FCC 95-502 Before the FEDERAL COMMUNICATIONS COMMISSION Washington, D.C. 20554 In the Matter of Implementation of Sections of the ) MM Docket No. 93-215 Cable Television Consumer Protection ) and Competition Act of 1992: Rate Regulation ) ) and ) )Adoption of a Uniform Accounting ) CS Docket No. 94-28 System for Provision of Regulated ) Cable Service ) SECOND REPORT AND ORDER, FIRST ORDER ON RECONSIDERATION, AND FURTHER NOTICE OF PROPOSED RULEMAKING Adopted: December 15, 1995 Released: January 26, 1996 By the Commission: Table of Contents Paragraph: L INTRODUCTION ............................................ 1 IL INTERIM COST OF SERVICE RULES - GENERALLY A. Background ........................................... 7 B. Comments ......................................... 18 C. Discussion ........................................... 25 m. RATEBASE - USED AND USEFUL PLANT AND EXCESS CAPACITY A. Background .......................................... 31 B. Comments ........................................... 34 C. Discussion ........................................... 36 IV. RATEBASE - INTANGIBLES A. Background .......................................... 40 2220 B. Comments ........................................... 45 C. Discussion ......................................... §2 V. RATEBASE-START UP LOSSES A. Background .......................................... 64 B. Comments ........................................... 66 C. Discussion ........................................... 70 VL RATEBASE - TANGIBLES A. Background .......................................... 73 B. Comments ........................................... 74 C. Discussion ........................................... 75 VH. RATE OF RETURN A. Background .......................................... 77 B. Comments ........................................... 78 C. Discussion ........................................... 81 Vm. DEPRECIATION A. Background .......................................... 83 B. Comments ........................................... 84 C. Discussion ........................................... 86 DL TAXES A. Background ......................................... 101 B. Comments .......................................... 102 C. Discussion .......................................... 104 X. COST ALLOCATION A. Background ......................................... 106 B. Comments .......................................... 113 C. Discussion .......................................... 119 XL ACCOUNTING REQUIREMENTS A. Background ......................................... 125 B. Comments .......................................... 127 C. Discussion .......................................... 131 XH. AFFILIATE TRANSACTIONS A. Background ......................................... 132 B. Comments .......................................... 134 C. Discussion .......................................... 138 XIH. SOCIAL CONTRACTS 2221 A. Background ......................................... 144 B. Comments .......................................... 147 C. Discussion .......................................... 152 XIV. HARDSHIP RATE RELIEF A. Background ......................................... 161 B. Comments .......................................... 162 C. Discussion .......................................... 164 XV. PROCEDURAL ISSUES A. Background ......................................... 166 B. Comments .......................................... 168 C. Discussion .......................................... 175 XVI. OTHER MATTERS ........................................ 186 XVIL APPLICABILITY OF THE FINAL RULES GENERALLY ............ 191 Xm. FURTHER NOTICE OF PROPOSED RULEMAKING A. Non-Unitary Rate of Return ............................. 194 B. Cost of Equity ....................................... 197 C. Cost of Debt ......................... *............... 216 D. Capital Structure ...................................... 221 XTX. REGULATORY FLEXD3HJTY ANALYSIS ........................ 228 XX. PAPERWORK REDUCTION ACT .............................. 234 XXL PROCEDURAL PROVISIONS ................................ 236 XXH. ORDERING CLAUSES ...................................... 240 APPENDIX A APPENDIX B APPENDIX C L INTRODUCTION 1. In this Second Report and Order, First Order on Reconsideration, and Further Notice of Proposed RtdemaJdng, we adopt final rules governing standard cost of service showings filed by cable operators seeking to justify rates for regulated cable services. We also seek comment on two aspects of these rules. 2222 2. Pursuant to the Cable Television Consumer Protection and Competition Act of 1992 (the "1992 Cable Act"),1 the Commission has promulgated rules to ensure the reasonableness of rates charged by regulated cable operators for their basic service tiers ("BSTs") and cable programming service tiers ("CPSTs").2 A cable system is subject to rate regulation if it does not face effective competition in the franchise area it serves.3 Regulatory authority over rates charged by cable operators is divided between local franchising authorities and the Commission. The local franchising authority has primary authority to regulate a cable system's BST rates, once the authority has been certified by the Commission to regulate rates.4 The BST must include, at a minimum, all local broadcast stations carried by the cable operator and all public, educational and governmental access programming required under the terms of the cable operator's franchise.5 The Commission regulates CPST rates directly, upon the filing of a valid complaint.6 The CPST includes any tier of programming, other than the BST, offered by the operator.7 Per-channel and per-program offerings are generally not subject to rate regulation. 