AFUDC is a Key Construction Cost in the Power and Utilities Industry
Include AFUDC on power and utilities construction projects and rates
The Allowance for Funds Used During Construction (AFUDC) is a best practice in the power and utilities industry. Including AFUDC in construction projects follows the guidelines for electric construction accounting in the Federal Energy Regulatory Commission's Uniform System of Accounts (FERC USOA) and RUS Uniform System of Accounts (RUS USOA). At times, mid-sized and smaller utilities (mainly municipal systems) leave some of the FERC USOA allowable costs of construction "on the table," i.e., not recording AFUDC as part of total construction costs. The impact of not including AFUDC will be felt in future years when it is time for asset replacement as without AFUDC the asset will not reflect its full construction or acquisition cost.
This article dives into the allowance for funds used during construction (AFUDC) and also discusses applying AFUDC to idle projects.
Key Takeaways
1. AFUDC is a best practice in the power and utilities industry, required by FERC and RUS to be applied to construction projects.
2. The electric industry's rate foundation is based on the approach that current ratepayers pay for their current use of the electric system that serves them. Including all of the costs of construction (including AFUDC) ensures that rates can be designed to recover construction costs through depreciation expense.
3. Not capitalizing construction interest under-recovers the asset's value in electric rates, leaving a portion of the replacement cost of the financed asset to be borne by future ratepayers.
4. For governmental utilities, GASB 89 does have an exception to record construction interest as a regulatory item. While this complicates the accounting, it is preferable to NOT recording construction period interest.
Gas-fired power plant
What is AFUDC?
AFUDC. or the Allowance for Funds Used During Construction is the opportunity cost of funds used in construction projects. For example, a utility or cooperative could take $1,000 and spend it for utility personnel raises, new capital projects, research, maintenance, or leave those funds on deposit in a bank. Each potential use of the funds has an opportunity cost associated with it.
The AFUDC is an interest rate applied to the funds spent on construction projects. The calculation of the interest rate (the AFUDC rate) is detailed in Section 3 of the FERC USOA plant instructions. The calculation is based on the funding source of projects and associated interest rate of each source. The AFUDC rate is in effect the cost of capital.
For example, the utility has planned projects of $10 million in the current year. The utility will be financing that construction through a combination of sources as shown in Table 1:
Table 1 – Project Financing Sources - AFUDC Example
The calculation shows that the utility’s cost of capital (or AFUDC rate) for this year is 4.3%, based on the combination of financing sources.
AFUDC rate application policy
Utilities and electric cooperatives have different policies on applying AFUDC based on the uniqueness of their operations. Some utilities and cooperatives apply the AFUDC rate to every dollar of spend on projects. Others apply the AFUDC percentage to projects over a specific size and duration (e.g., applying AFUDC to projects of over $50,000 that take at least three months to complete). Our opinion is that “a dollar is a dollar,” and no matter when the dollar is used, or for what it is used, the opportunity cost (interest cost) can be calculated and should be included in the total project cost. The only exception to this would be for grant funded projects or projects that are contributions in aid of construction.
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The impact of AFUDC
Table 1 calculates the AFUDC rate as 4.3%. Applying that AFUDC rate to the $10 million of projects will increase the total project costs (and thus the asset values) by $430,000 ($10 million x 4.3%). What is the impact of adding $430,000 in key areas that impact cash flows? The two main areas that are impacted are depreciation and the rate of return on ratebase.
Depreciation impact
For our example in Table 1, assume these are electric distribution projects. The typical useful life of electric distribution plant in service is approximately 30 years. The impact of adding AFUDC vs. not adding AFUDC is shown in Table 2:
Table 2 – Sample Depreciation Impact of AFUDC
In the example, adding AFUDC to the balance of current year projects results in an additional $14,333 annually included in rates due to the increase in depreciation expense over not including AFUDC in the project costs.
Rate of return impact
As shown in Table 3, adding $430,000 of AFUDC to the project balance and applying a standard rate of return on ratebase results in an additional $34,400 annually in customer rates.
Table 3 – AFUDC Example Rate of Return Impact
Total rate impact
Combining the additional depreciation expense and rate of return results in $48,733 annually being added to customer rates as shown in Table 4.
