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If you need the complete document, download the WordPerfect version or Adobe Acrobat version, if available. ***************************************************************** Before the Federal Communications Commission Washington, D.C. 20554 In the Matter of ) ) 1998 Biennial Regulatory Review -- ) CC Docket No. 98-137 Review of Depreciation Requirements ) for Incumbent Local Exchange Carriers ) NOTICE OF PROPOSED RULEMAKING Adopted: July 22, 1998 Released: October 14, 1998 Comment Date: November 23, 1998 Reply Comment Date: December 8, 1998 By the Commission: Commissioner Furchtgott-Roth issuing a statement. I. INTRODUCTION 1. The Communications Act, as amended, ("the Act"), seeks to develop efficient competition by opening all telecommunications markets through a pro-competitive, deregulatory national policy framework. To that end, Section 11 of the Act requires the Commission, in every even-numbered year beginning in 1998, to review its regulations applicable to providers of telecommunications service to determine whether the regulations are no longer necessary in the public interest as a result of meaningful economic competition between providers of such service and whether such regulations should be repealed or modified. 2. Our depreciation prescription process, as a central feature of traditional common carrier policy, is a prime candidate for this biennial regulatory review. When the Commission used cost-of-service or rate-of-return regulation, it required incumbent local exchange carriers ("LECs") to set prices based on costs, including depreciation expenses. Historically, each carrier seeking to change its depreciation rates has submitted a depreciation rate study that was reviewed by both the Commission staff and the representatives of the state public utility commission for the jurisdiction covered by the study. This depreciation prescription process required carriers to submit extensive data for each plant category to support the projection life, survivor curve, and future net salvage estimates underlying their proposed depreciation rates. These data requirements often necessitated voluminous submissions, with up to 25 pages of analysis for each of 34 plant categories. 3. Over the years, the Commission has taken steps to streamline the depreciation process. In 1980, the Commission departed from its previous practice of relying largely on historical experience to project equipment lives and began increasingly relying on company plans, technological developments and other future-oriented analyses. Because of the adoption of these and other reforms, incumbent LECs' reserve ratios increased from a low of 18.6 percent of total plant in 1980 to 49 percent in 1997. In 1993, the Commission issued the Depreciation Simplification Order. In that Order, the Commission adopted a simplified depreciation prescription process for AT&T. With regard to the incumbent price cap LECs, that Order provided for the establishment of ranges for the underlying life and salvage factors that those carriers could use to compute their depreciation rates. In the Second Depreciation Simplification Order, the Commission provided incumbent price cap LECs increased flexibility to set depreciation rates by identifying life and salvage factor ranges for 22 plant categories. In the Third Depreciation Simplification Order, the Commission adopted values for the ranges for eight additional plant categories and simplified procedures for the remaining categories. Incumbent price cap LECs that proposed life and salvage factors within the Commission-approved ranges no longer need to file detailed support for those rates. A carrier could, of course, propose a rate outside the range but it would have to provide cost support to justify it. As a result of these changes, the Commission reduced the typical carrier's filing requirements by 75 percent when its depreciation proposals are within the prescribed ranges. 4. In this Notice of Proposed Rulemaking ("Notice"), we propose to reduce or streamline further our depreciation prescription process by permitting summary filings and eliminating the prescription of depreciation rates for incumbent LECs, provided that the carrier uses depreciation factors that are within the ranges adopted by the Commission, expanding the prescribed range for the digital switching plant account, and eliminating salvage from the depreciation process. We also seek comment on whether we should permit carriers to set their own depreciation rates if they are willing to waive the automatic low-end adjustment. These proposed modifications are designed to minimize the reporting burden on carriers and to provide incumbent LECs with a greater flexibility to adjust their depreciation rates while allowing the Commission to maintain adequate oversight. II. BACKGROUND 5. Depreciation is the loss in service value of an asset due to the factors which cause retirement of the asset. Depreciation is the largest single operating expense that incumbent LECs incur, amounting to nearly $20 billion annually. Under our current rules, the Commission prescribes depreciation rates for dominant incumbent LECs with annual operating revenues of $112 million or more. These carriers are subject to Section 220 of the Act and must compute their depreciation rates by a formula that uses the carrier's accumulated depreciation balance and forecasts of two parameters: future net salvage ("FNS") and average remaining life ("ARL") for each plant account. 