Lesson 4 Overview

Overview

The next series of lessons, starting with this one, will develop quantitative tools that will allow you to prepare an assessment of the profitability of an energy project, whether that project falls into a conventional energy category (e.g., a natural gas power plant) or a sustainable energy category (e.g., solar hot water heating). While our focus here will be on profitability as a performance metric for project evaluation, it is possible to use other performance metrics (such as life-cycle impacts; embedded energy, carbon equivalent or water). In the investment world, these alternative metrics are used less frequently in project evaluation.

This lesson will build up to the construction of the "pro forma" financial statement for a single energy project. Along the way, we will learn a little about the unique language of accounting, what "depreciation" means to a tax accountant, and how a "10K" is not just a road race.

Learning Outcomes

By the end of this lesson, you should be able to:

• Discuss topics related to basic accounting and corporate finance
• Differentiate debits (assets) from credits (liabilities) in an accounting statement and verify the fundamental accounting identity
• Explain the process of financial depreciation and calculate depreciation using several different methods
• Explain sensitivity analysis and uncertainty
• Build a Revenue Time Series
• Construct an Operating Expense Time Series

Reading Materials:

Basic accounting concepts and the items on the pro forma income and cash flow statements will be explained using the following resources

• Accounting Basics [1]
• A Primer on Financial Statements [2]
• Primer on Financial Accounting, by Alison Kirby Jones [3] (especially the second part on income and cash flow)

What is due for Lesson 4?

This lesson will take us one week to complete. Please refer to the Course Calendar in Canvas for specific due dates. Specific directions and grading rubrics for assignment submissions can be found in the Lesson 4 module in Canvas.

• Participate in the Zoom call
• Complete Quiz 3
• Final Project: Revenue Time Series
• Final Project: Op Expense Time Series

Questions?

If you have any questions, please post them to our Questions? discussion forum (not email). I will not be reviewing these. I encourage you to work as a cohort in that space. If you do require assistance, please reach out to me directly after you have worked with your cohort --- I am always happy to get on a one-on-one call, or even better, with a group of you.

The Basic Language of Accounting

This is not a course in accounting. But I really recommend that you take one. Accounting often gets a reputation as a monotonous and boring field, and since there is so much number-crunching involved in accounting, there are times when this is true. But to really understand the drivers of how business decisions get made, you need to start with some accounting – because the process of accounting provides the basic language and building blocks for determining which companies, technologies, and projects will ultimately be viewed as successes and failures.

The goal in this section is to familiarize you with some of the most basic concepts in accounting. It's meant to get you comfortable with the language of ledgers, not necessarily to convert you into one of those guys with the green eyeshades [4]. And you might even understand why your taxes are so complicated (at least, if you live in the United States).

The website Investopedia has a very nice introduction to accounting concepts. [5] At this point, you should go ahead and read it, especially the first five parts (through the section on financial statements). Once you are comfortable with that material, go ahead and have a look at Alison Kirby Jones's accounting tutorial [3], which focuses nicely on financial accounting. The second part of the tutorial, which focuses on the accounting statements of income and cash flows, is most relevant to us.

What we will focus on in this lesson is the practice of financial accounting - the preparation of a synopsis of a company's financial health. The primary tools in financial accounting are a series of tables or "statements" that convey specific information about the financial position of the company. The most important of these statements are:

• Balance Sheet: Summarizes the financial position of a company - what its assets and liabilities are;
• Income Statement (or Profit and Loss or "P&L" Statement): Summarizes a company's operating revenues and expenses for a particular time period;
• Cash Flow Statement: Summarizes outflows and inflows of cash for a company over some period of time - it describes where a company gets its money (i.e., revenues from a product or service; investing activities, etc.). The income statement is generally divided into sections on "operating cash flow" (which comes from the income statement) and "investing cash flow," which is where we will find project capital costs.

The readings for this lesson and some of the discussion should focus on the company as the unit of analysis for accounting. But virtually all of the concepts that we develop can be applied to a specific project as well. In fact, the main purpose for going through these accounting concepts is so that you can apply them to the evaluation of energy projects, through a series of weekly assignments and (eventually) the final semester project.