3. The primary scheme for establishing initial rates for cable service employs a benchmark formula designed to ensure that an operator's regulated rates do not exceed what the operator would charge if it faced effective competition.8 Under the benchmark approach, most regulated cable operators were required to reduce their regulated rates to a level that represented then: September 30, 1992 regulated revenues reduced by a 17% competitive differential (adjusted for annual inflation increases, changes in external-costs 1 Cable Television Consumer Protection and Competition Act ("1992 Cable Act"), Pub. L. No. 102-385, 106 Stat 1460 (1992). 2 Sections 623(b), (c) of the Communications Act of 1934, as amended ("Communications Act"). 3 Id. at § 623(a)(2); see id. at § 623 (1)(1) (defining "effective competition"). 4 Id. at § 623(a)(2)(A); see id. at § 623(a)(3) (certification of franchising authorities to regulate rates). 5 Id'. at § 623(b)(7)(A). A cable operator is free to add additional programming to its BST. Id. at § 623(b)(7)(B). 6 Id. at §§ 623(b)(2)(B), 623(c). 7 Id. at § 623(1)(2). 8 Id. at § 623(b)(l). 2223 and changes in the number of programming channels).9 The 17% competitive differential represented the average difference that the Commission determined existed between the rates of competitive and noncompetitive systems.10 4. In adopting the benchmark methodology, the Commission sought to avoid the significant administrative and compliance costs that often result from using the cost of service methodology that is traditionally applied to public utilities. At the same time, we recognized that the benchmark approach might not produce fully compensatory rates in all cases. Therefore, we decided to permit operators to establish rates based on costs pursuant to individual cost of service showings.11 Thus, the cost of service rules provide a safety valve for operators that are unable to generate reasonable revenues under the primary benchmark mechanism.12 5. When we adopted our first order implementing the rate regulation provisions of the 1992 Cable Act, we found that the record did not contain sufficient information to enable us to develop detailed cost of service rules properly tailored for the cable industry.13 Therefore, pending the adoption of specific rules pursuant to a further rulemaking, we said that in lieu of the benchmark approach, operators could make individual cost showings that would be subject to case-by-case review. We subsequently issued the initial Notice of Proposed Rulemaking in this docket ("Cost Notice") seeking comment on specific regulatory requirements to govern cost of service showings.14 6. Based on the comments filed pursuant to the Cost Notice, we adopted the Report and Order and Further Notice of Proposed Rulemaking ("Cost Order" or "Further Notice"), implementing a cost of service alternative to the benchmark approach.15 In general, 9 See Second Order on Reconsideration, Fourth Report and Order and Fifth Notice of Proposed Rulemaking ("Second Reconsideration Order"), MM Docket No. 92-266, FCC 94- 38, 9 FCC Red 4119, 4124 (1994), off 'd in pertinent part Time Warner Entertainment Co., L.P. v. FCC, 56 F.3d 151 (D.C. Or. 1995), reh'gden. (July 17, 1995). 10 Id. 11 Report and Order and Further Notice of Proposed Rulemaking, MM Docket No. 92- 266, FCC 93-177, 8 FCC Red 5631, 5794 (1993) ("Rate Order"). 12 Id. 13 Id. at 5799. 14 Notice of Proposed Rulemaking, MM Docket No. 93-215, FCC 93-353 (1993). 15 Report and Order and Further Notice of Proposed Rulemaking, MM Docket No. 93- 215 and CS Docket No. 94-28, FCC 94-39, 9 FCC Red 4527 (1994). 2224 these cost rules are designed to permit a cable operator to recover its operating expenses and a fair return on its investment, while protecting subscribers from unreasonable rates. Deciding the precise manner in which operators must calculate the three major variables - expenses, rate of return, and ratebase raises numerous issues that we discuss with specificity hi the following summary and in the individual sections which address particular aspects of the interim rules. H. INTERIM COST OF SERVICE RULES - GENERALLY A. Background 7. In the Cost Order, we specified the principles that would guide our disposition of cost of service filings by operators seeking to justify rates independent of the benchmark approach, pending adoption of final cost of service rules. Many of the rules to be followed by cable operators making cost of service showings are presumptive only, and thus may be rebutted by operators making cost of service filings depending upon the circumstances of the individual case. This ensures that high-cost systems are able to recover their actual cost of providing regulated service. We articulated interim rules with respect to recovery of costs across all significant categories, measurement of the ratebase used to determine the return on invested capital, the proper rate of return, and all expenses associated with the provision of regulated services. Generally, the interim rules permit a cable operator to establish rates that will allow it to recover a fair return on its investment, or ratebase, plus all of its reasonable operating expenses. 