GAAP represent accounthing theory and practice that apply to enterprises in general. However, due to the peculiar nature of some industries and business entities, certain principles and practices which apply to businesses in general are inadequate or inappropriate. As a result, we see the development of specialized industry practices which vary from GAAP, adding to the confusion of financial statement users and limiting the comparability and usefulness of the statements. Nevertheless, certain circumstances make the specialized practices desirable, with the advantages of the variations from GAAP outweighing the disadvantages.

The FASB currently prescribes authoritative accounting guidelines for all enterprises, but regulated companies must also comply with the financial reporting requirements mandated by federal, state and local regulatory agencies. In the telecommunications industry, for example, an operating telephone company must report financial data to three regulatory entities--the Federal Communications Commission (FCC), the appropriate state Public Service Commission (PSCs), and the SEC. The accounting requirements of these agencies are not consistent. Federal and state regulators require data useful for interstate and intrastate rate-making purposes, respectively. The SEC, on the other hand, requires data which comply with GAAP for the protection of investors, creditors and other users of general purpose financial statements. The inconsistency for data requirements necessitates the application of separate accounting procedures and the maintenance of separate accounting records to satisfy both regulatory and financial reporting demands.

As shown in Exhibit 1, different income statement formats, as well as amounts, may be reported to the regulatory agencies because of the inconsistency of data requirements. In the telephone industry, the differences between these statements result from transactions known as "off-book adjustments" and "jurisdictional differences." Off-book adjustments, which generally reflect the effects of timing differences for recognition of expenses, account for the differences between reports to regulatory bodies and reports issued to external users. Jurisdictional differences (JDs) are the result of accounting requirements mandated by the state commissions, such as state-specific depreciation rates. These JDs are included in operating results for external reporting but are segregated as non-operating for FCC reporting purposes. While off-book and JD entries identify the differences between regulated accounting requirements and GAAP, SFAS 71, Accounting for the Effects of Certain Types of Regulation, provides for proper financial reporting where such differences exist.

Rate Regulation and GAAP

One of the primary functions of a regulatory agency, such as the FCC, is the establishment of the rates that a regulated company may charge its customers. Many regulators have instituted a Uniform System of Accounts (USOA) to ensure uniformity in accounting and financial data and also require specific accounting or financial reporting practices to ensure that regulated enterprises provide the data necessary for proper rate determination. Regulation of an enterprise's prices, or the rates charged to customers, is based on the enterprise's costs. These costs are known as "allowable costs" and may include operation, maintenance, depreciation and amortization expenses, taxes, and an allowance for the use of capital.

Regulatory agencies set rates so that the regulated business may generate revenues which will approximate these allowable costs. Because of specific accounting requirements demanded by regulators, however, some allowable costs may be included in a period other than the period in which the costs would be charged to expense by an unregulated company. In other words, regulators often require capitalization or deferral of expenditures that would normally be expensed in the current period by a nonregulated company following GAAP. Thus, the accounting practices prescribed by the regulatory body often differ from GAAP, with most differences attributalbe to requirements unique to the rate-making process. The regulatory accounting requirements which differ from GAAP often have a material impact on the regulated company's financial statements. In turn, movement toward consistency in financial reporting among regulated and non-regulated entities may also have a material impact on the financial statements of regulated enterprises, if economic realities of the regulating process are not property reported.

Authoritative Pronouncements and

Regulatory Accounting

The effects of regulatory requirements on utility accounting was addressed in a limited manner by standard-setting bodies which preceded the FASB. Their efforts were extremely general and actually created additional confusion in the accounting for regulated enterprises. They failed to identify the industries to which their guidelines applied and did not adequately define the accounting principles to be used by a regulated company in the preparation of general purpose financial statements.

As a result of existing questions and confusion about financial reporting for regulated entities, the FASB issued SFAS 71 in December 1982. This Statement focused attention on the type of regulation required for there to be an acceptable departure from GAAP and provided clearer direction as to when rate decisions provide a basis for special accounting treatment.