The remainder of this section will be devoted to understanding the Balance Sheet and the Fundamental Accounting Identity. The Balance Sheet is just a tabular summary of the net financial position of a company at some point in time (note that this is a fundamental difference between the Balance Sheet and the P&L or Cash Flow Statements, which usually capture financial positions over a period of time, rather than just a snapshot). The Balance Sheet has just two columns - one which measures what the company owns (or its assets, sometimes called credits) and the other that measures what the company owes (or its liabilities, sometimes called debits).

Assets and liabilities, from an accounting standpoint, are just two sides of the same coin. When a company has possession of something that it hopes will net it a future benefit (an asset), that future benefit generates a "claimant" (liability). After all, if a company purchases equipment, supplies or labor, the money for those assets had to come from somewhere. Typical examples of claimants would include lenders (like a bank), shareholders in the company, or even the company's owners if they are the ones that put up money. Table 4.1 summarizes things that would go in the Asset and Liability sides of the Balance Sheet (note that this is just a summary of the figures on pages 3 and 4 of the Jones reading).

One important feature of the Liabilities side of the Balance Sheet is how creditors (lenders) and suppliers are separated from equity owners (the company's employees and shareholders). Creditors and suppliers have claims to fixed sums of money from the company, equivalent to whatever they are owed. Equity owners have a claim to any "residual" income of the company after the creditors and suppliers have been paid. For this reason, equity owners are often referred to as "residual claimants."

Since every asset generates its own future liability, every entry on the Asset side of the Balance Sheet needs to have a corresponding entry on the Liability side. Put another way, Assets (the left side of the Balance Sheet) generally describe investing activities, which are undertaken by the company in order to make more money in the future (well, we hope). But the funds for those investing activities have to come from somewhere. So, the Liabilities (the right side of the Balance Sheet) describe the financial activities that are undertaken to support the investments. The Liabilities side of the balance sheet describes not only the total sum of what the company will owe to various parties in the future, but also what the distribution of those parties is (banks, shareholders, company owners, and so forth).

Owner's equity is the simplest example. If I set up a company with $10,000 of my own money, then the balance sheet on the first day of the company's operations would look like the one shown in Table 4.2:

Here is another example, which builds upon Table 4.2. Suppose now I issue shares of stock in my company, to the tune of another $10,000. I use $5,000 of that money to purchase a piece of office equipment. On the Assets side, I would then have $15,000 in cash and $5,000 worth of PP&E. On the Liabilities side, I would have $20,000 worth of owner's equity. This is shown in Table 4.3.

As one final example, suppose that instead of using the cash I raised to purchase the $5,000 worth of office equipment, I purchased the equipment half with cash and half on credit from an office supply store. This credit is a promise to pay the office supply store $2,500 at some future point. So, at that point, I would have $17,500 in cash and $5,000 worth of PP&E in the Assets column. As Liabilities, I would have the $2,500 of credit from the office supply store as Accounts Payable, plus the $20,000 in owner's equity. This situation is shown in Table 4.4.

You might have noticed that the Assets and Liabilities columns both add up to the same number ($10,000 in Table 4.1, or $22,500 in Table 4.4). This is no accident - the examples collectively illustrate what is known as the Fundamental Accounting Identity, which states that the sum of Liabilities to creditors and owner's equity (which, remember, includes shareholders) must equal the company's total Assets.

Depreciation Accounting

The term "depreciation" usually refers to the physical degradation of some capital asset, like wear and tear. My car, for example, doesn't drive as smoothly with 120,000 miles on it as it did when it had 12,000 miles. As some piece of capital gets older, you might naturally expect it to be worth less, either because it requires more maintenance or because it cannot be resold for as high a price. (Though the concept of "value" of physical plant can be a bit tricky, as we will learn in the next section.) It is often said that the value of a new car drops by 20% as soon as it is driven off the lot, even though it's basically the same vehicle that was bought for a new-car price. This illustrates the difference that can sometimes arise between physical depreciation and the depreciation in a capital asset's store of value.

Depreciation of an asset's store of value has substantial implications for the financial analysis of energy projects. You might recall from Lesson 5 that the profits of a regulated public utility are determined in large part by its total stock of non-depreciated capital. Who determines the rate at which a power plant, substation or other asset depreciates in value? Similarly, tax authorities in many countries allow companies to "write off" the depreciated value of assets when calculating their total income on which they are subject to paying tax. The term "write off" here refers to a deduction from total taxable income, rather than a deduction in the total tax bill, per se. For example, if you can claim that some capital asset has depreciated in value by $100 over the course of some year, and the tax rate is 35%, then that $100 asset depreciation will ultimately lower your tax bill by $35 (35% of $100), not by $100. This is the difference between a "tax deduction" and a "tax credit." Tax credits will appear later in the course when we discuss financial subsidies for energy projects.

