Opinion ID: 1362962
Heading Depth: 1
Heading Rank: 7

Heading: Depreciation Flow-Through Accounting.

Text: Plaintiff also objected to defendant's treatment of deferred taxes and investment tax credits in defendant's income indicator of value because the effect was flow-through accounting, ignoring the regulatory requirements placed on plaintiff which affect value as would be perceived by a buyer of the property. Actually, it was not entirely clear from the record that plaintiff's accounting procedure was required by regulation. There was evidence that permission from the PUC, FPC, and probably the IRS, would be required to make a change to flow-through accounting. Defendant had taken the present worth of the balance in current deferrals and of the future deferrals and the effect was to flow through something the company had normalized, as explained by plaintiff's witness Madden. Mr. Madden gave the following testimony with regard to these accounting procedures: Q Well, Mr. Madden, how does a reserve for deferred taxes arise? A This reserve can arise in several ways. For instance, in 1954, the Congress passed a law permitting companies to adopt accelerated depreciation for new property additions. Over the life of the asset involved, depreciation expense is no greater than what would be allowed under straight-line depreciation. However, the depreciation allowed in the early years of the life is greater, but is offset by a lesser amount of depreciation allowed in the latter [sic] years. At the end of the asset's life, no greater amount of depreciation is allowed than what is allowed under ordinary book straight-line purposes.    Q Does a company's use of liberalized depreciation have any effect on its tax liability? A It results in a lower current tax liability because the depreciation claimed under liberalized depreciation for tax purposes is greater than that recorded on the books for book purposes. Q Now, when you speak of a lower tax liability, is that in any particular period of time? A That reduced tax liability occurs in the early years of the life of that particular asset. This is reversed in the latter [sic] years of the life of that equipment so that over the life of the equipment involved, the tax liability remains the same.    Q Is there any way to smooth out this side effect which you've just described of the use of a liberalized method of depreciation? A Yes, there is. What is normally employed is what has been referred to as normalization. Q And what does this involve? A Normalization involves setting up a deferred tax expense to reflect the difference between the depreciation claimed on the books and the depreciation claimed for tax purposes so as to smooth out the process. If this was not done, operating income in the early years of an asset's life, because of the tax allowed depreciation, would be overstated while operating income in the latter [sic] years of the asset's life would be understated. By providing this reserve, the income flow from that asset is smoothed out and will be constant, all other things being equal.    Q Well, are there any other methods that are used for accounting for the reduction in taxes that takes place initially because of the use of shorter lives or liberalized methods of depreciation? A Not all companies follow normalization accounting procedures because the regulatory bodies require that to fill  to only record the actual current cash tax expense. This is known as a flow-through method. In this  Q Well, would you please explain exactly what you mean by the flow-through method? A The flow-through method involves the flowing through to income of the tax deferral or the deferred tax expense associated and arising from the difference between the depreciation allowed for tax purposes and the depreciation allowed used on the books in the early years of the life of the asset. Mr. Madden went on to testify that the effect of the flow-through method would be lower earnings in later years than at present due to higher taxes. The investor would perceive a greater risk in the flow-through company because the company is not recording an expense currently which will have to be recouped later on. Mr. Madden also testified that plaintiff's adoption of normalization in the early 1970's improved its price-earnings ratio which in turn improved the market price of its stock. Defendant did not offer effective rebuttal of this testimony, and Mr. Bredehoeft agreed that the stock value would be higher for the normalizing company. We find that it was improper for defendant to treat plaintiff here as a flow-through company when plaintiff in fact does normalize. Also, a change from normalization to flow-through accounting would affect a buyer's perception of the property's value.