Meltdown - or not? For utilities.

The accounting treatment for nuclear decommissioning costs may be changing.

Taking a nuclear power plant out of service is a bit like trying to close a very large Pandora's box. From a financial reporting perspective, the FASB project on accounting for the retirement of long-lived assets will have a significant impact on how the electric utility industry accounts for this often rigorous process. The 53 utilities that currently have nuclear plants will have to spend almost $33 billion to decommission them.

Because of the lack of guidance on accounting for these costs, most utility company financial statements do not fully reflect decommissioning liabilities. Under FASB's proposed standard, however, utilities would have to recognize those liabilities at the time of initial plant operation. This would put a liability on the balance sheet that has been off-balance-sheet for the majority of utilities. The impact of this change would make key ratios, such as debt to equity, look much worse. FASB believes its proposal better reflects the economics of operating a nuclear power plant than does current accounting practice.

FASB issued the original ED, Accounting for Certain Liabilities Related to Closure or Removal of Long-Lived Assets, in February 1996. The board is revising the ED--retitled Accounting for Obligations Associated With the Retirement of Long Lived Assets--which is expected to be issued later this year. Because FASB is proposing a standard that would change how utilities account for nuclear decommissioning costs, it is imperative that CPAs at utilities with nuclear plants examine the standard's implications for their companies. Now is the time to provide FASB with input on the accounting changes--before the standard becomes final.

A UNIQUE ENVIRONMENT

Although the proposed standard would affect any industry that incurs costs to retire and dispose of long-lived assets, the focus of this article is on how such new rules would affect utilities. Imminent deregulation makes the business environment in which utilities operate unique. CPAs and other financial managers need to understand how utilities ac count for nuclear decommissioning costs on their financial statements and what changes the ED is likely to bring. It also is useful for utilities to understand how their peers account for these obligations, because differences in current accounting practices mean the impact of any new standard will vary widely.

There are several reasons why the ED's potential impact on utilities will be different from its effect on other industries. The utility industry itself is in a state of flux. Deregulation of energy providers will bring retail competition to many states in the early part of this decade. Furthermore, most nuclear plants are jointly owned by more than one utility. Given the joint and several nature of most environmental liabilities (whereby any owner of an asset may be responsible for the entire liability associated with that asset), it is unclear whether proportion of plant ownership will determine responsibility for the decommissioning liability. Industry deregulation also may affect the ability of utilities to continue to recover decommissioning costs from ratepayers.

CURRENT PRACTICE VS. ED REQUIREMENTS

To understand how utilities account for nuclear decommissioning costs, we examined the annual reports and form 10-Ks of the 53 investor-owned utilities with nuclear facilities. We matched financial statement disclosures with data related to nuclear decommissioning costs provided by Goldman, Sachs & Co. While the information comes from 1994 annual reports, few if any utilities have made major changes in their accounting methods since that time as they awaited a new FASB standard.

The amount and quality of the disclosures utilities provided varied widely. Utilities most frequently accounted for nuclear decommissioning costs (the method approximately 57% of utilities used) by recording the costs as a part of depreciation expense with a corresponding entry to accumulated depreciation. The expense amount a utility recorded usually was what it had collected from customers in rates. By recording the decommissioning provision as a contra-asset instead ora liability, companies essentially took the liability (and the corresponding asset) off their balance sheets, thereby improving debt-to-equity and other key ratios. The credit to accumulated depreciation also implied that the net book value of a nuclear plant could in some cases become negative--a possibility FASB has attempted to preclude through the proposed treatment in the ED.

The second most frequently used accounting method (employed by approximately 26% of the utilities) was to account for decommissioning costs exclusively as a liability accrued over the life of the nuclear plant. At the end of the plant's life, the liability is supposed to approximate the estimated decommissioning liability. Since a company incurs its obligation for decommissioning costs at the time of initial plant operation, the decommissioning liability is significantly understated, especially in the early years. This also is true for utilities that accounted for nuclear decommissioning costs exclusively as a liability.

A few companies recorded a liability for part of their future decommissioning costs and credited accumulated depreciation for the remainder. Four companies provided no disclosures about the method they used for decommissioning costs. We found no instances where a utility recorded as a liability the present value of the total projected decommissioning cost obligations, which the El) would require. This is presumably because the accounting treatment the ED requires would make the balance sheets of utilities look worse than under current practices.

Most of the utilities had decommissioning trust funds. The average annual fund contribution was $20 million. In general, the amount a company contributed equaled the amount it recovered in customer rates. As of 1994, the average amount in the fund was $139 million; the median was $58 million. For comparison, the average projected cost--based on estimates required by the Nuclear Regulatory Commission--for individual utilities to decommission the plants in which they have ownership was $546 million. The median was $358 million. While almost all utilities disclosed the existence of external decommissioning trusts, only 85% disclosed fund balances. Few utilities disclosed information about how they estimated decommissioning costs. For example, 30% disclosed the assumed rate of cost escalation (inflation) and 28% disclosed the assumed rate of return on trust funds.