8. The largest portion of an operator's ratebase is its plant hi service. Under the interim rules, an operator may include in its ratebase only that portion of plant representing prudent investment and that is used and useful, since this portion of the plant directly benefits subscribers.16 We said that valuation of the plant should be measured based on the original cost of the equipment, rather than by the market value, replacement cost, or some other approach.17 Subject to certain restrictions, the ratebase also may include accumulated start-up losses18 and investments associated with three categories of intangible assets: organizational costs, franchise costs, and customer lists.19 We generally limited start up losses to losses incurred hi the first two years of operation.20 Under the Cost Order, plant under construction is excluded from the ratebase, but operators may calculate an allowance for 16 Id., 9 FCC Red at 4546-47. 17 Id. at 4554-55. 18 Id. at 4563-65. 19 Id. at 4576-77. 20 Mat4564. 2225 funds used during construction which may be included in the ratebase when the plant is placed into service.21 Operators may also include in the ratebase certain amounts attributable to excess capacity that the operator intends to use within 12 months and cost overruns.22 9. Although an operator's ratebase must reflect the depreciated value of its assets, we did not prescribe specific depreciation rates or schedules in the Cost Order. Instead, we said that depreciation rates claimed by operators would be subject to case-by-case review.23 10. With respect to the return allowed on the ratebase, we provided a presumptive overall after-tax rate of return of 11.25%.24 This is a presumptive unitary rate; any party seeking a different after-tax rate may rebut the presumptive 11.25% rate by showing that a different rate is warranted given the particular circumstances of the operator in question. We applied the discounted cash flow method to determine the cost of equity, using the third quartile of the Standard & Poor's 400 stock index ("S&P 400") as a surrogate for regulated cable service.25 With respect to debt cost, we estimated an average debt cost for the industry of 8.5%.26 Using a capital structure range of 40% to 70% debt, we developed a range of total capital costs and selected a rate toward the higher end of this range; the resulting figure was 11.25%.27 11. As noted, the interim rules also allow the operator to recover all operating expenses normally incurred by cable operators in the provision of regulated cable service. An operator may not recover through regulated rates other expenses, such as costs associated with nonregulated services, lobbying expenses, or club memberships.28 However, recoverable operating expenses do include depreciation expense29 and an amount to allow for 21 Id. at 4586. 22 Id. at 4592-93. 23 Id. at 4603-04. 24 Id. at 4635. 25 Id. at 4623-27. 26 Id. at 4628. 27 Id. at 4631-35. 28 Id. at 4597-98. 29 Id. at 4603-04. 2226 taxes on the provision of regulated service.30 12. In calculating its ratebase and operating expenses, the operator must use data from its most recent fiscal year.31 The operator must adjust these "test year" data for known and measurable changes that have occurred by the time the rates take effect32 13. In the Cost Order, we stated our intent to adopt a uniform accounting system for those cable operators electing cost of service regulation.33 We concluded that a uniform accounting system would simplify cost of service proceedings and ensure accurate reporting.34 Therefore, we proposed and sought comment on an accounting system we felt was workable and reliable.35 Until a uniform system of accounts can be finalized, operators electing cost of service regulation are required to use an interim summary accounting system, as set forth in FCC Forms 1220 and 1225.36 To ensure that subscribers to regulated services pay only for the cost of those services, we require operators to allocate costs among basic and cable programming service tiers, nonregulated programming services, other cable activities, and non-cable activities.37 14. In developing the interim rules, we recognized the potential for abuse of the cost of service scheme through affiliate transactions.38 Accordingly, we promulgated rules for valuing transactions between cable operators and affiliated companies designed to prevent favorable self-dealing between affiliated companies which could distort the magnitude of costs recoverable in regulated rates. In general, the price of assets or services conveyed by a cable operator to an affiliate, or from the affiliate to the cable operator, must be based on the price at which the provider has sold the same kind of asset or service to a substantial 30 Id. at 4607-10. 