NASUCA MID-YEAR MEETING
SANTA FE, NEW MEXICO
JUNE 13-16, 1990
Panel Title: WHERE, OH WHERE, WILL THE MONEY GO?
BOC Depreciation Issues In
the States
Remarks of:
Michael J. Majoros, Jr.
I would like to thank NASUCA for inviting me. The subject of my discussion is BOC
Depreciation. I have been involved in
several BOC Depreciation proceedings over the past six to seven years. My comments today reflect that experience,
however, the primary basis of these comments is a recent Southern
Bell of Florida case. That case covered just about all the BOC
Depreciation issues of which I am aware.
Furthermore, Southern Bell’s motivations are no
different than any other BOC. Therefore,
the information obtained in the Florida
case is relevant for all other BOC’S.
The primary issue is
money. One BOC Depreciation expert aptly
stated – depreciation is money – it is green pieces of paper with pictures of
presidents on it. Where will the money go? It
appears that if the BOC’S have their way – it will flow from ratepayers into
the companies in the form of regulated rates and from there to shareholders in
the form of unregulated profits.
During the 1980’s, most BOC’s switched from whole-life to remaining life
depreciation; adopted equal life group depreciation, obtained depreciation
lives much shorter than are indicated by statistical life analyses, and
amortized reserve deficiencies on an accelerated basis (commonly referred to as
RDA). Each one of these changes produced
higher depreciation expenses. In turn,
many BOC’s service rates were increased to
accommodate the higher depreciation charges.
As often, the BOC’s avoided reductions that
would otherwise have been ordered.
Notwithstanding, the
propriety or impropriety of any of these changes, from the ratepayer’s standpoint,
it was generally assumed that RDA would be the end of the BOC’s
major depreciation expense increases. A
depreciation reserve deficiency is the difference between a so-called
theoretical depreciation reserve and the actual book reserve. Theoretical reserves calculated by the BOC’s reflected the much shorter lives and equal life group
procedures approved in the 1980’s and a result were substantially higher than
the actual book reserves.
The difference was
allowed to be amortized by the FCC over five years and by many state PUC’s over periods ranging from three to five years. As indicated, since the RDA’s reflected the
shorter lives and accelerated procedures, it was reasonable to assume that once
the amortization was completed – depreciation expense would decline
substantially. It was also reasonable to
assume that rates for service would decline correspondingly especially in light
of declining unit costs produced by
advanced technology.
Such has not been the
case – at least not in most of the states with which in I am familiar. BOC’s continue to
request higher depreciation expenses.
But now, they usually attempt to sell the request as package deals at
both the FCC level and the state legislative level through intensive lobbying
efforts. Typically, the deal is that the
BOC will increase its internal cash flow through higher depreciation expense
without increasing rates for service and, in the mean time, make greater
investments in modern plant. It should
be obvious that the higher cash flow is coming from the BOC’s
monopoly ratepayers – under regulation.
The kicker is an implied
threat and a promise. The threat is that
if the deal is not accepted the state’s infrastructure problems will not be
solved. The promise is that if the deal
is accepted, the state will singularly draw substantial business from all
states and the world in general. Both
the threat and the promise are fairly potent rhetoric. If the BOC’s are
successful, through their lobbying efforts, then the obvious result is that
current ratepayers pay higher depreciation expense to the BOC’s
in the form of higher rates or foregone rate reductions.
PURPOSE OF DEPRECIATION
Depreciation is the
process of writing off plant over its service life through non-cash charges to
income. The shorter
the life the higher the depreciation expense. Depreciation can produce real incremental
cash flow for public utilities whose prices are set using rate base/rate of
return regulation. If a public utility
is allowed to increase its depreciation expense and correspondingly increase
its service rates or forego a warranted rate reduction then its internal cash
generation from ratepayers is increased.
This fundamental arithmetic does not hold for an unregulated business in
a truly competitive environment. In that
situation, the market determines whether prices will allow recovery of
accelerate depreciation associated with obsolete plant.
It is my opinion that a
competitive market would not have allowed the RDA described above to be
reflected in competitive prices.
Nevertheless, it was approved in many states and produced incremental
cash flow for many BOC’s. As indicated, the quid pro quo was the
reasonable anticipation that once completed, both depreciation and rates for
service would correspondingly decline.