FASB's proposal mandates that utilities recognize a liability for nuclear decommissioning obligations at the time they incur those obligations--generally at the time of initial plant operation. FASB's view is that a utility incurs the liability (the radioactive contamination) as soon as its plant begins operation. Therefore, if a company recognized the liability immediately, it would provide a fairer representation of the economics of nuclear plant operation and would present investors and others who rely on the company's financial statements with a more complete picture than current practices allow.

The amount of the liability the utility recognized would be the fair value of future decommissioning costs--the price the entity would have to pay a willing third party of comparable credit standing to assume the liability in a current transaction. In general, the company's corresponding debit would be an increase in the cost of the plant asset. Utilities also would be required to disclose how they determined the fair value of the liability, information about funding policies and the fair value of assets dedicated to satisfy the liability. If the company did not report decommissioning costs as a separate item on its financial statements, it also would be required to identify under which item it included the costs.

THE IMPACT OF PROPOSED DISCLOSURES

The proposed requirements for decommissioning costs would have a substantial impact on entities' financial statements. A liability that was in the past either off the balance sheet or substantially understated would be fully recognized, with a significant increase in the amount of disclosure about the liability. On average, the present value of future decommissioning costs would represent more than 6% of total utility assets and exceed four times net income. Recognizing liabilities of this magnitude undoubtedly would affect the inferences analysts typically draw from financial statements. In addition, since the primary impact of the accounting change would be on utilities involved with nuclear power, intraindustry comparisons also would be affected.

Ratios. Under current utility accounting practice, leverage ratios for utilities with nuclear plants are stronger than they would be under the proposed changes. For example, debt-to-total-asset ratios for the utilities examined averaged 0.67 in 1994 (liabilities averaged $6.063 billion; assets, $8.988 billion). Under the proposed statement, the average debt-to-total-asset ratio for utilities with nuclear plants could increase to approximately 0.71 (an average of $7.054 billion in liabilities and $9.978 billion in total assets). From an investment perspective, a change of this magnitude could have an adverse financial impact on utilities with nuclear plants, particularly when compared with nonnuclear utilities. This change also could result in the violation by some utilities of their debt covenants, causing them to incur additional costs to renegotiate or refinance that debt.

The income statement effects of the proposed new rules would be more ambiguous. A utility's recognized expenses in general would be lower in the early years of a plant's life. The impact on net income would depend on how regulators adjust permitted rate recoveries and whether companies would be allowed to record regulatory assets and liabilities to account for the differences between related cash inflows and recognized expenses in accordance with FASB Statement no.71, Accounting for the Effects of Certain Types of Regulation.

ADDITIONAL INDUSTRY CONSIDERATIONS

The preceding discussion assumes that the cost estimates the Nuclear Regulatory Commission requires accurately reflect the costs utilities will incur. However, determining future decommissioning costs is problematic. Since most nuclear plants are jointly owned by more than one utility, if one or more of the owners are unable to pay the decommissioning costs, the remaining owners probably will bear additional costs. In addition, due to the joint and several nature of most environmental liabilities, the degree of ownership may not necessarily determine each owner's fair share.

There is limited historical information available on decommissioning costs. To date few commercial nuclear reactors have been decommissioned, so the accuracy of existing cost estimates has not been assessed.

Radioactive waste issues may render the timing of decommissioning costs uncertain. The Department of Energy was supposed to begin accepting high-level nuclear waste in 1998. However, due to scientific problems and political delays, a permanent repository will not be available until 2010 at the earliest. Absent a permanent waste storage facility to accept spent nuclear fuel, a number of nuclear plants around the country face the prospect of premature shutdowns. Early shutdowns are likely to result in seriously under-funded decommissioning trusts and high costs stemming from maintaining plants in a safe condition until they are decommissioned.

UTILITY INDUSTRY DEREGULATION

Deregulation of the utility industry adds an interesting twist to the FASB ED since deregulation may make it difficult for utilities to recover nuclear decommissioning costs from ratepayers. Under the current regulatory scheme, utilities are reimbursed for their costs and recover nuclear decommissioning costs in rates from current and future ratepayers--as is the case with all other operating costs.

Upon deregulation, however, it is unclear whether utilities will be able to continue re covering decommissioning costs from ratepayers, particularly for plants that will not be decommissioned for many years (some are scheduled to be decommissioned as late as 2030). Decommissioning costs therefore may be borne not by ratepayers but, rather, by utility shareholders. Even if FASB's proposal does not develop into a new accounting standard, deregulation may affect how utilities recognize decommissioning costs. Most utilities currently accrue such costs only to the extent they are recovered in rates. Under deregulation, future rate recoveries are uncertain. Several states have mandated that utilities be allowed to recover decommissioning costs in the transition charges they levy on customers in the change to a competitive market, but this may not be true for all states.