Table 4 – Total AFUDC impact on depreciation and rate of return
The $48,733 increase in rates is the amount needed for just this year’s projects. Consider the annual effect as year after year of projects are include. The idea is not to needlessly increase customer rates, but to recover the full costs of construction in rates. This follows the foundation of power and utilities rates that customers pay for their current use of the plant in service that provides them with service.
Applying AFUDC to projects “on-hold “
We have been asked, "should AFUDC be applied to construction projects that are on hold and not advancing due to factors such as permitting, regulatory approvals, or financing?"
The short answer, in my opinion, is "yes," as the capital has been committed to the project and is not available for other projects. We have seen some varying approaches to the short answer:
Organizations may stop the application of AFUDC pending the resolution of permitting, regulatory, or board approval to continue a project.
Some organizations apply a lower AFUDC rate to the project. However, I do not follow this logic, as the organization's cost of capital has not changed unless the underlying interest rate factors have changed.
As amounts of AFUDC for projects on hold are likely not material to the financial statements, your organization's auditors will not raise an issue if AFUDC is not applied strictly following the FERC USOA or RUS USOA. But, organizations should strive for consistency in their approach to construction accounting practices.
Applying AFUDC to projects impacted by a construction stoppage
Suppose a project has been impacted by a construction stoppage. In that case, the logic follows to continue to apply AFUDC to the project balance as the capital has been committed to the project and is not available for other projects. There are bigger fish to fry in the instance of a construction stoppage.
A utility that follows governmental accounting standards must consider the project's temporary or permanent impairment. The governmental utility must evaluate whether an impairment has occurred and record an impairment if the project will not be completed. Governmental Accounting Standards Board Statement No. 42 - Impairments, specifically calls out construction stoppage as a potential impairment.
Organizations that follow Financial Accounting Standards Board standards must also evaluate whether a construction stoppage has caused an impairment. ASC 360-10-35 considers a stoppage a "triggering event" and that an organization must determine if the construction costs' carrying amount (i.e., construction costs) is recoverable. In other words, will construction be completed, and the asset serve customers and be recovered in customer rates?
GASB 89 for governmental utilities says to expense AFUDC?
Governmental Accounting Standards Board (GASB) Statement No. 89, Accounting for Interest Cost Incurred Before the End of a Construction Period requires municipal utilities to expense construction period interest unless a utility chooses to record capitalized interest as a "regulatory asset". Not capitalizing interest may exclude those costs from electric rates.
Capitalized interest can be a substantial part of the construction costs of major projects. We see many municipal electric utilities of all sizes following the option to expense construction interest. Does this do a disservice to their ratepayers? See our article on GASB 89 for a deeper discussion on this topic.
How often should the AFUDC rate be changed?
Interest rates are not static. At a minimum, the AFUDC rate should be calculated annually. The mix of resources and interest rates used to fund projects varies from year to year and will impact the weighting of each financing source, and thus the weighting of the interest cost of that type of financing, i.e., short and long-term debt, stock, and internal reserves.
Summary
This article discusses the issue at a high level, but the application of AFUDC is not an overly complicated process. Overlooking this area of utility work order accounting will lead to a cash flow shortfall when it is time for asset replacement.
A detailed deep discussion and analysis of applying overheads to construction projects can be found in our course – Utility Construction Accounting – Level 2.
About Russ Hissom - Article Author
Russ Hissom, CPA is a principal of Utility Accounting & Rates Specialists a firm that provides power and utilities rate, expert witness, and consulting services, and online/on-demand courses on accounting, rates, FERC/RUS construction accounting, financial analysis, and business process improvement services. Russ was a partner in a national accounting and consulting firm for 20 years. He works with electric investor-owned and public power utilities, electric cooperatives, broadband providers, and gas, water, and wastewater utilities. His goal is to share industry best practices to help your business perform effectively and efficiently and meet the challenges of the changing power and utilities industry.
Find out more about Utility Accounting & Rates Specialists here, or you can reach Russ at russ.hissom@utilityeducation.com.
The material in this article is for informational purposes only and should not be taken as legal or accounting advice provided by Utility Accounting & Rates Specialists. You should seek formal advice on this topic from your accounting or legal advisor.