THE ALLOWANCE FOR WORKING CAPITAL

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IN A RATE CASE

HEN, for the purpose of regulation, the appraisal of the physical property of a public utility has been completed, an addition is usually made to the valuation as allowance for working capital. Fundamentally a company is entitled to earn a fair return on all its property reasonably employed in serving the public. This property consists of so-called fixed capital and working capital. The former includes all the more permanent assets devoted to specified purposes and in practice is usually valued independently by the means of an appraisal. It constitutes the bulk of a company's investment. Working capital consists of the more temporary assets which may be devoted or readily turned to any purposes that the company may have. Its amount is added to the fixed capital as determined by the appraisal, and the company is allowed a return on the entire valuation.

While the principles and methods involved in the appraisal of fixed property have been discussed extensively in recent years, the question of how the value of working capital should be determined has received slight consideration, either in public discussion or in the opinions of the commissions and courts. The reason doubtless is that fixed capital in any case constitutes by far the greater proportion of the property of the company and therefore naturally merits and receives the greater and more careful consideration. That allowance should be made for working capital is generally admitted or widely assumed. But what controlling ideas or principles should be followed in the determination of the allowance has never been, so far as the writer knows, very definitely and completely set forth in any formal opinion or in other published material on the subject. This does not mean that there have been no commission or judicial dicta on the matter, or that the general idea of working capital has not been discussed, but simply that the scope and limits of the notion have never been carefully examined. Since

the amounts involved are always relatively small, the regulating bodies have contented themselves in any given case with the immediate practical aspects before them, without considering the finer principles involved. The purpose of this article, therefore, is to analyze the general concept of working capital and to outline how the amount may be fairly determined in a

case.1

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It is a general rule in a physical appraisal to consider simply the property and to disregard the source of the funds used in acquiring the property. In other words, the commissions look upon the concrete plant and equipment used in serving the public, and seek to place a fair valuation upon them, paying little or no attention to the stocks, bonds, and other obligations or interests covering the property. They consider the items that appear on the assets side and not those on the liabilities side of the balance sheet.3 If this view were followed consist

1 The more usual view of working capital is that it consists of current assets less current liabilities. This view is followed in the main by the Public Service Commission of New York, Second District. The Wisconsin Railroad Commission, while considering the statements of current assets and liabilities, also the requirements of a company as to cash and stocks of materials and supplies, usually makes its statement of working capital a percentage of the gross revenue of gas, current, or other service sold. See State Journal Printing Co. v. Madison Gas and Electric Co., 4 W. R. C. R. 501, 551; also Superior Commercial Club v. Superior Water, Light and Power Co., 11 W. R. C. R. 704, 745–747. In a number of judicial and engineering dis. cussions, working capital is based on the quantity of service sold. The Public Service Commission of New York, First District, seems inclined to the view that working capital consists of the carrying charges borne by the company; this view will be considered in the latter part of this discussion.

* In the noted Ames Case, the formula is that a company has a right to a fair return on its property employed for the use of the public, with due regard for the actual cost, reproduction cost, and the par and market value of the stocks and bonds outstanding. While this formula has never been directly modified, in practice no attention is paid in a valuation to securities outstanding. It is the property, not the rights covering it, that is the subject of the valuation on which a return is allowed.

The balance sheet of a public-service corporation is intended to present the investment at a particular time. On the left side it has a list of all the different classes of property in the business and shows the cost of each class, while on the right side it shows the amount of funds contributed by each class of persons with financial interests in or claims on the business. Source is therefore indicated on the right side. We may think of the accounts on this side as representing claims upon the property

ently throughout and applied to property of every sort, then the question of what is working capital would be answered simply enough. If source were completely disregarded, if it were to make no difference where the property came from, by what obligation or interests it is covered, then working capital would consist of all the property reasonably employed in connection with the service and not included in the appraisal of fixed capital-all so-called current assets. This would include cash, materials and supplies, accounts receivable, prepayment and any similar items. There would be no deduction for obligations of any sort. The test by which to determine whether any particular item should be counted would be whether it is reasonably held in connection with the service. If so, the item would be added to working capital irrespective of the source from which the funds for the purchase of the item were acquired.

