Regulated utilities such as Duke Energy are authorized to earn a specific rate of return on their capital investments. Energy regulators set a rate that 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.

DUKE ENERGY SETTLES WITH STATES ON CHARGES IT UNDERSTATED NET
Duke Energy Corp.’s regulated electric utility, Duke Power, agreed to pay $25 million to its customers to settle allegations the company had underreported profit in order to avoid having to reduce its electricity rates.
Energy regulators in North Carolina and South Carolina had ordered an audit of Duke Power’s books. The inquiry, conducted by accounting firm Grant Thornton LLP, found the utility had failed to report about $123 million in pre-tax income from 1998 to 2000. . . .
“They manipulated their earnings in an effort to ensure that they didn’t report numbers above the authorized rate of return,” said Gary Walsh, executive director of the South Carolina [Public Service] commission.
Grant Thornton concluded that the $123 million in accounting entries were “inconsistent with applicable accounting principles, inconsistent with Duke Power’s past practice and without proper justification.” The report says there was a coordinated effort by the utility unit’s top management to underreport net income by over-reporting expenses, specifically insurance for its nuclear operations.
Duke Energy, in a written statement, said it had reached “different professional opinions” than Grant Thornton on the accounting issues but had agreed to change the way it accounts for certain items, specifically nuclear insurance, as part of the proposed settlement. Duke Energy, which hasn’t admitted to any wrongdoing, said it would take a $19 million charge in the fourth quarter in connection with the settlement if it is approved. . . .
The utility’s underreporting to regulators didn’t affect Duke Energy’s report of net income, the Grant Thornton report said. . . .
Duke Power’s accounting problems started in late 1998 when a neighboring utility was ordered to cut rates to its customers after it had earned more than the amount allowed by state regulators. According to the audit of Duke Power’s books, as well as Duke internal documents cited in the report, Duke executives at that point realized their utility risked a similar order and decided they had to change the handling of certain accounting items to avoid showing too high a rate of return.

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 Energy 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 Energy 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. According to the news article, “The utility’s underreporting to regulators didn’t affect Duke Energy’s report of [GAAP] net income.” Explain why.