SFAS 71 was intended to apply to the general purpose external financial statements issued by enterprises which have regulated operations. It does not apply to the financial statements submitted to the regulatory authorities. The pronouncement recognizes that regulatory agencies will require deviations from GAAP for rate-making purposes; however, it empahsizes that regulatory accounting procedures not related to the economic effects of rate-making are not appropriate and GAAP must be followed. While the Statement does not specifically identify which regulated industries (i.e., railroad, telecommunication, or utility) must comply with its guidelines, it sets forth the following three criteria to aid in that determination. Basically, a company is considered "regulated" if:

1. An independent third party regulatory or governing body can approve or establish the rates the entrerprise can charge its customers for services or products;

2. The rates are intended to recover the specific costs of the regulated services or products; and

3. The rates are reasonable and likely to be collected.

The Statement sets forth three general standards for the effects of regulation, as defined:

1. Rate action of a regulator can provide reasonable assurance of the existence of an asset. Thus, before costs which would otherwise be expensed are capitalized or deferred, it must be probable that the regulator will allow their recovery in the future by the established rates.

2. A regulator can impose a liability on an enterprise. For example, it is not uncommon for a regulator to order a refund or revenues to customers or make provisions in rates for costs not yet incurred. Revenue refunds are recorded in the fiscal year and interim period in which such refunds become probable.

3. Rate actions of a regulator can reduce or eliminate the value of an asset. If an asset is disallowed by the regulator as an allowable cost, the asset cannot be expected to produce revenue in the future through the rate-making process. Since the asset has been impaired, it must be written down.

SFAS 71 also outline specific standards derived from these general guidelines. Regulated enterprises subject to the provisions of the Statement must comply with specified reporting requirements for capitalization of interest, intercompany profits, and interperiod tax allocation.

The concept of an allowance for funds used during construction (AFUDC) results from a regulatory belief that today's utility customers should not pay for the costs of financing construction that will benefit only future users; that is, current customers should pay a return only on assets currently performing a useful service. As a result, regulators withhold major plant construction costs from the rate until the plant is placed in service. To provide a return on their investment during a period of construction, utilities are allowed to recover the cost of construction funds from future users by capitalizing an allowance for funds used during construction. AFUDC is subsequently recovered through depreciation and is allowed a return through its inclusion in the rate base.

Certain regulators, such as the FCC, require capitalization of both debt and equity components of funds used during construction. The Interstate Commerce Commission, on the other hand, disallows capitalization of the equity portion. This is more in line with nonregulated reporting as defined in SFAS 34, Capitalization of Interest Costs, which prohibits the inclusion of the equity component in AFUDC. In either case, when a cost of funds is capitalized, net income for the period is increased by a corresponding amount, appearing on the income statement as an item such as "Income From Interest Charged During Construction." Although such income is not currently realized in cash, it will be realized over the service lives of the related plant assets as the resulting higher depreciation expense (included in rate base) is recovered in the form of increased revenues. Due to large long-term construction programs in electric utility companies in recent years, AFUDC has had a material impact on both the income statement and the balance sheet. As a result, many regulators are readdressing the issue of allowing construction costs in the rate base. The FCC has altered its position and now requires projects with construction periods of less than one year to be included in the rate base and prohibits recognition of AFUDC on such funds.

GAAP requires that the profit on sales of assets within an affiliated group of companies be eliminated in consolidated financial statements. Under SFAS 71, however, a regulated enterprise shall not eliminate intercompany profits on sales to regulated affiliates if: 1) the sales price is reasonable; and 2) it is probable that future revenue approximately equal to the sales price will result from the regulated affiliate's use of the item.