Source, however, is not consistently disregarded. While the physical appraisal of fixed capital is commonly made without inquiry as to obligations or interests covering the property, in the determination of working capital, deductions for current liabilities of some sort are usually made. To the extent of such deductions, source is clearly considered in the valuation. Ordinarily assets covered by so-called permanent obligations are included, while those covered by more temporary or current liabilities are not. Why this difference in treatment? The general principle is that a company may earn a return on all its property reasonably employed in serving the public. On what grounds, then, may a distinction be made between funds derived from one source and those obtained from another?

The commissions usually take current assets, less current liabilities, as the amount of working capital allowed in a valuation. In this practice they simply take over the everyday business notion of working capital, without considering, however, the relation of the notion to the general doctrine that source should not be regarded in a rate case. Practically, of

on the left side, or as interests or equities in the property, or simply as covering the property. The term "equity" is, of course, not used in the usual legal sense, but in the special accounting sense as indicated.

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course, this has not been a serious matter. The method has operated quite satisfactorily, without involving any particular injustice or inconsistency in practice. The absence of a definitely formulated principle, however, has made it difficult to distinguish clearly between obligations to be deducted from the assets and those to be disregarded. In general the distinction made has been that between current and more permanent obligations. But why deduct the one and not the other? And where precisely is the dividing line between the two? Is it merely the element of time or some other fundamental consideration? This is the theoretical point to be especially treated in this paper. In general the writer subscribes to the formula that working capital consists of current assets less current liabilities. Funds held to pay accrued interest, taxes, wages, and similar items, should not be made the basis of a return in the valuation. But the reason for the exclusion should be clear. While the amounts involved can usually make no appreciable difference in the rates to be fixed, still the entire procedure in establishing a valuation should be theoretically clear and definite.

As a basis of a theoretical distinction between obligations deducted from current assets and those not deducted, it is well to state once more the fundamental principle of law that a return must be allowed on all the company's property reasonably used in serving the public. If a distinction is to be made, it evidently should rest on the special idea of the company's property. May some of the property used in service be considered fundamentally as that of the company and some as representing obligations to outsiders? What is the company's property? What interests go together to form the company as viewed in connection with regulation? 1

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It should be emphasized at the start that the term "company" will not be used in the usual legal sense-the stockholders in their corporate entity. It will signify the groups of interests shown on the right side of the balance sheet, which are viewed in our system of regulation as covering the property employed in the public service. This includes not only the stockholders' interests, but also the bondholders and others which fit into the scheme of regulation. The " company "interests may be called 'capital obligations," and all the non-company interests "current liabilities."

In the balance sheet, all the assets or property of every sort are listed on the left-hand side. These items are covered on the other side by capital stock, funded debt and other obligations. Clearly the two sides are co-extensive, forming the same valuation viewed from different standpoints. The lefthand side presents the view of the assets themselves, while the other shows the source of the assets-the equities, interests, or rights covering them. The assets may thus be divided according to their source, that is, according to the rights covering them. Those representing equities of the company are included in the valuation, and source is disregarded, while those covered by claims other than the company's are not included. What rights then should be considered as constituting the company? These may be considered as capital obligations, and it is only property covered by them that should be included in the valuation entitled to a return.

In ordinary business corporations, the stockholders, of course, form the company, and the capital stock outstanding, together with the surplus, listed on the right side of the balance sheet, show the company's equity or investment in the business. In a public-service corporation, however, the notion of what is really the company has been very much extended. For the purpose of regulation, no difference is made between stocks and bonds outstanding. Both are equally considered as capital obligations or equities of the company. Further, this idea of the company includes all interests of a more permanent nature, covering funds which are expected to be used regularly in the service of the public, but it does not include rights of a temporary sort, representing funds which are held primarily to meet these obligations.

Although the terms "more permanent" and "more temporary" are here used, the distinction between company or capital obligations and other claims is fundamentally not based on time, but upon the special form or nature of the rights. In definitely drawing the distinction, the principles and technique of public-utility accounting and regulation must be properly considered. In harmony with the usual accounting classifications for public utilities, in addition to capital stock, all interest