31 Id. at 4612. 32 Id. 33 Id. at 4641. 34 Id. at 4641-45. 35 Id. at 4681-83. 36 Id. at 4643-44. 37 Id. at 4650-51. 38 Id. at 4663-64. 2227 number of third parties.39 If such a "prevailing company price" cannot be calculated for a service, then its price shall be based on the provider's cost40 Absent a prevailing company price for an asset, the price is the higher of net book cost and estimated fair market value when the operator is the seller, and the lower of those two amounts when the operator is the buyer.41 15. Apart from the standard cost of service showing, the Cost Order established other mechanisms by which operators can establish or adjust rates. First, to ease regulatory burdens for smaller cable systems, we developed a streamlined cost of service scheme exclusively for their use.42 Second, an operator that has established rates in accordance with our benchmark approach may make an abbreviated cost of service showing that permits a rate adjustment reflecting solely the cost of a significant upgrade to the cable system.43 This approach encourages operators to make upgrades that will return benefits to subscribers, but without forcing the operator to make a full-fledged cost of service showing in order to cover the cost of the upgrade. A third alternative approach provides for hardship rate relief for any operator that can demonstrate that neither the benchmark nor cost of service rules generate revenues necessary for its continued operation, despite prudent and efficient management44 Finally, the Cost Order introduced the concept of the upgrade incentive plan, intended to encourage the deployment of new technologies and services, promote operating efficiencies, and increase penetration. Pursuant to such a plan, an operator planning an upgrade to its system would be given substantial flexibility with respect to pricing of new services, in return for which subscribers would be guaranteed reasonable and stable rates for existing services.45 16. The cost rules and other requirements set form in the Cost Order were adopted on an interim basis. As we introduced those rules, we simultaneously adopted the Further Notice of Proposed Rulemafdng requesting comment on our proposal to adopt the interim rules on a permanent basis.46 The Further Notice also proposed a productivity factor 39 Id. at 4665-66.. 40 Id. 41 Id. 42 Id. at 4671-72. 43 Id. at 4674-75. 44 Id. at 4676-77. 45 Id, at 4677-80. 46 Id. at 4681. 2228 that could be incorporated into the price cap mechanism that governs rate adjustments.47 We also specifically sought comment on rate of return prescription methodologies,48 on a uniform accounting system for cable operators,49 and on rules applicable to affiliate transactions.50 17. In adopting these interim rules, we stated that our cost of service requirements are designed "to produce rates that approach as closely as possible those that would evolve in a competitive market, while still allowing the operator of a high-cost system adequate recovery."51 Rates determined by the cost of service rules are more reflective of the cost experience of the particular operator than are rates established through the benchmark rules, which are based not on costs but rather on an evaluation of rates charged by a broad spectrum of systems.52 Thus, while both the benchmark and the cost of service methodologies seek to achieve competitive rates, they do so by different approaches, "one based on observed prices of cable systems, one based on actual costs."53 B. Comments54 18. Cable operators contend that the 1992 Cable Act prohibits traditional common carrier regulation of the cable industry and that the Commission's interim cost of service rules violate mis command by burdening the cable industry with common carrier regulation.55 These commenters further assert that the proposed rules are equally at odds with the legislative command mat the Commission adopt an administratively simple regulatory 47 Id. at 4686-89. We subsequently rejected this proposal. Memorandum Opinion and Order, MM Docket No. 93-215, FCC 94-226, 9 FCC Red 5760 (1994). 48 Id. at 4681. 49 Id. at 4681-83. 50 Id. at 4683-86. 51 Id. at 4536. 52 See Second Reconsideration Order, 9 FCC Red at 4153. 53 Id. 54 The comment summaries contained in this item incorporate filings received pursuant to the Further Notice as well as petitions for reconsideration, and associated responses and replies, from the Cost Order. " Time Warner Comments at 4; TCI Comments at 3-6. 