Regulated utilities such as Duke Power Co. (a subsidiary of Duke Energy Corporation) are authorized to earn a specific rate of return on their capital investments. Energy regulators set a rate the utility can charge its customers for the electricity. If the cost of fuel and other operations decreases and a utility earns more than its authorized rate of return, regulators may cut the rate a utility charges its customers.

   In 2002, Duke Power agreed to repay $25 million to customers to settle charges the company underreported earnings in 1998 through 2000 in order to avoid reducing its electricity rates. An audit concluded that Duke’s management overreported its insurance expense. The underreporting of net income to regulators did not affect net income under GAAP, however.

Required:
  1. Many earnings management devices are intended to accelerate revenue or delay expenses and thus increase current earnings. Explain how electricity rate regulation sometimes creates incentives for utility executives to overstate expenses and understate earnings.
  2. Documents produced by Duke Power in connection with this matter indicate that some personnel at the company characterized “above-the-line” expenses as those that Duke’s electric customers paid—meaning they were accounted for and included in the electric rates paid by customers—while “below-the-line” expenses were characterized as “paid” by Duke’s shareholders. Suppose Duke Power spent $10 million hiring a consulting company to develop a new logo for the company. Explain why customers and shareholders care whether the cost of logo development is classified by the company as “above” or “below” the line.
  3. Explain why underreporting income to regulators does not affect net income under GAAP.