers revenue requirements, consistently with the costs (depreciation) that are affecting income tax expense As the rate-making process necessarily involves the deferral of costs such as plant investment and distribution of these costs over time, normalization is used to produce a consistent determination of income tax expense Normalization also recognizes that the using up of tax basis of depreciable property (or using up an asset s ability to reduce taxes) creates a cost This cost should be recognized as the tax payments are reduced Basing tax expense solely on taxes payable without recognizing the cost of achieving reductions in tax payments is not consistent with accrual accounting Although ow-through rate making ignores this current cost, this cost does not disappear any more than the nonrecognition of depreciation for rate making would make that cost disappear (iii) Provisions of the Internal Revenue Code Complicating the regulatory treatment and nancial reporting of income taxes for utilities are signi cant amounts of deferred income taxes that are protected under provisions of the IRC That is, normalization is required with respect to certain tax and book depreciation differences if the utility is to remain eligible for accelerated depreciation A historical perspective of tax incentives and tax legislation, as they relate to the utility industry, is helpful in understanding why the regulatory treatment of income tax is of such importance (iv) The Concept of Tax Incentives The rst signi cant tax incentive that was generally available to all taxpayers was a provision of the 1954 Code that permitted accelerated methods of depreciation Prior to enactment of this legislation, tax depreciation allowances were generally limited to those computed with the straight-line method, which is traditionally used for nancial reporting and rate-making purposes The straight-line method spread the cost of the property evenly over its estimated useful life The accelerated depreciation provisions of the 1954 Code permitted taxpayers to take greater amounts of depreciation in the early years of property life and lesser
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33 30 COMPARISON OF NORMALIZATION AND FLOW-THROUGH Normalization Year 1 $1,000 (200) (600) 200 68 68 $ 132 $ 132 68 204 $ 396 102 (34) 204 200 600 148 16 16 $132 $1,000 (200) (600) $3,000 (600) (1,800) $(948) (200) (600) Year 2 Year 3 Total Year 1 Flow-Through Year 2 $1,000 (200) (600) 200 68 68 $ 132 Year 3 $1,052 (200) (600) 252 120 120 $ 132 Total $3,000 (600) (1,800) 600 204 204 $ 396 200 34 34 68
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Revenues Depreciation Other expenses
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Income taxes Payable currently Deferred taxes
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Exhibit 3310 Illustration of normalization versus ow-through differences
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3311 OTHER SPECIALIZED UTILITY ACCOUNTING PRACTICES
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amounts in later years Although accelerated methods permit taxpayers to recover capital investments more rapidly for tax purposes, deductions are limited to the depreciable cost of property Thus, only the timing, not the ultimate amount of depreciation, is affected Because utilities are capital intensive in nature, accelerated depreciation provisions generate signi cant amounts of tax deferrals Additionally, other sources of deferred taxes can be relatively small in some industries but are magni ed in the utility industry because of its large construction programs Among the major differences, generally referred to as basis differences, are interest, pensions, and taxes capitalized as costs of construction for book purposes but deducted currently (as incurred) as expenses for tax purposes Once again, it is the timing, not the ultimate cost, that is affected Accelerated methods and lives were intended by the US Congress to generate capital for investment, stimulate expansion, and contribute to high levels of output and employment The economic bene t to the taxpayer arising from the use of accelerated depreciation and capitalized costs is the time value of the money because of the postponement of tax payments The availability of what are effectively interest-free loans, obtained from the US Treasury, reduces the requirements for other sources of capital, thereby reducing capital costs Prior to the Tax Reform Act of 1986, these capitalized overheads represented signi cant deductions for tax purposes However, subsequent to that Act, such amounts are now capitalized into the tax basis of the asset and depreciated for tax purposes as well Thus, the bene ts that once resulted from basis differences have, to a large extent, been eliminated (v) Tax Legislation A brief history of the origin of accelerated tax depreciation and the intent of the US Congress in permitting liberalized depreciation methods is helpful in understanding the regulatory and accounting issues related to income taxes
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Tax Reform Act of 1969 The accelerated tax depreciation methods initially made available to taxpayers in 1954 were without limitations in the tax law as to the accounting and rate-making methods used for public utility property However, in the late 1960s, the US Treasury Department and Congress became concerned about larger-than-anticipated tax revenue losses as a result of rate regulatory developments Although both Congress and the Treasury realized that accelerated tax deductions would initially reduce Treasury revenues by the tax effect, they had not anticipated that ow-through would about double (at the then 48% tax rate) the Treasury s tax loss because of the tax-on-tax effect Depending on the exact tax rate, about one-half the reduction in payments to the Treasury came from the deduction of accelerated depreciation and the other one-half from the immediate reduction in customer rates from the use of ow-through It was this second one-half reduction of Treasury revenues that was considered unacceptable Furthermore, immediate owthrough of these incentives to utility customers negated the intended congressional purpose of the incentives themselves It was the utility customers who immediately received all of the bene t of accelerated depreciation Accordingly, the utility did not have all the Treasury capital that was provided by Congress for investment and expansion Faced with larger-than-anticipated Treasury revenue losses, Congress enacted the Tax Reform Act of 1969 (TRA 69) By adding Section 167(1), it limited the Treasury s exposure to revenue losses by making the accelerated depreciation methods available to public utility properties only if speci c qualifying standards as to accounting and ratemaking were met Although Section 167(1) did not dictate to state regulatory commissions a rate-making treatment they should follow with respect to the tax effects of accelerated depreciation, the Act provided that:
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