2229 scheme.56 Cable operators vigorously oppose any suggestion that the Commission establish so-called "regulatory parity" between cable operators and telephone companies, based upon congressional intent as well as on differing characteristics of the cable and telephone industries.57 19. Continental Cablevision, Inc. ("Continental"), for example, identifies distinctions between telephone companies and cable operators, stressing among other things the larger revenues, consistent payment of dividends, and the greater passing and penetration rates of the former.58 Continental also argues that telephone companies have not encountered anything comparable to the substantial increase in the number of cable programmers in recent years, a development that has greatly increased operators' need for capital to fund upgrades needed to accommodate the additional programming.59 Continental describes telephone technology as being heavily focused on switching, multiplexing, and call routing and notes that consumer demand can vary significantly during different parts of the day. Cable operators, on the other hand, must concentrate on capacity, due to the bandwidth requirements of video, and on consistent operations throughout the day, according to Continental.60 Continental states that telephone and cable companies also differ in that the former have what Continental says are effectively "perpetual franchises," while a cable operator faces the threat of the termination of its business at the end of a franchise term that can be as short as five years.61 To the extent the Commission is inclined to pursue regulatory parity as a goal, Continental urge the issuance of a notice of inquiry to ensure that we act on the basis of a record that accurately reflects the state of the telecommunications industries.62 20. Time Warner Entertainment Company, L.P. ("Time Warner") argues that the Commission's failure to recognize the exceptionally limited role that costs may play, i.e., as a safety net rather than a full regulatory alternative, has created a regulatory scheme that exceeds the Commission's jurisdiction.63 First, Time Warner suggests that the Commission has relied on the availability of a cost of service alternative as a justification for 56 Time Warner Comments at 6; TCI Comments at 3-6. 57 Time Warner Comments at 11-15; TCI Comments at 11-13. 58 Continental Reply Comments at 4-5; see Time Warner Comments at 11-16. 59 Id. at 5. 60 /rf. at7-8. 61 Id. at 8-9. 62 Id. at 17. 63 Mat8. 2230 what Time Warner deems to be a "draconian" benchmark formula.64 Second, Time Warner argues that the Commission's failure to consider the allegedly limited utility of cost based regulation has resulted in extending the uniform system of accounts, affiliate transaction rules and other cost based regulations to'benchmark-electing companies.65 Third, Time Warner argues that traditional cost-based regulation is backward and inefficient and thus unsuitable for the high-growth cable industry.66 Finally, Time Warner argues that the Commission's proposal to adopt the cost of service interim rules as permanent rules is at odds with Congress' intention that cable rate regulation be implemented on a transitional basis, i.e. until effective competition is established.67 Likewise, Tele-Communications, Inc. ("TCI") argues that because the proposed cost of service rules are rigid and of a public utility-style, they are inappropriate as a backstop mechanism for transitory price regulation of a dynamic industry.68 21. Comcast Cable Communications, Inc. ("Comcast") labels the interim rules a "cynical sham."69 Comcast accuses the Commission of having "full knowledge" at the time it adopted the interim rules that they would "offer no relief whatever" to cable operators.70 Comcast claims that in fashioning the rules, the Commission "reilexively and irresponsibly chose as its model traditional public utility regulation, a model suited only to mature industries from which cable differs in many respects."71 In particular, Comcast argues that the Commission's restrictions on cost recoveries interfere with operators ability to earn a return for the benefit of investors and lenders that provided capital to cable operators in an unregulated environment 22. Telephone companies generally support our proposal to adopt the interim rules on a permanent basis.72 GTE Service Corporation "("GTE"), for example, describes the interim rules as "a balanced and reasonable means for cable operators facing 64 Id. 65 Id. at 9. 66 Id. at 9-10. 67 Id. 10-11. 68 Id. at 7-10. 69 Comcast Petition at 4. 70 Id. at 5. 71 Id. at 10. 72 See, e.g., GTE Comments at 4-5. 2231 extraordinary circumstances or substantial underearnings to establish fair cost-based rates."73 GTE opposes relaxation of the presumptions contained hi the interim rules and urges us to affirm that the benchmark approach should serve as the primary rate setting methodology.74 GTE states that the Commission's interim rules provide more than an adequate opportunity for operators to justify inclusion of any costs in regulated rates because they are free to rebut presumptively disallowed costs on an individual case basis, or in hardship showings to the extent that such operators establish that their costs ultimately benefit subscribers and resulting rates are not above competitive levels.75 23. Telephone companies argue that cable operators are wrong in asserting that the Commission should not work towards regulatory parity between the cable and telephone industries. BellSouth Corporation ("BellSouth") warns that regulatory parity is necessary "to avoid artificially favoring or handicapping one competitor over another as cable companies move into increasingly direct competition with telephone companies both in the consumer market and hi capital markets where they compete for investor dollars."76 While acknowledging that our rules should take account of "legitimate differences" between the cable and telephone industries, Bell Atlantic Telephone Companies ("Bell Atlantic") states that regulatory parity is the "natural policy outgrowth" of the convergence of the cable and telephone industries.77 In addition, Bell Atlantic argues that the 1992 Cable Act requires the Commission to establish regulatory parity between the cable and telephone industries because the principal goal of the 1992 Cable Act is to encourage competition from alternative and new technologies.78 24. Bell Atlantic contends that differences between the two industries described in the comments of cable operators do not justify "preferential regulatory treatment" of cable.79 For example, the absence of rate regulation for most of the history of cable television simply reinforces the need for strict regulation, Bell Atlantic suggests.80 Failing to achieve regulatory parity will hamper efforts by telephone companies to compete with cable, 73 GTE Comments at 4. 74 GTE Response to Petitions at 6-7. 75 Id. 76 Bell Atlantic Reply Comments at 3. 77 Bell Atlantic Comments at 3; see US West Reply to Petitions at 1-3. 78 Id. at 6-9. 79 Id. at 4. 80 Id. at 5. 2232 in contravention of Congress' goal of encouraging such competition, according to Bell Atlantic.81 TCI responds that in fact cable companies and telephone companies "do not provide services in competition with one another, making 'parity' a superficially attractive but nevertheless substantively irrelevant policy objective."82 TCI claims that state laws continue to protect many telephone companies from competition.83 C. Discussion 25. We believe the argument that the interim cost of service rules conflict with congressional intent too narrowly construes the actual intent of Congress. We reiterate that our primary approach to rate regulation for cable services is the benchmark approach. That approach does not replicate Title II regulation and is thus consistent with congressional intent Cable operators are not required to use the cost of service methodology at all; it is a safety valve approach. Moreover, our cost of service rules do not replicate Title II regulation because they impose fewer regulatory burdens than their common carrier counterparts. For example, common carriers are subject to more comprehensive rules with respect to systems of accounting and more detailed rules with respect to cost allocations, filing requirements, and universal service. Indeed, the comments from telephone companies, arguing for more "regulatory parity" between the telephone and cable industries, evidence the substantial differences between our cable cost of service rules and common carrier regulation. 26. In considering the issue of regulatory parity,, or any other issue, we must remain faithful to the intent of Congress as expressed in the 1992 Cable Act Our mandate under that statute was to adopt regulations that ensure the reasonableness of the rates charged to subscribers of systems that are not subject to effective competition84 while minimising the regulatory burdens imposed upon all parties, including cable operators and local franchising authorities.85 To satisfy these sometimes conflicting goals, Congress dictated several rules of general applicability. For example, in fashioning rules the Commission must consider such factors as the cost of obtaining and transmitting certain types of programming, franchise fees, taxes, and a reasonable profit for cable operators.86 Our cost of service rules take account of these factors and hence follow the dictates of the 1992 Cable Act. 81 Id. at 6, citing H.R. Rep. No. 628, 102d Cong., 2d Sess. 27 (1992). 82 TCI Reply Comments at 8. 83 Id. at 8-9. 84 Communications Act § 623(b)(l) (regulation of basic tier rates); Communications Act § 623(c)(l) (regulation of cable programming services). 85 Communications Act § 623(b)(2)(A). 86 Communications Act § 623(b)(2)(C). 2233 27. Apart from these specific requirements, however, Congress granted the Commission the discretion to "adopt formulas or other mechanisms and procedures in complying" with its duties under the Communications Act.87 In Grafting these provisions, the overriding intent of Congress was to ensure that the Commission had the flexibility it needed to address the many considerations that Congress knew the Commission would face in adopting a regulatory scheme to govern rates charged by cable operators: Rather than requiring the Commission to adopt a formula to set a maxirrmm rate for basic cable service, the conferees agree to allow the Commission to adopt formulas or other mechanisms and procedures to carry out this purpose. The purposes of these changes is to give the Commission the authority to choose the best method of ensuring reasonable rates for the basic