The rate at which an asset is financially depreciated for tax, regulatory, or other financial purposes may be very different than the rate at which the asset actually physically depreciates in value. It is even possible that an asset could be treated as completely depreciated in the eyes of a regulator or the tax authority, yet could still be generating a lot of value for its owner. Many power plants or natural gas mains in the U.S., for example, are several decades old - well beyond their intended 30 to 40 year life spans. These assets are mostly considered to be depreciated assets, yet some continue to be highly profitable.

Depreciation allowances are usually determined by the regulator, tax authority or other relevant oversight body in order to allow the owners of depreciable capital assets to recover the costs of those assets through a series of tax deductions or other gains over the course of some number of years. The idea here is to encourage investment by allowing companies to use investment vehicles to reduce their tax burden. Our discussion here will focus on depreciation allowances that are allowed by tax authorities, since those allowances are ultimately the most important for development of energy project financial statements. The U.S. Internal Revenue Service, if you happen to be interested, maintains a mind-bogglingly complex list of types of property that are eligible for different depreciation schedules and methods. Here is an "introduction" to depreciation [6] from the IRS.

A depreciation schedule lists the percentage of the original (so-called "book") value of a piece of property that can be claimed as a depreciation allowance for tax reporting purposes. Broadly, there are two types of depreciation schedules: straight-line depreciation and so-called accelerated depreciation methods.

Before we get into the mechanics of depreciation, we need to develop some notation.

• P = the up-front cost of the asset;
• F = the salvage value of the asset at the end of its useful life;
• N = the number of years over which the asset will be depreciated;
• A(t) = the depreciation allowance for year t (t = 1,…, N), in percentage terms, such that ${\displaystyle \sum _{t=1}^{N}A(t)=1}$ (i.e., the asset must be fully depreciated over N years);
• D(t) = the depreciation allowance for year t (t = 1,…, N), in dollar terms, so that D(t)=A(t)×P;
• B(t) = the remaining book value of the asset after year t.

Based on these definitions, we can immediately see that B(t) is just equal to the original book value (P) less all of the cumulative depreciation allowances from year 1 to year t. In mathematical terms,

$B(t)=P-{\displaystyle \sum _{k=1}^{t}D(t)}$

Table 4.5 provides the mathematical formulas for some common depreciation methods. Note that Modified Accelerated Cost Recovery Systems (MACRS), which have become more commonplace, are not included in Table 4.5 but will be discussed below.

The most straightforward depreciation method is straight-line depreciation. Under straight-line depreciation, the book value of an asset (less its salvage value, if any) can be depreciated evenly over some number of years. For example, if you had an asset with a book value of $1,000; no salvage value; and a ten-year depreciation horizon, you could claim $100 each year for ten years as a depreciation expense and tax deduction.

The other three depreciation methods that we will discuss here - sum of the year's digits, declining balance, and MACRS - are all forms of "accelerated depreciation." Under accelerated depreciation systems, a larger proportion of the asset's book value is allowed to be depreciated in the earlier years of its use, with smaller proportions depreciated in later years of use. This allows the asset owner to enjoy a lower tax burden earlier in the asset's life. Other things being equal, this leads to higher profits in the years immediately following investment. Accelerated depreciation can substantially affect the value of an asset to its owner; we will see later just how this re-allocation of tax burden and profits across the useful life of an asset increases the asset's lifetime benefit to its owner.