Deferred income taxes result from timing differences when plant assets are depreciated under the straight-line method for general purpose financial statement reporting and under an accelerated method for tax reporting purposes. This difference is reflected as a liability on the books of an unregulated enterprise but is not allowed for many regulated companies. Some regulatory agencies exclude deferred taxes from allowable costs and include income tax expense in the rate base only in the period in which the income tax is paid. In such cases, SFAS 71 does not allow deferred taxes to be shown on the balance sheet. However, it does require disclosure of the net cumulative amount of temporary differences not recorded by an enterprise as deferred income tax.

SFAS 71 does not provide specific guidelines for accounting for other regulatory deviations from GAAP, such as the capitalization of research and development costs. However, it does specify that if a conflict arises between application of an authoritative pronouncement and SFAS 71, then SFAS 71 should be applied. Regulated companies following SFAS 71 provisions are reporting in conformity with GAAP.

Discontinuance of Application of

SFAS 71

The recent changes in business and political environments affecting regulated companies have caused the FASB to give guidance to enterprises when they find they no longer, in whole or in part, meet the criteria of SFAS 71. Deregulation, value-based rate-making, and competitive limitations and regulatory constraints on a utility's ability to sell products and services at rates that recover costs are all issues that altered the appropriateness of SFAS 71 and have resulted in the recent issuance of SFAS 101.

Regulated Enterprises--Accounting

for the Discontinuance of

Application of SFAS 71

SFAS 101 states that if a company determines that its operations in a jurisdiction, or a separable portion of its operations, fail to meet the criteria for application of SFAS 71, then application of the Statement to the operations or the separable portion shall be discontinued. Once SFAS 71 is discontinued, a firm must eliminate from its externally reported financial statements the effects of any actions of regulators which created assets or liabilities on the books of the regulated company which would not have been recorded on the books of nonregulated enterprises in conformity with GAAP (deferred research and development costs, for example). In the case of regulatory-created assets, this reasoning is based on the concept that an asset must "embody a probable future benefit that involves a capacity to generate future net cash inflows." If a company, or segment of a company, is no longer regulated, then rate actions of a regulator cannot provide reasonable assurance of the existence of the asset nor provide the future revenue effects on which the asset is based. Thus, the asset should be written off since it possesses no probable future benefits.

SFAS 101 states the adjustment of the carrying amounts of plant, equipment and inventory (assets impacted by AFUDC and intercompany profits) shall not be adjusted unless these assets are impaired. Thus, only those regulatory-created assets which are recognized because of a regulatory promise for cost recovery shall be written off. Remaining long-lived assets recorded at historical cost will be subject to an unusual impairment test. The income statement effect resulting from any adjustments will be recorded as an extraordinary item in the period in which SFAS 71 is discontinued.

Developments in Regulatory

Accounting as it Relates to the

Telecommunications Industry

The FCC has long been cognizant of the need for closer alignment of regulated telecommunications accounting practices to GAAP. In a study performed for the FCC by the Telecommunication Industry Group in 1984, 21 accounting practices were identified where the current procedures required by the regulator differed from GAAP. In light of these disparities, the FCC agreed that changes were necessary and that changes would be effective January 1, 1988, with the implementation of a revised system of accounts.

Conformity to GAAP resulted in many areas including compensated absences, leases and income tax accounting. It is now apparent that regulatory accounting in the telecommunications industry is moving toward consistency with GAAP as applied to nonregulated entities. However, because the regulatory rate-making process is of paramount concern to the FCC, it is doubtful that regulated telephone companies will ever produce general purpose financial statements in full accordance with nonregulated GAAP.

Concluding Remarks

Many regulated entities are confronted with a transition from a regulated to nonregulated environment. Changing regulatory climates, competition, deregulation of previously tarriffed services, and the replacement of the cost-based rate process with value-based rate-making may accelerate this change. However, regulated companies faced with this possibility now possess appropriate guidelines for accounting for this occurrence, guidelines which were not previously available. Not only will SFAS 101 help ensure uniformity and comparability of financial statements for those regulated companies which move, in total or in part, to this nonregulated environment, but it will allow for further reconciliation of the differences between regulatory accounting practices and nonregulated GAAP.