service tier and to encourage the Commission to simplify the regulatory process.88 28. There are sound reasons for the similarities between the regulation of telephone companies and that of cable operators. The two industries share physical and technical similarities. Moreover, our regulation of both industries has identical goals: to protect consumers from unreasonable rates while allowing for a reasonable return for the service provider. In view of these circumstances, we believe that some parallel treatment of cable operators and telephone companies is inevitable. By the same token, as highlighted by Continental, differences between the industries require the adoption of distinctive regulatory schemes in some instances. We believe this is the approach mandated by Congress and reflected in both our interim and our final cost rules. 29. We understand Tune Warner to argue that rules regarding affiliate transactions and uniform accounting system effectively apply to benchmark operators, to the extent the operators anticipate ever making a cost of service of filing, since they deem it necessary to adjust their books now hi accordance with such rules. In view of our decision, infra, not to adopt a uniform system of accounts, this concern is limited to the burden of maintaining books tfrat accurately reflect affiliate transactions. Even assuming a cable operator decides to change its accounting methods for this reason, we do not believe that the voluntary decision of a cable operator to make certain adjustments in its accounting system equates to the imposition of accounting requirements, much less the imposition of the full panoply of Title n requirements. 87 Communications Act § 623(b)(2)(B). 88 H. Rep. 862, 102d Cong., 2d Sess. 62 (1992). While this language refers in particular to basic tier regulation, Congress did not express an intent to grant any less discretion to the Commission with respect to CPST regulation. 2234 30. Although Comcast suggests that the interim cost of service rules would put operators out of business, it offers no proof to back up this assertion. We have justified our interim rules, and now the final rules, hi accordance with well-accepted regulatory principles, deviating as necessary to accommodate the peculiar characteristics of the cable industry. In addition, most of the cost rules are applied on a presumptive basis only, thus giving an individual operator an opportunity to justify a treatment different than strictly applying the presumptive rules. In sum, we find no support in the record for Comcast's unsubstantiated assertions regarding the adequacy of the interim rules. m. RATEBASE - USED AND USEFUL PLANT AND EXCESS CAPACITY A. Background 31. As the Commission stated in the Cost Order, under traditional ratebase/rate of return principles, it is necessary to determine the allowable ratebase in order to calculate the return or profit component of the revenue requirement89 The largest component of the ratebase is "plant hi service." The interim cost rules state that to be included as part of "plant in service," plant must be "used and useful hi the provision of cable service," and must be the result of prudent investment90 The used and useful standard thus prohibits the inclusion of the cost of plant in ratebase unless the plant is hi operation and providing direct benefits to subscribers. A related concept is that of excess capacity. Excess capacity is plant which has been built but is not currently used and useful. 32. For valuating plant under construction for ratebase purposes, we adopted the capitalization method. Thus, an operator must exclude plant under construction from the ratebase, but may calculate an allowance for funds used during construction ("AFUDC") and include mis allowance in the cost of construction.91 AFUDC is accrued at a rate based on the actual cost of debt92 As construction is completed and the plant placed into service, the cost of construction, including AFUDC, is included hi the ratebase and recovered through depreciation.93 33. In adopting the interim rules the Commission stated that the used and useful standard would ensure that subscribers pay for only those portions of plant that are 89 Cost Order, 9 FCC Red at 4545. 90 See 47 C.F.R. § 76.922(g)(6)(i). 91 Cost Order, 9 FCC Red at 4586. 92 Id. at 4586, n. 204. 93 Id. at 4586. 2235 used and useful in the provision of regulated cable services.94 The Commission intended that applying the used and useful standard together with the prudent investment standard would achieve a fair balance of consumer and investor interests in determining regulated cable service rates under our cable cost of service standards. In addition, the standard is the same as that which the Commission has applied to telephone companies, and thus was expected to be simple to apply and to administer.95 The Cost Order also concluded that excess capacity could be included in ratebase if it would be used and useful within one year.96 B. Comments 34. Continental asks the Commission to clarify that used and useful plant is 100% of energized plant that is actually used to send signals to customers