Capitalizing an allowance for funds used during construction: the impact on earnings quality

Allowances for funds used during construction (AFUDC) of utilities are isolated and analyzed to determine their influence on utility common stock prices. Accounting procedures for construction work in progress (CWIP) require that all charges be included in the project's cost and capitalized, while AFUDC are added to income. This procedure is generally understood to lower the quality of earnings. The authors outline their methodology and findings in terms of the impact of lower quality earnings on investors, utilities, customers, and regulators. Empirical tests show that AFUDC accounting tends to depress market-to-book valuations of electric utility stocks. This may result partly because AFUDC rates are lower than the incremental weighted average cost of capital.