The BOC’s
intend to keep the money. In 1988 Southern
Bell of Florida
filed petitions to freeze local rates at pre-existing levels, reduce certain
toll rates and provide a sharing mechanism for excess equity returns earned
over the three years ending in 1990. The
company filed a projection of its earning which purported to demonstrate it
would not over-earn if its plan was approved.
The earning projections
included the assumption of substantially increased depreciation expense even
though it had just recently obtained substantial depreciation increases for
accelerated amortization such as the RDA.
These amortizations were scheduled to cease in 1989 and 1990. The sole purpose of the increased
depreciation in the Company’s earnings projections was to offset the cessation
of these amortization schedules which would have decreased depreciation expense
substantially and, in turn, would have resulted in greater service
reductions. The Florida
commission set aside the depreciation increases in anticipation of a
depreciation study yet to be filed.
In 1989 Southern
Bell filed a depreciation study which matched, almost to the
dollar the money set aside by the Commission.
It was evident that the underlying rationale of the study was to keep
the cash set-aside by the Commission.
The following statement was contained in an internal letter obtained
from the Company:
…if the Company is successful in negotiating new depreciation
rates/amortization sufficient to cover these amounts, it can keep the cash flow
as capital recovery. Otherwise,
the Commission will return the unsubstantiated portion of these amounts to
ratepayers.
Clearly, the impetus was to keep the cash flow rather than return it to
ratepayers. I would like to state that
in my opinion this was an understandable desire from the Company’s standpoint,
however, it was undesirable from the standpoint of its monopoly
ratepayers. This is one reason why we
regulated monopoly prices.
THE STUDY
There are several
parameters involved in a traditional depreciation study: Service lives (as indicated earlier),
retirement dispersion curves, net salvage ratios, methods, procedures and
techniques. Each of these was subject to
challenge in Southern Bell’s study. However, it was clear upon reading the narrative
discussions in the study and other information obtained from the Company that
the primary focus was a substantial depreciation and amortization increase
resulting from shorter lives as a direct result of an early change-out of plant
(network modernization) in anticipation of a broadband integrated services
digital network – BISDN.
BISDN
Hear are but a few of
the comments contained in Southern Bell’s study.
- The next decade information age and intelligence
network requirements will rapidly accelerate not only the demise of present
analog switches but even existing digital switches that can not evolve to the
next general broadband integrated services digital network (BISDN) switch.
- Delivery of high capacity services will require
a well planned network with uniform bandwidth capabilities. Completion of the SONET specifications
provides the direction of cohesiveness necessary to create compatible equipment
required for the future optical network, BISDN.
- Technically, a SONET network is a digital,
fiber-optic network whose capabilities far eclipse today’s network.
- A ‘Pipeline’ for HDTV (and all other information
services). That new pipeline is
fiber-optic.
The study was replete with references to the tremendous future revenues
from HDTV and other entertainment service available from BISDN. In fact, the Company acknowledge that “the
stage is being set today fro the battleground of the 1990’s,” with its major
opponent being the cable television industry.
It is important to note that the battle is for future, highly
profitable, revenues (primarily cable TV revenues) and that the anticipation of
those revenues is the primary reason for shorter lives of today’s plant. It is going to take a substantial investment
to purchase the equipment and technology to produce the future revenues. The cheapest source of financing is, of
course, cost free cash flow from ratepayers.
At least one person
representing Southern Bell anticipated in an internal
memorandum that by the time the future revenue streams begin, rate of return
regulation will not exist, and that the Company will be able to keep the higher
profits despite the low level of incremental cost required to
provide the service.
Of course, there will be
a low level of future incremental cost to provide BISDN services if a majority
of the primary incremental cost, i.e., the initial investment, has been paid
for by cash flow derived from substantially increased depreciation and
amortization associated with the early charge-out of existing plant.
The important point is
that the company itself through internal correspondence provided the linkage
between higher depreciation charges today – under regulation – and the
retention of the resulting future profits in an unregulated environment. Therefore, notwithstanding the implied threat
and promise, I concluded that its request for higher cash flow now was directly
attributable to the anticipated future BSIDN revenues. Were it not for the anticipation of those
revenues, it is unlikely that lives would be further shortened today relative
to the various changes that already took place during the 1980’s.