The three accelerated depreciation methods that we will illustrate in this lesson are:

1. Sum of the Year's Digits (SYD): SYD is best illustrated using a simple example. Suppose that an asset could be depreciated over five years. Then the sum of the digits would be 1+2+3+4+5 = 15. The first year, you could claim 5/15 = 33% of the asset's book value as a depreciation expense, so that A(1) = 33%. The second year, the depreciation allowance would be A(2) = 4/15 = 27%. You can verify for yourself that A(3) = 20%; A(4) = 13%; and A(5) = 7%.
2. Declining balance: This could also be called "exponential depreciation" since it depreciates an asset at a constant rate, rather than a constant amount. If an asset is depreciated using the declining balance method over a fixed number of years, the residual book value of the asset is used as the depreciation allowance in the final year. For example, if you had a $100 asset with no salvage value, and were claiming depreciation according to the declining balance system at 25% per year over five years, in the first year your depreciation allowance would be D(1) = 0.25 × $100 = $25. In the second year, you would have D(2) = 0.25 × ($100 - $25) = 0.25 × $75 = $18.75. You can verify for yourself that D(3) = $14.06; D(4) = $10.55, and D(5) = $7.91.
3. Modified Accelerated Cost Recovery: MACRS, popular in the United States, is embodied in a series of depreciation tables published by the U.S. Internal Revenue Service. The tables dictate the values of A(t) to be used each year, and also describe which types of assets are eligible for MACRS and over how many years. In other words, different asset types have different values of N and different depreciation schedules A(t). One thing to note about MACRS is that the N-year depreciation schedules actually cover N+1 years (so, for example, five-year MACRS allows depreciation over six years).

As a means of comparison between all of these methods, let's take a hypothetical asset with a book value of $1,000 and zero salvage value, and depreciate that asset over a ten-year time horizon. Table 4.6 and Figure 4.1 show the values of B(t) during each year for each of the four methods. For declining balance, we will use 25% per year. For MACRS we are using the 10-year table in Appendix 1 of Publication 496 [7].

As an exercise, see if you can reproduce the table and the figure.

Figure 4.1: Book value B(t) of a $1,000 asset with four different depreciation methods.

Credit: @ Penn State is licensed under CC-BY-NC-4.0

The Pro Forma Income (P&L) and Cash Flow Statements

The Balance Sheet that was discussed earlier in this lesson provides a snapshot in time of the financial health of a firm or the valuation (again, at a snapshot in time) of a specific investment project. The last two financial statements - the P&L and the cash flow statement - are used in two ways, depending on whether the entity under analysis is a company or a specific project. Either way, they have roughly the same format.

At this point, please read "A Primer on Financial Statements. [8]" The first big table in the article lays out the structure of the P&L statement pretty nicely, at least up until the row that is labeled "Net Income." The rows below Net Income pertain to calculating financial metrics for valuation of specific companies. The P&L and cash flow statements for U.S. companies, at least those that are publicly traded, are laid out in a mandatory quarterly filing to the Securities and Exchange Commission called the Form 10K. Some companies publish similar information in their annual reports to shareholders, but these annual reports are not subject to any sort of regulatory scrutiny, whereas 10K filings can be audited if necessary. So, the 10K is the real deal as far as determining the financial position of a company. This is not to say that all companies massage the numbers in their annual shareholder reports, only that you may find differences between the annual report and the 10K, if you look hard enough. 10K filings in the U.S. are public information, so you should be able to easily find them, as long as the company is required to file one.

Individual energy projects are often evaluated using P&L and Cash Flow statements that jointly are known as the "pro forma." Unlike the P&L and Cash Flow statements for a company, which should represent actual historical data, the pro forma represents the analyst's evaluation of the financial worthiness of a potential energy project. (It is possible to put together a historical pro forma for an individual energy project, but we'll focus on the pro forma for evaluation of potential energy projects.)

As we go through the various parts of the pro forma, it will be useful to refer to a numerical example, to keep things a little less abstract. I have posted a simple pro forma statement for a hypothetical natural gas power plant, in Microsoft Excel format. Look for the Pro Forma Example.xlsx file in the Lesson 04 - Basic Accounting and Corporate Finance, Cot'd module in Canvas. Please download the spreadsheet for reference (for those who do not have access to Excel, the spreadsheet should be easily opened in Open Office or in a Google Spreadsheet). The spreadsheet has four tabs:

• The Plant Properties tab contains some overview information about the power plant. This is reprinted here as Table 4.7.
• The Depreciation tab contains the annual depreciation allowances (the A(t) values) assuming that all components of the plant are eligible for 10-year MACRS depreciation.
• The P&L tab contains the P&L statement for a fifteen-year operational period.
• The Cash Flow tab contains the Cash Flow statement for the same fifteen-year operational period.

Our hypothetical natural gas power plant has the following properties that are shown in Table 4.7 (from the Plant Properties tab). Some of these plant properties aren't relevant to us right now, but we will come back and use this hypothetical plant as an example in future lessons.

