Opinion ID: 1926458
Heading Depth: 1
Heading Rank: 9

Heading: Research and Development

Text: South Central Bell included in its test year expenses an amount paid under a license contract agreement to A. T. & T. for various services and benefits, among which was the right to share in the results of Bell System research and development. Until October 1, 1974, the amount charged South Central Bell under the contract could not exceed 1% of the subsidiary company's revenues; at that time, however, the maximum was increased to 2½% of the gross annual earnings. Other operating companies of the Bell System have similar contracts with A. T. & T. The Commission expressed reservations about the validity of any assessment in excess of 1% of gross earnings because of the unique relationship between South Central Bell and its parent and the vagueness of the utility witnesses' evidence concerning the services performed under the agreement. Instances in which other regulatory agencies have totally disallowed such increases were cited by the Commission: Re South Central Bell Telephone & Telegraph Co., 12 P.U.R. 4th 426 (Ky.1972); Re New England Telephone & Telegraph Co., 11 P.U.R. 4th 297 (Mass.1975). Rather than completely disallowing the increase, however, the Commission found that it would be appropriate to require that the amount attributable to research and development costs be capitalized and amortized over a future period of approximately twenty years. The Commission acknowledged the accepted accounting practice of treating research and development costs as current expenses, but decided that the costs should be capitalized to conform with a more basic principle of economics and regulation, i. e., costs which benefit future ratepayers should be capitalized and expensed in the future. The Commission explained the reasons and calculations underlying its treatment as follows: The fact that accountants often treat research and development expenditures as a current expense is no reason for doing so for regulatory purposes. It appears that the basic reason why accountants reflect research and development as a current expense is that there is uncertainty, or at minimum, a high degree of risk associated with the prediction of the revenue accomplishments associated with research and development costs as compared to other asset expenditures. When faced with a high degree of uncertainty, the accountant invokes the convention of conservation and effects an immediate charge off of research and development costs. This conservative approach is, however, in conflict with the more basic underlying accounting concept which calls for an association of costs with the time periods benefited and/or the revenues produced by such costs. However, under regulation there is no uncertainty as to the inclusion of research and development costs in the price of a regulated public utility's service. In order to bring South Central Bell's net operating income into accord with sound principles of regulation and economics, we have made an adjustment to reflect the capitalization and subsequent amortization of research and development costs. We have used the ratio of research and development expense to total allocated license contract expense of 39 per cent as shown in the record for the year 1974. Thus, 39 per cent of the 1975 license contract expense was treated as research and development expense. After allowing for annual amortization at the overall depreciation rate of 5.3 per cent and a return of 13.33 per cent (the allowed before-tax rate of return on 1975) on the capitalized portion of research and development, we find that an aftertax adjustment to increase net operating income of $853,000 is required. 15 P.U.R. 4th 87, 115-16. The district court found the Commission had no reasonable basis for departing from its past practice of treating the research costs as current expenses. Accordingly, the court disapproved this adjustment as an abuse of regulatory discretion. In this Court South Central Bell argues that the district court's decision was justified because the adjustment by the Commission was arbitrary and unreasonable. It asserts that the Commission's change from treating research payments as current expense to requiring capitalization and future amortization is contrary to the Uniform System of Accounts prescribed by the F. C. C., to generally accepted accounting principles, and to the past practices of the Public Service Commission. The Company further contends that no regulatory commission has ever approved such an adjustment, and that some commissions have considered and rejected the capitalization treatment. See, Re Chesapeake and Potomac Telephone Co., ___ P.U.R.4th ___ (Md.1977); Ohio Bell Telephone Co., 15 P.U.R.4th 344 (Ohio 1976). South Central Bell's statement of the agency determinations in the above-cited cases is essentially correct. However, in both of these proceedings, the regulatory agency itself, after a review of all of the evidence, determined that current expense treatment was preferable to capitalization. These decisions were based simply upon what the agencies perceived to be the better accounting procedure; the agencies did not reject capitalization because they thought it would amount to arbitrary or unreasonable regulatory action. Furthermore, we are aware of no appellate court decision in which such a conclusion was reached. In our earlier discussion of capital structure, we articulated our view that consistency of administrative treatment is desirable and that capricious alterations of regulatory practices will not be upheld. Nevertheless, the Commission is free to make modifications in its rate making procedures which are reasonably calculated to protect the interests of Louisiana ratepayers while treating the utility fairly. Otherwise, there could be no improvement in the regulatory process or variation to meet changing circumstances. In the instant case, we find that the actions of the Commission were not arbitrary or precipitous. The adjustment made by the Commission was its first change of course regarding the treatment of South Central Bell's research and development costs, and the change was apparently instituted in good faith after careful consideration. Moreover, the Commission's determination to depart from current expense treatment appears to have an adequate rational basis. The line of demarcation between capital expenditures and revenue charges is a flexible one that is a source of disagreement between accountants in tax matters and in other areas. See, E. M. Faris, Accounting for Lawyers, pp. 85-92 (3d ed. 1975). The fact that capitalization of research costs may not accord with accounting practices prescribed by the F. C. C. does not necessarily render it unreasonable. As we have seen in the case of adjustment and treatment of other financial data for regulatory purposes, accounting rules and even legal forms sometimes must be disregarded by the rate making body in order to properly account for economic realities and to defend legitimate ratepayer interests. Accounting practices are established for the benefit of many different observers of corporate activity, and a practice may vary depending upon whether it was adopted to facilitate analysis by stockholders, creditors, management or the Internal Revenue Service. See, Faris, supra, p. 86. Although an accounting procedure formulated for a non-regulatory purpose may provide one rational basis for a regulatory determination, there is no logical reason why a rate making agency cannot base its decision upon another reasonable procedure devised solely for the purpose of considering the merits of a proposed utility rate increase. Because the reasons advanced by the Commission for its ruling make a great deal of sense when judged on their merits, and because the departure from past regulatory practice was not unfair under the circumstances, proper judicial inquiry should have ended with the conclusion that the administrative agency's determination was not arbitrary or unreasonable.