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Metropolitan Power Supply: Expense construction costs?

Your firm audits Metropolitan Power Supply (MPS). The issue under consideration is the treatment of the company's financial statements of $700 million in capitalized construction costs relating to Eagle Mountain, a vertically completed nuclear power plant.
Seven years ago, MPS began construction of Eagle Mountain, with an original cost estimate of $400 million and completion expected within five years. Cost overruns were enormous, and construction has been repeatedly delayed by litigation initiated by the antinuclear lobby. At present, the project is little more than 50 percent complete, and construction has been halted because MPS does not have the funds to continue.
If Eagle Mountain is ultimately completed, the state utilities commission will determine the extent to which MPS may recover its construction costs through its rate structure. The commission's rulings are difficult to predict, but it is quite possible that the commission will not allow MPS to include all of the Eagle Mountain construction costs in its "rate base." If Eagle Mountain were abandoned today, none of the construction costs would be recoverable. The related write-off would amount to over 70 percent of MPS stockholders' equity, but the company would survive.
MPS's management, however, remains committed to the completion of the Eagle Mountain facility. Management has obtained authorization from the company's stockholders to issue $500 million in bonds and additional shares of common stock to finance completion of the project. If MPS incurs this additional debt and is still not able to make Eagle Mountain fully operational, it is doubtful that the company can avoid bankruptcy. In short, management has elected to gamble?all its chips are riding on Eagle Mountain.

Discuss the arguments for and against the auditors insisting that MPS begin expensing some portion of the construction costs rather than continuing to accumulate an ever-increasing asset. Indicate the position you would take as the auditor.

Discuss whether the auditors should modify their report because of uncertainty as to whether or not MPS can remain a going concern. Indicate the type of opinion that you would issue.

Solution Preview

The general rule for U.S. GAAP is spelled out in 980-340-25 which is cut and pasted for you here:

"980-340-25-1 Rate actions of a regulator can provide reasonable assurance of the existence of an asset. An entity shall capitalize all or part of an incurred cost that would otherwise be charged to expense if both of the following criteria are met:
â?¢ a. It is probable (as defined in Topic 450) that future revenue in an amount at least equal to the capitalized cost will result from inclusion of that cost in allowable costs for rate-making purposes.
â?¢ b. Based on available evidence, the future revenue will be provided to permit recovery of the previously incurred cost rather than to provide for expected levels of similar future costs. If the revenue will be provided through an automatic rate-adjustment clause, this criterion requires that the regulator's intent clearly be to permit recovery of the previously incurred cost.
A cost that does not meet these asset recognition criteria at the date the cost is incurred shall be recognized as a regulatory asset when it does meet those criteria at a later date."
Expensing Portion of Construction Costs:

1. The FASB ASC requires that for a regulated entity to capitalize an asset, the future revenue must ...

Solution Summary

Your tutorial is 767 words and two references and discusses three pros and five cons to expensing the deferred costs of the plant. A recommendation on asset reporting is given and a report type is recommended and discussed. The relevant portion of the FASB codification is cut and pasted and included in the posting.