Below this table on the Plant Properties tab, you will notice a set of assumed annual sales prices, in $ per MWh, for the fifteen-year operational period.

Table 4.8 shows the first few years of the P&L statement (not all fifteen; for the full P&L statement, please refer to the Excel spreadsheet in Canvas). We will refer to Table 4.8 as we go through the items on the P&L statement.

First, note that we label the construction year as "Year 0" and the operational years as "Year 1-15." That is just a numbering convention indicating that we assume that the power plant is built this year and is operated beginning the following year for fifteen subsequent years.

The first section of the P&L, on lines (1) through (5), outlines the costs and revenues of the power plant project.

• Line (1) contains the construction cost from the Plant Properties tab. This cost is assumed to be incurred only in Year 0.
• Line (2) contains the annual revenue from energy sales, equal to the annual production of 4,500 MWh times the annual electricity price (which changes from year to year).
• Line (3) contains the annual variable operating cost, which is equal to the annual production of 4,500 MWh times the sum of the marginal cost and the variable O&M cost (both are assumed to be constant at $60 per MWh and $5 per MWh, respectively).
• Line (4) contains the fixed O&M cost, assumed to be $10,000 per year.
• Line (5) shows net operating revenue before taxes and depreciation, also known sometimes as the EBIDTA (Earnings Before Interest, Depreciation and Taxes). This is equal to total revenues minus total expenses, or Line (2) less the sum of Lines (3) and (4).

Lines (7) and (9) incorporate the depreciation allowance. The depreciation allowance is calculated using the $500,000 book value of the plant (i.e., the construction cost) and the annual depreciation allowance percentages from the MACRS table (the Depreciation tab in the spreadsheet). Taxable net income on Line (9) is calculated as the net operating revenue or EBIDTA, less the allowable tax deduction for depreciation.

Taxes owed by the plant are shown in Line (11), equal in this example to 35% of taxable net income, as long as taxable net income is positive. In year 2, for example, you will notice that the plant has a large negative taxable net income. This is not because the plant did not make any money (it made a little bit as you could see from Line (5) in Table 8.8) but because the allowable depreciation expense is so large that for tax purposes it appears as though the plant lost money. In this case, there is no income to be taxed, and the plant would not pay any taxes that year. On the P&L statement, its income net of taxes (Line (13) in Table 4.8) would be negative.

Of course, the plant did not really lose money in year 2, because the depreciation expense is not a real expense, in the sense of representing a cash outlay by the company that owns the power plant. For the purposes of calculating tax liability, however, the depreciation allowance is treated as a real expense.

Finally, we move onto the Cash Flow statement. In this example, the Cash Flow statement is much easier to put together than the P&L statement. Table 4.9 shows the first few years of the Cash Flow statement for purposes of illustration.

The first line on the Cash Flow statement lists all investment activities in that year - these represent outlays of cash (even if the Balance Sheet for that year would indicate that the investment activities were financed through debt or owner/shareholder equity). In our example, there is only one year - the construction year - with any investment activities. Line (3) is the final line item from the P&L statement, showing the post-tax net income from operating activities. The crucial point to remember here is that this figure includes the depreciation expense, which is not a real expense in the sense of any cash outlays. So, to get a real sense of how the project's cash holdings have changed throughout the year we need to add the depreciation expenses (Line (5) in Table 4.9) back to the net income (Line (3) from Table 4.9). The resulting sum is the "Net increase or decrease in cash," and it shows the end-of-year cash holdings for the power plant project. These cash holdings are used to pay back creditors and are disbursed among equity shareholders (i.e., the project's owners).

Lesson 4 Summary and Final Tasks

Summary

Accounting is the language that is used to describe business transactions and the financial viability of companies and projects. This same language is used to determine the viability of any type of for-profit energy company and project, whether based on conventional or alternative energy resources or technologies. We learned about the three fundamental accounting statements – the Balance Sheet, the P&L, and the Cash Flow. The latter two of these make up the “pro forma” evaluation of a potential energy project.

Reminder - Complete all of the Lesson 4 tasks!

You have reached the end of Lesson 4! Double check the What is Due for Lesson 4? list on the first page of this lesson to make sure you have completed all of the activities listed there before you begin Lesson 5.