Deregulation also may force less financially secure utilities out of business. As inefficient utilities leave the market, the costs of decommissioning their nuclear plants either will be acquired along with the utilities' plant assets (in the case of an asset sale or liquidation) or will have to be borne by the remaining plant owners (in the case of bankruptcy). In the latter case, the financial stability of plant co-owners could have an impact on the extent of decommissioning costs each owner would pay.

CHANGE IN THE WIND

If FASB's proposed rules for accounting for the retirement of long-lived assets become effective, the financial statements of utilities with nuclear plants will change significantly. It's critical for CPAs to be aware of the business environment in which utilities operate to understand the economics behind any new financial statement numbers concerning nuclear decommissioning costs, particularly in view of imminent deregulation of the utility industry.

EXECUTIVE SUMMARY

* A FASB ED ON ACCOUNTING FOR the retirement of long-lived assets may have a significant impact on the balance sheets of electric utilities with nuclear power plants. Such companies face $33 billion in decommissioning costs, which currently are not fully reflected on their financial statements.

* UTILITIES OPERATE IN A UNIQUE ENVIRONMENT. Retail competition via deregulation is coming. Another unique factor is joint ownership of most nuclear plants, which could make a company's exact decommissioning liability hard to estimate.

* OF THE 53 UTILITIES EXAMINED THAT HAVE NUCLEAR facilities, 57% record decommissioning costs as part of depreciation expense with a corresponding entry to accumulated depreciation. Another 26% account for those costs exclusively as a liability. The FASB proposal mandates that utilities recognize a liability at the time they incur the nuclear decommissioning obligations--generally at the time of initial plant operation.

* THE PROPOSED RULES WOULD HAVE A SUBSTANTIAL impact on utilities' financial statements by fully recognizing a liability that previously was either off the balance sheet or substantially understated. On average, the present value of future decommissioning costs would represent more than 6% of total utility assets.

* INDUSTRY DEREGULATION MAY MAKE it difficult for utilities to recover decommissioning costs from ratepayers. This means utility shareholders may have to bear some or all of these costs.

JULIA D'SOUZA, PhD, is assistant professor of accounting at Cornell University in Ithaca, New York. Her e-mail address is [e-mail]. JOHN JACOB, PhD, is assistant professor of accounting at the University of Colorado at Denver. His email address is [e-mail]. NAOMI SODERSTROM, PhD, is associate professor of accounting at the University of Colorado at Denver. Her e-mail address is [e-mail]. CAROL PANCHULA completed her MBA at the Thunderbird American Graduate School of International Management in 1999. Her e-mail address is [e-mail].

How to Shut Down a Nuclear Facility

Decommissioning a nuclear power plant--defined as ceasing operations and withdrawing the facility from service--is intended to put the facility in a condition that protects the health and safety of the general public and the environment. Although most plants were designed to last for several decades, it is economic and safety considerations that largely determine a facility's operating life. Decommissioning generally involves three stages:

Stage 1: Removing the spent fuel from the reactor, draining the liquid systems, disconnecting the operating systems, blocking and sealing the mechanical openings and controlling the atmosphere inside the containment building.

Stage 2: Removing or decontaminating all equipment and buildings that can be dismantled easily, leaving only the reactor core structure and its extensive shielding.

Stage 3: Removing all materials whose radioactivity levels exceed the natural radiation environment (unless the site, equipment or buildings are to be reused for other nuclear purposes). The site is then released without restrictions or further surveillance.

Similar, Yet Different

There are some interesting analogies between the proposed accounting for nuclear decommissioning costs and the accounting treatment for leases under FASB Statement no. 13, Accounting for Leases. Specifically, the practices utilities currently follow in dealing with the nuclear decommissioning cost obligation closely resemble the operating lease treatment companies typically followed for lease obligations before Statement no. 13 was issued. Decommissioning expenses generally would be limited to the amount of related rate recoveries (cash inflows) regulators permit; lease-related expenses were limited to the contractually determined cash outflows paid to the lessor.

Analogous to the accounting for capital leases, the proposed accounting for nuclear decommissioning costs would result in a utility's recording an asset and a liability equal in magnitude only at the time of initial plant operation. The asset would decrease thereafter according to a specified depreciation schedule; the liability would change from period to period based on the discount rate used initially to compute the liability. However, unlike the capital lease liability (which decreases over time), the nuclear decommissioning liability would increase each period as the utility recognized interest expense. This in turn implies that, unlike expense recognition under capital leases, recognized decommissioning expenses would be lower in the earlier part of the nuclear plant's life and would increase as the decommissioning year got closer.