6. Although price caps regulation largely eliminated the direct link between costs and prices, a carrier's depreciation remains significant, even under current price cap rules, in the following situations: (1) a calculation of a low-end adjustment; (2) a recalculation of the productivity factor; (3) an exogenous cost determination; (4) a calculation of the Base Factor Portion that is used to determine how much a carrier can recover through End User Common Line charges; or (5) the cost support a carrier would have to provide if it proposed an Actual Price Index ("API") higher than its Price Cap Index ("PCI"). In addition to these price cap effects, changes in depreciation expense may also affect prices or federal support payments through new mechanisms created to implement the Telecommunications Act of 1996. For example, the Commission required incumbent LECs to use depreciation factors within the FCC authorized ranges when calculating forward-looking economic costs for universal service high cost loop support purposes. Also, state commissions have required incumbent LECs to use interstate depreciation rates or life and salvage factors developed during the Commission's depreciation prescription process when calculating rates for interconnection or unbundled network elements. Finally, depreciation may play a role in a takings claim under the Fifth Amendment. III. DISCUSSION 7. As soon as robust competition exists in the local exchange markets, we believe our depreciation process should be eliminated because it will be unnecessary. In a robustly competitive market, both the incumbent LECs and their competitors should charge prices that are at or near their costs, including depreciation, in order to attract customers and maximize their profits. In such a market, a carrier's ability to raise its depreciation rates would be constrained by its need to compete against other carriers, rather than by government regulatory constraints. Unfortunately, the local exchange market today is not such a market. In this Notice, we seek comment on conditions under which carriers could set their own depreciation rates without compromising the Commission's oversight, even in the absence of full competition. In addition, we offer a number of proposals to streamline these depreciation rules by eliminating all unnecessary regulatory requirements. We therefore initiate this proceeding to modify those rules. In addition to our more specific requests for comment below, we invite commenters to submit information on the costs and benefits of the rules at issue in this proceeding and of our proposed modifications. 8. BellSouth suggests that the Commission allow carriers to set their own depreciation rates on the condition that they not seek an automatic low-end adjustment. This condition appears to address the low-end adjustment situation. We seek comment on BellSouth's proposal. We also seek comment on what additional conditions could be imposed to eliminate our need for depreciation prescription in the other contexts upon which we rely on it. If we can identify conditions that would eliminate the need for us to prescribe depreciation in the remaining situations we have identified, we propose to allow carriers to set their own depreciation rates. 9. In the event that we continue to set some depreciation rates for some carriers, we tentatively conclude that the depreciation prescription requirements for incumbent LECs subject to the depreciation prescription process should be further streamlined by doing the following: (1) reducing the supporting documentation required for carriers selecting depreciation factors from within the prescribed ranges; (2) eliminating depreciation prescription for carriers that select depreciation factors within the ranges; (3) expanding the range of lives for digital electronic switching equipment; and (4) eliminating net salvage from the depreciation prescription process. 10. Filing and Prescription Procedures: Under current procedures, carriers are required to file an average of five pages of information per account to support the selection of new depreciation factors for represcription of depreciation rates when those factors fall within the ranges prescribed by the Commission. Because there are 34 plant accounts, a typical filing would contain approximately 170 pages. The approval of the rates proposed in such filings has typically been pro forma as long as carriers selected depreciation factors from within the ranges. In this Notice, we propose to reduce filings to four summary exhibits and the electronic data files used to generate them, provided carriers select depreciation factors from within the ranges and certify that their selections are consistent with their operations. We further propose that, if a carrier selects depreciation factors from within the ranges for all of its accounts, the Commission would permit the rates to go into effect without a prescription order. We believe that our proposal to eliminate Commission prescription of depreciation rates under these conditions will save time and resources for both the Commission and incumbent LECs. We seek comment on this proposal and on SBC's proposal that the Commission remove itself completely from the prescription of depreciation rates for price cap carriers. 