Include AFUDC on Power and Utilities Construction Projects and Rates

The Allowance for Funds Used During Construction (AFUDC) is a best practice in the power and utilities industry. Including AFUDC in construction projects follows the guidelines for electric construction accounting in the Federal Energy Regulatory Commission's Uniform System of Accounts (FERC USoA) and RUS Uniform System of Accounts (RUS USoA).

At times, mid-sized and smaller utilities — mainly municipal systems — leave some of the FERC USoA allowable costs of construction "on the table" by not recording AFUDC as part of total construction costs. The impact of not including AFUDC will be felt in future years when it is time for asset replacement: without AFUDC, the asset will not reflect its full construction or acquisition cost, and rates will under-recover the cost of capital used to finance it.

This article dives into the Allowance for Funds Used During Construction (AFUDC) and also discusses applying AFUDC to idle projects.

What Is AFUDC?

AFUDC — the Allowance for Funds Used During Construction — is the opportunity cost of funds used in construction projects . For example, a utility or cooperative could take $1,000 and spend it on utility personnel raises, new capital projects, research, maintenance, or leave those funds on deposit in a bank. Each potential use of the funds has an opportunity cost associated with it.

The AFUDC is an interest rate applied to the funds spent on construction projects . The calculation of the interest rate — the AFUDC rate — is detailed in Section 3 of the FERC USoA plant instructions. The calculation is based on the funding source of projects and the associated interest rate of each source. In effect, the AFUDC rate is the cost of capital .

Table 1 — AFUDC Rate Calculation (Project Financing Sources)

For example, the utility has planned projects of $10 million in the current year, financed through a combination of sources. The AFUDC rate is the weighted average cost of capital across all financing sources:

AFUDC Rate Application Policy

Utilities and electric cooperatives have different policies on applying AFUDC based on the uniqueness of their operations. Some utilities apply the AFUDC rate to every dollar spent on projects. Others apply the percentage only to projects over a specific size and duration — for example, projects over $50,000 that take at least three months to complete.

Our view is that "a dollar is a dollar" — no matter when it is used or for what purpose, the opportunity cost can be calculated and should be included in total project cost. The only exceptions would be for grant-funded projects or projects that are contributions in aid of construction (CIAC).

The Impact of AFUDC

Table 1 calculates the AFUDC rate as 4.3%. Applying that rate to $10 million of projects increases total project costs — and thus asset values — by $430,000 ($10,000,000 × 4.3%). The two main areas impacted are depreciation expense and the rate of return on ratebase.

Depreciation Impact

For this example, assume these are electric distribution projects with a typical useful life of approximately 30 years. The impact of adding AFUDC versus not adding it is shown in Table 2:

Calculation: $430,000 AFUDC ÷ 30-year useful life = $14,333 additional annual depreciation expense included in customer rates

Rate of Return Impact

Adding $430,000 of AFUDC to the project balance and applying a standard rate of return on ratebase results in additional annual revenues in customer rates, as shown in Table 3:

Calculation: $430,000 AFUDC × 8.0% rate of return = $34,400 additional annual return included in customer rates

Total Rate Impact — Table 4

Combining the additional depreciation expense and rate of return, Table 4 shows the total annual amount added to customer rates by including AFUDC:

The $48,733 increase in rates is not about needlessly raising customer rates. It follows the fundamental principle of power and utilities ratemaking: customers pay for their current use of the plant in service that provides them with electric service. Full cost recovery — including the cost of capital used to build the system — is required to maintain a financially healthy utility.

Applying AFUDC to Projects "On Hold"

Should AFUDC be applied to construction projects that are on hold and not advancing due to permitting delays, regulatory approvals, or financing constraints?

In our opinion, the short answer is yes . When capital has been committed to a project, it is effectively unavailable for other uses. Therefore, an allowance for funds used during construction remains appropriate.

That said, we have observed varying interpretations in practice:

• Some organizations suspend the application of AFUDC while awaiting resolution of permitting, regulatory, or board approvals needed to proceed.
• Others apply a reduced AFUDC rate during the hold period — though this approach is questionable unless the organization's underlying cost of capital has actually changed.

In most cases, AFUDC amounts related to temporarily inactive projects are not material to the financial statements, so auditors are unlikely to raise concerns. However, organizations should aim for consistency in their construction accounting practices to ensure transparency and sound financial reporting.

Construction Stoppages and Impairment

If a project has been impacted by a construction stoppage, the same logic applies: continue to apply AFUDC to the project balance, as the capital remains committed and unavailable for other uses.

However, a utility that follows governmental accounting standards must also consider whether an impairment has occurred. GASB Statement No. 42 — Impairments specifically calls out construction stoppage as a potential impairment trigger. Organizations following FASB standards must similarly evaluate under ASC 360-10-35 , which treats a stoppage as a triggering event requiring assessment of whether the construction costs are recoverable.

GASB 89 for Governmental Utilities — Expense AFUDC?

GASB Statement No. 89, Accounting for Interest Cost Incurred Before the End of a Construction Period , requires municipal utilities to expense construction period interest — unless the utility chooses to record capitalized interest as a regulatory asset under GASB 62.

Not capitalizing interest may exclude those costs from electric rates. Capitalized interest can be a substantial part of the construction costs of major projects. Many municipal electric utilities of all sizes follow the option to expense construction interest — but this does a disservice to their ratepayers. See our related article on GASB 89 for a deeper discussion.

How Often Should the AFUDC Rate Be Changed?

Interest rates are not static. At a minimum, the AFUDC rate should be calculated annually. The mix of resources and interest rates used to fund projects varies from year to year, impacting the weighting of each financing source and thus the weighted average cost of capital used as the AFUDC rate.

Summary

This article addresses the topic at a high level, but the application of AFUDC is not an overly complicated process. Overlooking this area of utility work order accounting will lead to a cash flow shortfall when it is time for asset replacement — and will leave future ratepayers funding a cost that current ratepayers should have borne.

A detailed discussion and analysis of applying overheads to construction projects can be found in our course: Utility Construction Accounting — Level 2 .

The material in this article is for informational purposes only and should not be taken as legal or accounting advice provided by Utility Accounting & Rates Specialists, LLC. You should seek formal advice on this topic from your accounting or legal advisor.