Allowance for funds in construction: accounting stepchild and regulatory football

AFC (allowance for funds in construction) is an accounting method of recording the use of additional capital needed to compensate the capital already invested in construction work in progress (CWIP) where CWIP is excluded from the utility's rate base. As a practical matter, the compensation in the form of interest on debt, dividends on preferred and common stocks, and reinvested earnings is paid or recorded currently. Since the CWIP is not included in rate base and current customers are not paying any revenues to support the CWIP capital, the cash to pay the interest comes from a variety of sources, including cash revenues covering depreciation and reinvested earnings on rate base capital as well as from sales of additional bonds and stock. Commissions and courts have examined AFC in some depth, but many problems remain. Four unresolved areas are examined in this paper: (1) should AFC be compounded, whether directly or indirectly; (2) who should benefit from the current tax reduction associated with the interest component of AFC; (3) is AFC really a noncash accounting gimmick; (4) what happens when you sell AFC-bearing construction work in progress to a third party. The author presents examples to show why he believesmore » AFC represents valid, good-quality earnings for utilities. It properly represents cash income if certain prerequisite conditions are present and prerequisite procedures followed in its calculation. Among the factors cited in favor of such an allowance by regulators is an avoidance of regulatory lag in much the same way as provided by automatic cost adjustments. (MCW)« less