11. Equipment Life Ranges: When it adopted the life and salvage factor ranges, the Commission stated that it would review them periodically and revise them as necessary. Accounting and other evidence strongly suggests the prescribed digital switching equipment lives should be lowered. Since the early 1990s, retirement rates for digital switching have nearly doubled and are now at approximately three percent. This reflects an accelerating rate of replacement of major components of digital switches with newer, more powerful components. For example, incumbent LECs are replacing switch processors, line modules, and switch memory devices in order to enhance the call handling capability of switches and to provide improved and enhanced telecommunications services such as enhanced caller ID and enhanced CENTREX and to provide substantial improvements to network maintenance and administration. Incumbent LECs contend that "this increase in the retirement rate is not a temporary aberration, but the beginning of much higher rates." We expect that the retirement rates for digital switching will continue to increase and therefore we propose to expand the range for digital switching equipment from a range of 16 to 18 years to a wider range of 13 to 18 years. Our proposal will permit a carrier that can support life estimates between 13 and 16 years to select a new life estimate without an out-of-range filing. We request comment on this proposal. We have reviewed recent industry data and have concluded that, except for the digital switching equipment account, we have no evidence indicating that the current ranges are either too long or too short. We ask whether the ranges for any of the accounts other than digital switching require revision. Commenters proposing range changes should propose specific new ranges and should provide justifications for their proposals. 12. Pursuant to Sections 0.457 and 0.459 of the Commission's rules, carriers sometimes request confidential treatment for information provided about various types of equipment, including digital switching. In these requests, carriers have expressed concern that public disclosure of their detailed cost support would reveal proprietary information that could adversely affect their dealings with competitors and equipment vendors. We therefore request comment about whether the Commission's existing confidentiality procedures are adequate or whether additional safeguards need to be adopted to protect information that carriers regard as confidential. 13. Proposed Treatment for Salvage and Cost of Removal: Salvage and cost of removal are two components that are currently considered in calculating depreciation rates. Salvage is the estimated scrap value or other proceeds a carrier will receive when it sells equipment retired from service, and cost of removal is the estimated cost a carrier will incur to dismantle and remove equipment retired from service. Because both salvage and cost of removal are estimates of future amounts related to the retirement of equipment, the two estimates are netted to a single amount (net salvage) in the calculation of depreciation rates. Although it is referred to as net salvage in our depreciation formula, cost of removal has traditionally exceeded salvage, which results in a negative net salvage amount. To illustrate net salvage, assume an asset costs $1,350, has an estimated life of 5 years, is expected to sell for $50 scrap value upon retirement, and is expected to cost $200 to remove from service. In this illustration the asset has a net salvage value of - $150, i.e., $50 salvage minus $200 cost of removal. Under these circumstances, a carrier would record depreciation expense of $1,500 over 5 years at $300 per year. The $1,500 charged to depreciation expense over the life of the equipment represents the original cost of $1,350 plus the $150 net cost to retire the equipment. 14. Estimating future gross salvage and cost of removal can be inordinately complex, time consuming, and speculative. To estimate what they will receive for equipment when it is retired and sold, carriers must project whether the equipment will be salable as useful equipment or as scrap many years in the future and what the price for commodities, such as copper, may be. Also, estimating cost of removal requires carriers to project what portion of equipment will actually have to be removed, how many labor hours removal will typically take, and what the cost of that labor will be many years in the future. Consequently, the estimation of net salvage is a complex and inexact process that imposes substantial burdens on both the carriers and the state and federal commissions. The current process also requires the Commission to establish and review ranges for salvage and requires carriers to provide more