This relationship
invoked several accounting, economic, and regulatory concepts. For example, the concepts of matching
revenues with cost, cost causation, and incremental costing. Logically each of these concepts would
require the matching of higher depreciation expense with the anticipated
revenues causing the higher depreciation expense.
OBSTACLES
Logical as they are,
however the deck is stacked against consumer advocates and the monopoly
ratepayers they represent. The obstacles
include but are not limited to:
- Heavy lobbying efforts by the BOC’s;
- Complex depreciation studies which, in the final
analyses the BOC’s essentially disavow;
- Arcane engineering jargon which obfuscates the
real issues involved;
- A sense that only BOC employees understand
telephone depreciation; and
- A strict adherence to dogmatic accounting rules
when it is in the best interest of the BOC to do so.
Having been trained as an accountant, I consider this last obstacle to be
extremely disingenuous. There is, or at
least used to be, the accounting concept of “substance over form.” Substance over form would, in my opinion,
require at a minimum the matching of higher depreciation charges caused by the
anticipation of future new revenues with the new revenues. But you can be certain that the BOC’s will revert to the accounting principle of
depreciation assets over their shortened service lives notwithstanding the fact
that the sole reason for the shortened service lives is the anticipation of the
new future revenues.
ALTERNATIVES
What alternatives do
consumer advocates have? Basically, you
can either fight the higher depreciation charges or accept them. If you choose to fight, it is going to be a
tough battle.
- Consumer advocates can argue that lives won’t get
shorter. This may work at the FCC level
since they have already been shortened drastically. The BOC’s will
undoubtedly accuse you of being a dinosaur with absolutely no vision of the
future.
- Consumer advocates could argue that the purpose of the BOC’s activities is to put the cable television industry
out of business at the expense of current monopoly ratepayers. But then you will be accused of striking and
unholy alliance.
- Consumer advocates can accept that lives will become
shorter as a result of BISDN but argue that the cost of the shorter life ought
to be charges to the people who benefit from the BISDN services. Therefore, a mechanism must established to match the cost to these future, probably
unregulated, services.
In Florida, I proposed the
first and third alternatives, while the cable television industry pursued the
second alternative independently.
Unfortunately, it appears that the only party to whom the Commission
listed was the Company.
We filed a traditional
depreciation study which examined all lives, curves, salvage values, etc., but
did not accept the added life shortening effect of anticipated BISDN
services. Most of the lives in the
traditional study were shorter than history would indicate and yet, they
resulted in an overall decrease in depreciation expense.
The alternative proposal
accepted all of the Company’s lives and salvage values but established a BISDN
correction mechanism to ensure that the higher deprecation expense would be
matched to the BISDN revenues.
Here is how it was
done. Each of the Company’s Accounts was
examined to determine if BISDN was the primary motivation for the requested
service life reduction. Therese ere designated as BISDN accounts.
A BISDN depreciation
reserve was calculated for each of the BISDN accounts. I have a hand-out which demonstrates how this
calculation was performed. This is for
the buried cable metallic account which is one of the largest on most
companies’ books. The current depreciation
rate for this was account 5.0 percent.
The Company proposed to increase the rate to 7.9 percent. On lives 8 to 11, the current 5 percent rate
is held constant, and the Company’s remaining life and future net salvage
requests were accepted to solve for the BISDN corrected reserve. Finally, the book reserve was subtracted from
the BISDN correct reserve. The
difference is the BISDN correction.
The BISDN correction is
the amount of additional depreciation required in the depreciation reserve to accept
the lives shortened by BISDN but not increase depreciation rates. This amount should be matched to the BISDN
revenues.
SUMMARY
As I stated,
depreciation is money, it is the major source of cash for the BOC’s. It is cost
free, and comes straight from the BOC’s monopoly
ratepayers. Given the magnitude of the
dollars involved, and the intensive BOC lobbying efforts, depreciation is a
tough battle for the ratepayers to win.
Apparently, in Florida the
Company was the winner, but that does not change the validity of the evidence
we obtained directly from the Company itself in that proceeding. That evidence proves that the BOC’s intend to use cash flows from the higher depreciation
charges today under regulation to finance the investment in equipment and
technology to produce new, unregulated future revenue streams in the future.
