General Price Level Adjustments and Return on Investment

In their article in the May/June 1975 issue of Financial Analysts Journal, Professors Davidson and Weil showed that if public utilities had adopted the Financial Accounting Standards Board’s proposal for general price level adjustments, restated 1973 earnings would have been higher by about two-thirds. The present authors analyze the impact of general price level adjustments on earnings of utility firms in five major groups—telephone and telegraph, flow-through electric, normalized electric, natural gas and air transportation—with special attention to the likely effect on inflation adjusted earnings of treating utility assets as monetary rather than nonmonetary.

The dramatic earnings increases resulting from price level adjustments disappear if plant assets are treated as monetary: The sample’s 1974 reported earnings of nine billion dollars (treating plant assets and deferred taxes as nonmonetary) turn into a loss of $633 million.

In order to assess the implications of rate regulation the authors examine (1) the case where the regulatory authority permits no adjustment for expected inflation on either the rate base or the allowed rate of return; (2) the case where they permit an adjusted rate base; and (3) the case where they permit a change in the allowed rate of return. Finding that the FASB proposal for general price level adjusted earnings generates reasonable results only in the second case, the authors argue for monetary treatment when no rate base adjustment is permitted.