What Is Allowance for Funds Used During Construction?
Understand how regulated companies use an accounting allowance to treat financing costs as a capital asset, affecting net income without providing cash flow.
Allowance for Funds Used During Construction (AFUDC) is an accounting practice for regulated industries like electric and gas utilities. It allows a company to recover financing costs for large, long-term construction projects. These capital-intensive projects can take years to complete, during which the company spends money on financing without earning revenue from the unfinished asset.
Regulatory bodies, such as the Federal Energy Regulatory Commission (FERC), permit this practice to protect a company’s financial health during construction. By capitalizing these financing costs, they become part of the asset’s total cost. This cost is then recovered from customers through rates over the asset’s useful life, ensuring that those who benefit from the new facility pay for its financing.
The Two Components of AFUDC
AFUDC is comprised of two parts that reflect how a company finances a project: borrowed funds and equity funds. The first component, the “cost of debt,” represents the actual interest paid on money borrowed for the construction project. This is a direct, measurable expense from loans, bonds, or other forms of debt.
The second component is the “cost of equity.” This concept is more abstract because it is not a direct cash payment but an imputed cost reflecting the return shareholders are entitled to on their investment. When capital is tied up in a non-revenue-generating project, shareholders forgo the opportunity to earn a return elsewhere. Regulators allow companies to calculate a reasonable rate of return on this equity to acknowledge this opportunity cost.
This two-part structure is a distinction from standard interest capitalization rules for non-regulated industries. While other industries can only capitalize the actual interest on debt, the regulated utility model acknowledges that equity capital also has a cost. Both components are combined to form the total AFUDC, which is then added to the project’s cost.
Calculating the AFUDC Amount
The calculation of AFUDC is prescribed by regulatory bodies like FERC and is performed regularly, often monthly. The formulas are detailed in regulatory guidelines, such as those provided in FERC’s Uniform System of Accounts. These calculations ensure the amount capitalized is a fair representation of the financing costs.
The borrowed funds component is calculated by multiplying the construction costs financed by debt by the company’s weighted average interest rate. This includes various types of debt, such as short-term notes and long-term bonds. The formula ensures the capitalized amount accurately reflects the real interest expenses being incurred.
The equity component calculation is similar but uses a different rate. It involves multiplying the construction costs financed by equity capital by a rate of return on common equity. This rate is approved by the primary regulatory authority in the utility’s last rate case to compensate shareholders for the use of their funds.
To illustrate, consider a utility constructing a $10 million facility financed with 60% debt ($6 million) and 40% equity ($4 million). If the utility’s average cost of debt is 5% and the regulator has allowed a 10% rate of return on equity, the AFUDC for a year would be calculated as follows. The debt component would be $300,000 ($6,000,000 5%), and the equity component would be $400,000 ($4,000,000 10%). The total AFUDC capitalized for that year would be $700,000, which is added to the project’s total cost.
Financial Statement Reporting
The accounting for AFUDC impacts both the balance sheet and the income statement. The entire calculated AFUDC amount is capitalized, meaning it is added to the cost of the asset under construction. This is recorded on the balance sheet as an increase to the Construction Work in Progress (CWIP) account, a long-term asset account.
On the income statement, AFUDC is recognized as non-operating income, which increases a company’s reported net income even though no cash was generated. Companies have flexibility in how they report it, as the full amount can be shown as other income or it can be split. In the split approach, the debt component reduces interest expense, and the equity component is reported as other income.
Because AFUDC is a non-cash source of income, it requires specific adjustments on the Statement of Cash Flows. The equity portion is a non-cash item subtracted from net income in the cash flows from operating activities section. The debt portion, representing capitalized interest, is classified as a cash outflow for investing activities.
Once the construction project is completed and the asset is placed into service, the accounting treatment changes and the capitalization of AFUDC ceases. The entire balance in the CWIP account, including all direct construction costs and capitalized AFUDC, is transferred to the Plant, Property, and Equipment (PP&E) account. The utility then begins to recover these costs from customers through rates and starts to record depreciation expense on the asset’s total capitalized value.