Opinion ID: 263341
Heading Depth: 1
Heading Rank: 3

Heading: relevant accounting theory

Text: 19 The traditional treatment of depreciation is by the straight line method. Under this method the cost or other basis of the property (less estimated salvage value) is deducted in equal annual installments over the estimated life of the property. Thus, if the acquisition price or other basis of a piece of property were $100 and its useful life ten years, then, assuming the property had no salvage value, it would be depreciated at the rate of ten dollars per year for ten years. 20 In an attempt to encourage capital investment, Congress has enacted provisions in the Revenue Code permitting a taxpayer to write off the bulk of his investment during the early years of its useful life. Relevant here are section 167 of the Internal Revenue Code of 1954, 26 U.S.C.A. § 167, permitting liberalized depreciation, and section 168 permitting accelerated amortization. For example, section 167 provides two specific methods of liberalized depreciation — the declining balance method and the sum of the years-digits method. 2 Under the declining balance method up to twice the rate used in the straight line method is applied to the cost of the property in the first year of its use. In each succeeding year this same rate is applied to successively diminishing balances — hence the name declining balance. The sum of the years-digits method similarly produces early write-offs in slightly varying amounts. The use of either method is within the discretion of the taxpayer, and his decision will depend upon a myriad of business factors, a discussion of which is not necessary here. Regardless of which method is used, however, the total amount depreciated at the end of the depreciation period is the same. 3 21 The use of liberalized depreciation affords the taxpayer considerable tax savings in the early years of the life of the property. But in the later years, when the depreciation permitted is less than it would have been had the taxpayer utilized the straight line method of depreciation, the tax liability is increased. 22 In the utility industry, the rate which the public pays for a service is controlled by regulatory agencies. In determining whether a given rate will yield a proper return, it is necessary for the agency to deduct applicable expenses from operating revenues. Tax expense is one of the applicable expenses, Georgia R. & Power Co. v. Railroad Commission, 262 U.S. 625, 632, 43 S.Ct. 680, 67 L.Ed. 1144 (1923); Galveston Electric Co. v. Galveston, 258 U.S. 388, 42 S.Ct. 351, 66 L.Ed. 678 (1922); South Carolina Generating Co. v. Federal Power Comm., 249 F.2d 755 (4th Cir. 1957). The use of liberalized depreciation and rapid amortization has a significant effect on a utility's rates, for in the early years of liberalized depreciation when the utility is writing off a large percentage of its investment and its tax expense is accordingly relatively low, its net income is relatively high. The opposite is true in the later years of depreciation. Both the high income of early years and the low income of later years may invite rate proceedings — in the first instance to lower rates and in the second to raise them. 23 So as to eliminate the impact of tax fluctuations upon net operating income arising from a utility's use for income tax purposes of any of the several techniques for the rapid expensing of depreciable assets, a number of regulatory agencies have permitted utilities to normalize their net operating income for regulatory book accounting purposes. This normalization process is commonly referred to as deferred tax accounting. Where a utility does not use, or is prohibited by the regulatory agencies from resorting to normalization, it is said that the utility is using flow-through accounting — so called because the immediate effect of tax expenses resulting from a utility's use of liberalized depreciation for income tax purposes is flowed through directly to income. 24 In Cities of Lexington, etc., Ky. v. Federal Power Comm., 295 F.2d 109 (4th Cir. 1961), this court approved the Federal Power Commission's sanction of the use of deferred tax accounting. We there noted the conflicting views as to the propriety of such accounting. The Kentucky cities had argued that only taxes actually paid should be deducted from operating revenues. They also contended that the use of liberalized depreciation did not create increased tax liability for future years because the expanding nature of the utility industry would probably require continuous capital expenditures with the result that utilities would be left with a permanent reserve for taxes which would never be needed to meet tax liabilities. 25 The utilities, on the other hand, argued that the normalization method resulted in a tax deferral and not a tax saving. 4 They also maintained that any assumption that the utility industry would indefinitely continue making capital investments at a rate faster than it retired old investments was speculative. 26 This court, noting that various state agencies and federal regulatory commissions had come to opposite conclusions as to the relative merits of the flow-through and normalization methods, acknowledged that it was confronted    with a problem in a special field which requires the exercise of expert skill and concluded that since the Federal Power Commission had not abused its discretion in authorizing deferred tax accounting, its decision should be followed.