Railroads’ Disadvantage in Contest for Capital Could Be Fixed With Regulatory Change - The American Spectator | USA News and Politics
Railroads’ Disadvantage in Contest for Capital Could Be Fixed With Regulatory Change

You won’t find many railroad executives running afoul of the Sarbanes–Oxley Act, or at least not the provision that requires they accurately report earnings.

In the railroad industry, accurate financial information is essential to survival. Make too much money, and the government can conclude they are operating in a non-competitive environment and enforce price controls. Make too little, and it’s hard to attract the capital necessary to survive.

In other words, railroads are being subjected to regulation to trim their prices based on profitability levels far below those of similarly situated companies outside the industry.

Complicating the situation is that because of what some industry observers say are problems with how profitability for railroads is measured, railroads are undervalued, which makes it harder for them to attract the capital needed to compete.

For railroads, rates of return on investment are calculated using accounting book values, which include depreciation of original costs, as opposed to economic book values that attempt to capture the value of a company if all its assets were sold in real time.

A five-year depreciation schedule is unrealistic for railroads — the equipment they buy lasts and retains its value far longer than five years — and this lower assessment “does not consider the railroads’ ability to compete for capital,” say a pair of University of Chicago professors, Kevin Murphy, an economist, and Mark Zmijewski, an accounting professor.

It also does not consider deferred taxes from depreciation to be assets of the railroads, even though the purpose of deferring these taxes is to provide capital for railroads to reinvest in their businesses and grow.

The result is that railroads are judged by market standards but valued by accounting standards applicable only to them. Measured properly, Murphy and Zmijewski say, they would be competitive with similar industries and generate a return on investment comparable to most of the companies listed on the Standard and Poors 500.

The Surface Transportation Board, which determines how much railroads make, says it seeks to establish the levels of earnings railroads must achieve to meet present and future demand and cover operating expenses, including depreciation and obsolescence, plus a reasonable profit or return on capital.

The Surface Transportation Board is directed by provisions of the Staggers Act of 1980 to compare railroads’ financial success with other industries in unregulated markets with which it competes for capital.

But the methods used to calculate its financial success are different from those of the other industries, and industry experts say change is overdue, the measurements in place are inadequate, and the results do not accurately depict the ability of railroads to compete for capital.

Basically, if a railroad has a cost of capital that is less than its return on investment, it is considered “revenue adequate” by the Surface Transportation Board. Too much revenue adequacy can force price fixing or other similar measures.

The professors devised a model to test comparable firms by the standards applied to railroads and found 89 percent of the companies in the Standard and Poors 500 were revenue adequate, but most at profit margins far larger than any railroad.

In other words, railroads are being subjected to regulation to trim their prices based on profitability levels far below those of similarly situated companies outside the industry. Measuring all these temperatures with the same thermometer indicates virtually everyone has the fever the price controls are supposed to treat.

As a result, the industry is asking the Surface Transportation Board to reconsider how it measures revenue adequacy. It has developed a petition to ask that the board use a comparison approach that contrasts annual revenue adequacy determinations, however they are calculated, against the performance of other companies in the Standard and Poors 500 and to use the same methodology for both.

It also has asked that the board modify its treatment of deferred taxes in its revenue adequacy determinations to provide a more accurate look at railroad returns and to avoid having to make adjustments every time Congress changes corporate tax policy.

Supporters say the proposal to apply economic book accounting measures, the same as other industries, would give policy-makers a clearer view of the financial state of railroads, allow railroads’ finances to be considered in relation to the rest of the economy, which is not the case now, and fulfill the wishes of Congress as expressed through the Staggers Rail Act to treat the railroad industry like any other business.

Allowing deferred taxes to be considered would give a more practical look at the finances of the railroads as well.

The argument against these changes is that the economic valuations would be too hard to do with an industry with the unique characteristics of railroads. But it’s been 40 years since this began, and we’re better at capturing the necessary data. Indeed, the professors say they have created a formula based on the standards the Surface Transportation Board observes and got results that reflected the true state of railroad financing.

Railroads are a bit different. They are vital to U.S. security and commerce, and their regulatory history sets them apart. But it’s time to look at them — at least from an accounting standpoint — the same as other similar industries. After all, the railroads have an interest in getting this right as much as anyone.

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