extensive cost support if they propose salvage factors that are outside of the ranges prescribed by the Commission. Given the speculative nature of the estimates and the burdens associated with their calculation, we tentatively conclude that the prescription of net salvage no longer serves a regulatory purpose and that eliminating that factor from the depreciation prescription formula would significantly reduce the regulatory burden of the depreciation prescription process. Accordingly, we propose to eliminate the future net salvage factor from the depreciation formula and to record salvage and cost of removal as a current expense in the period incurred. Alternatively, we could make the elimination of salvage from the depreciation formula optional, allowing each incumbent LEC the option to treat net salvage as either a current expense or a component of depreciation. We seek comment on these proposals. 15. In commenting on the proposed removal of net salvage from the depreciation process, commenters should address the effect this change could have on the current depreciation rates, whether new rates should be prescribed, whether the elimination of salvage would require adjustment of depreciation reserves, and what accounting changes would be necessary to effectuate the change. 16. We tentatively conclude that, if we remove net salvage from the depreciation process, we should create a new account, Account 6566, Net cost of removal, to record both salvage receipts and removal costs incurred. We also tentatively conclude that we should revise Sections 32.3100, Accumulated depreciation, and 32.2000, Instructions for telecommunications plant accounts, to eliminate the provisions that salvage and cost of removal be recorded in the depreciation reserve account. We request comment on the tentative conclusions. We also request comment on whether we should require carriers to keep subsidiary record categories in Account 6566 for salvage and cost of removal. 17. Reporting Requirements for Mid-Sized LECs: In separate proceedings on ARMIS and Accounting Biennial Review, we propose to create a category of mid-sized incumbent LECs that would be subject to a lighter regulatory burden than would be imposed on large incumbent LECs. Similarly, we propose in this proceeding, in addition to the streamlined processes proposed for all carriers, that mid-sized incumbent LECs not be required to file annual theoretical reserve studies. Because we would continue to receive theoretical reserve studies from the largest incumbent LECs, which represent over 90 percent of the industry, this proposal would relieve these mid-sized companies of this regulatory burden without seriously encumbering our ability to monitor our depreciation prescription process. To avoid unnecessary complexity, we tentatively conclude that we should apply the definition of mid-sized LEC that is adopted in the ARMIS proceeding to our depreciation prescription requirements. We request comments on this proposal. 18. Low-End Adjustment: One of the reasons the Commission has retained some control over depreciation rates is because of carriers' ability to seek a low-end adjustment. Without such controls, carriers could manipulate depreciation expense to reduce their return and obtain a price increase through the low-end adjustment. We seek comment on whether we should permit carriers to set their own depreciation rates, as proposed by several incumbent LECs, or alternatively, whether such carriers should be permitted to do so only on the condition that they become ineligible for a low-end adjustment. 19. Conclusion: Prior to the 1996 Act, Section 220(b) of the Act required that the Commission prescribe depreciation rates for subject carriers. The 1996 Act amended Section 220(b) such that prescription of depreciation rates is now within the Commission's discretion. Although we recognize that, for price cap carriers, depreciation generally no longer serves its original purpose of setting prices, it affects many other aspects of our regulation of the incumbent LECs. We tentatively conclude that the elimination of depreciation regulation at this time would have an adverse impact in several critical areas, including the calculation of universal service high cost loop support, takings claims, and the low-end adjustment. We tentatively conclude that, if adopted, our proposal would eliminate all unnecessary depreciation prescription requirements and retain only those essential to the sound administration of the universal service high cost loop support and the achievement of the Commission's other regulatory goals. We seek comment on this tentative conclusion and solicit comment on SBC's alternative proposal that depreciation rates for price cap carriers should be based on "economic analysis consistent with the procedures called for by Generally Accepted Accounting Principles ("GAAP")." We also seek comment on how we should determine when sufficient competition exists to allow us to eliminate the depreciation prescription process. IV. PROCEDURAL ISSUES A. Ex Parte Presentations 20. This is a permit but disclose rulemaking proceeding. Ex parte presentations are permitted, except during the Sunshine Agenda