The Editors' Blog

Duke Energy, regulation and the matching principle

Some folks are against government regulations because they think that they hinder economic growth.

And some regulations are ridiculous and do interfere unnecessarily with the free market.

But I think about the accountant’s thankless job when I think about regulation.

Accountants, bless ‘em, spend a lot of time trying to figure out whether some business activity is profitable.

The fundamental challenge is to make sure that for a given amount of revenue from a business activity, that all the costs are counted against it. This is known as the “matching principle.” It is a foundation of accrual accounting. It may be that the cash for the expense won’t be paid for several months down the road, but accrual accounting insists on matching expenses against revenues in the most timely way so everyone knows how profitable something really is.

For example, if you have a business that generates $1,000 of revenue each month, but the rent, $120, is paid every three months, accrual accounting would say that $40 should be charged to the business each month as an expense, even if the rent check wasn’t sent out.

But as a society, we operate a lot of time on a cash basis. We pretend like there’s no rent expense for two months, and then act surprised when there’s a $120 rent expense in the third. This may be good for a mom-and-pop business that operates out of its checkbook, but not necessarily for a society.

When we are looking at benefits from a certain activity (revenues), we should know what the costs are that we are incurring (the rent), even if that rent check won’t be paid right away.

The current controversy over the coal-ash ponds operated by Duke Energy is a case in point. For decades, Duke power plants burned coal, an abundant and relatively cheap fossil fuel.

So Duke customers benefited from coal in the 1950s and 1960s and 1970s, etc., etc.

Burning coal created a byproduct, ash, which was stored at the coal plants. Many of these plants were built next to rivers, streams and other waterways. The coal ash holding facilities, thus, were next to water.

And now these coal ash holding facilities need to be cleaned up and otherwise dealt with, because society has decided that it doesn’t want them leaking into rivers, endangering wildlife and dumping upstream from municipal water intakes.

The matching principle of accrual accounting would say that power companies should have spent money many years ago to have set up a much safer disposal system for coal ash. A system that would have disposed the ash far away from rivers and streams and aquifers. That would have cost a lot of money, and the generation of electricity from coal wouldn’t have looked as economical to Duke or its customers. (See also nuclear power, spent fuel disposal costs.)

This is when regulation is the most difficult and most unpopular in some precincts. Lots and lots of people were thrilled when Duke was building coal plants years ago, because the electricity spurred the economic development of North Carolina, providing power to textile and furniture mills and the growing cities and towns.

If the accountants had been in charge, they might have said in the 1930s, well, there’s a big check that’s going to have to be cut at some point to move that coal ash way away from that riverbank there, and we better figure a better way to do this and start paying for it.

Mostly, in real life, it’s the government regulators who are fussy about things being done in a particular way so the tab is paid for as much as possible, as soon as possible, and by the beneficiaries of economic activity.

This is called avoiding “externalities,” i.e., a situation that arises when costs have to be paid by people, such as taxpayers, who didn’t get the full benefit from whatever activity caused those costs. (This is a fancy way that economists talk about the choice between accrual and cash basis accounting, because economists are big thinkers, as opposed to mere bookkeepers.)

Efforts to avoid externalities cause big, big arguments.

There’s a big debate, for example, over the cost of flood insurance, with some regulators saying that coastal development ought to pay more to cover the cost of the inevitable Hurricane Sandys.

There are always arguments over big rezonings, with benefits going early to landowners, developers and builders, and many costs coming later for school districts and state and local highway, public utility and public works departments. Not to mention when the new subdivision causes runoff that floods backyards nearby. State and local regulators are forever in a tussle with developers, and these fights invariably center on the desire of the regulators to eliminate externalities.

As a society, as I said above, we have always leaned more towards cash basis thinking. But eventually, stuff has to be cleaned up and the rent comes due. It’s good business to know the real bottom line sooner versus later, and who should pay.