This study centered on the stock market reaction to current accounting practice for the allowance for funds used during construction. Specifically, the following question was addressed: Do investors in electric public utilities consider allowance income as being lower quality than other utility income?

A theoretical model was developed to predict how investors should view allowance income if the market is efficient. Based on the theoretical model, it was concluded that for the majority of the electric public utilities allowance income is lower quality than other utility income and thus allowance income should be discounted by investors. However, for a small number of utilities it was concluded that there is conceptually no difference between allowance income and other utility income and therefore, for these firms, investors should not discount allowance for funds used during construction income. The difference in the two groups of firms is due to commission policy with respect to the inclusion of construction work in process in the rate base.

The theory was tested empirically using data from the period 1965 to 1974. Three tests were employed. First, a regression model was employed to measure the impact of changes in the percent of net income represented by the allowance for funds on share prices. Next, the cost of equity capital was compared for the two groups of firms, and finally, the price to book value ratios were compared. The three tests indicated that the stock market appears to be efficient since the empirical results were consistent with what the theory predicted would occur. Specifically, the results indicate that the market tends to discount allowance income for one group of firms, but that the market does not appear to discount allowance income for the second group of firms.

The results of this study have implications in three major areas, accounting, market efficiency, and ratemaldng. Based on a review of 1975 annual reports, it was concluded that, in view of the theoretical and empirical work in this study, present accounting practices for the allowance need, at least for the majority of electric utilities, to be revised. The material in this study lays the groundwork for future research in how the allowance should be accounted for. In the area of efficient markets, this study indicates that the stock market is efficient in the sense that it has, over the ten year study period, recognized the conceputal difference in allowance income for the two groups of firms. Since no attempt was made to measure instantaneous market reaction, this is suggested as an area for future research. The principal ratemaking implication is that conceputal differences in commission procedures with respect to the allowance income do appear to be reflected in utility common stock prices.