period, provided that they are disclosed as provided in the Commission's rules. See generally 47 C.F.R.  1.1202, 1.1203, and 1.1206. B. Regulatory Flexibility Analysis 21. The Regulatory Flexibility Act ("RFA") requires that an initial regulatory flexibility analysis be prepared for notice-and-comment rulemaking proceedings, unless the agency certifies that "the rule will not, if promulgated, have a significant economic impact on a substantial number of small entities." The RFA generally defines "small entity" as having the same meaning as the terms "small business," "small organization," and "small governmental jurisdiction." In addition, the term "small business" has the same meaning as the term "small business concern" under the Small Business Act. A small business concern is one which: (1) is independently owned and operated; (2) is not dominant in its field of operation; and (3) satisfies any additional criteria established by the Small Business Administration ("SBA"). 22. This Notice proposes to eliminate the prescription of depreciation rates for incumbent LECs in most cases, expand the prescribed range for the digital switching plant account, and eliminate salvage from the depreciation process. This Notice also asks whether we should permit carriers to set their own depreciation rates if they are willing to waive their right to a low-end adjustment. The Notice proposes to further reduce the reporting requirements for certain mid-sized incumbent LECs by eliminating their obligation to file an annual theoretical reserve study. Neither the Commission nor SBA has developed a definition of "small entity" specifically applicable to LECs. The closest definition under SBA rules is that for establishments providing "Telephone Communications, Except Radiotelephone," which is Standard Industrial Classification ("SIC") code 4813. Under this definition, a small entity is one that, including affiliates of the entity, employs no more than 1,500 persons. 23. We certify that the proposals in this Notice, if adopted, will not have a significant economic impact on a substantial number of small entities. Pursuant to long-standing rules, incumbent LECs with annual operating revenues exceeding the indexed revenue threshold must comply with the Commission's depreciation prescription process. This Notice proposes to reduce certain of these depreciation requirements. These changes should be easy and inexpensive for incumbent LECs to implement and will not require costly or burdensome procedures. We therefore expect that the potential impact of the proposal rules, if such are adopted, is beneficial and does not amount to a possible significant economic impact on affected entities. If commenters believe that the proposals discussed in the Notice require additional RFA analysis, they should include a discussion of these issues in their comments. 24. The Commission's Office of Public Affairs, Reference Operations Division, will send a copy of this Notice, including this initial certification, to the Chief Counsel for Advocacy of the Small Business Administration. A copy will also be published in the Federal Register. C. Paperwork Reduction Act 25. As part of our continuing effort to reduce paperwork burdens, we invite the general public to take this opportunity to comment on information collections contained in this Notice of Proposed Rulemaking, as required by the Paperwork Reduction Act of 1995, Pub. L. No. 104-13. Public and agency comments are due at the same time as other comments on this Notice of Proposed Rulemaking. Comments should address: (a) whether the proposed collection of information is necessary for the proper performance of the functions of the Commission, including whether the information shall have practical utility; (b) the accuracy of the Commission's burden estimates; (c) ways to enhance the quality, utility, and clarity of the information collected; and (d) ways to minimize the burden of the collection of information on the respondents, including the use of automated collection techniques or other forms of information technology. D. Comment Filing Procedures 26. Pursuant to Sections 1.415 and 1.419 of the Commission's rules, 47 C.F.R.  1.415, 1.419, interested parties may file comments on or before November 23, 1998, and reply comments on or before December 8, 1998. Comments may be filed using the Commission's Electronic Comment Filing System (ECFS) or by filing paper copies. 27. Comments filed through the ECFS can be sent as an electronic file via the Internet to . Generally, only one copy of an electronic submission must be filed. If multiple docket or rulemaking numbers appear in the caption of this proceeding, however, commenters must transmit one electronic copy of the comments to each docket or rulemaking number referenced in the caption. In completing the transmittal screen, commenters should include their full name, Postal Service mailing address, and the applicable docket or rulemaking number. Parties may also submit an electronic comment by Internet e-mail. To get filing instructions for e-mail comments, commenters should send an e-mail to ecfs@fcc.gov, and should include the following words in the body of the message, "get form