or will be used within one year, claiming that it would be arbitrary and unreasonable not to allow the operator to include all of the cost of the plant in the ratebase simply because the system can carry programming on more channels than are actually activated. Continental also asks the Commission to clarify that all of this plant must be allocated among regulated and unregulated service baskets based on a reasonable measure of the current usage of that plant97 35. Viacom International, Inc. ("Viacom") suggests that the Commission include in ratebase any excess capacity that will be used within a 24 month period, asserting that the 12 month period is unreasonably short because a prudent cable operator will always design the construction project to include a reasonable amount of excess capacity in order to meet expected but not yet current demand. According to Viacom, the Commission's interim rule provides cable operators with an incentive to make significantly smaller upgrades, which may make it necessary for operators to make upgrades more frequently, resulting in consumers having to pay higher prices.98 C. Discussion 36. In general, except as described below, we make permanent our interim rules regarding ratebase issues. In response to Continental's request, we clarify that used and useful plant is plant that is actually used to send signals to customers. Plant which is not currently used and useful, however, is excess capacity, and operators may include this excess capacity in the ratebase only if it is fully constructed plant mat will be used to provide 94 95 Id Cost Order, 9 FCC Red at 4547. 96 Id at 4592. 97 Continental Comments at 29-32. 98 Viacom Comments at 11-13. 2236 regulated service within 12 months. The Commission clarifies that there are two types of excess capacity. First, where plant is being used but not to its full capacity, the portion of the plant allocated to the unused channels is excess capacity. For example, where a system provides programming over 36 channels but is capable of transmitting 48 channels of programming, the plant associated with the 12 channels not currently being used is excess capacity. In other words, in this example, the operator may only include 75% of the cost of the plant hi the ratebase as used and useful plant, and may include the other 25% as excess capacity only if the 12 channels will be activated within one year. Second, excess capacity is fully constructed plant that is not being used at all, such as where the cable operator has extended its distribution line into an unserved portion of the franchise area, is ready and able to provide service to that area, but is not yet providing such service.99 The operator may include such plant in its ratebase to the extent it intends to place the plant into service within 12 months. However, the operator must make a corresponding adjustment to its subscriber count to include a reasonable estimate of the number of subscribers it expects to serve with that plant by the end of the 12 month period. 37. The Commission also clarifies that plant in service must be allocated between regulated and unregulated services based on a reasonable measure of the current usage of that plant Section 76.922(g)(6)(i) of our rules100 currently uses the phrase "used and useful in the provision of cable services," but does not specify that such cable services must be regulated cable services. Since our authority to determine cable rates extends only to regulated services as defined by the Communications Act,101 only plant used and useful in the provision of regulated services should be included in the ratebase. Accordingly, for our final rules, we will make this point explicit and will amend the interim rule to specify that tangible plant must be used and useful hi the provision of regulated cable services hi order to be included hi the ratebase. This will ensure that the ratebase for regulated cable service only includes plant used for such regulated cable service, and that subscribers to regulated tiers are not forced to subsidize plant that is used solely for premium services. 38. In addition, we recognize that what constitutes a reasonable measure of the current usage of the tangible plant depends on the circumstances. We believe that hi many cases a reasonable measure would be a straight channel ratio. In other words, if an operator provides programming over a total of 40 channels, 32 of which are BST and CPST channels and eight of which are premium and pay-per-view channels, the operator must allocate 80% of its plant in service to regulated cable service and 20% to unregulated service. We do not believe, however, that the channel ratio should be weighted by customer. The cost of physical plant is directly related to the provision of cable channels and the amount of channel capacity a particular cable system has. The cost of that plant does not vary 99 Note, however, that excess capacity does not include plant under construction. 100 47 C.F.R. § 76.922(g)(6)(i). 101 Communications Act, § 623(a)(2). 2237 depending on how many subscribers receive each channel. It would be inappropriate to weight the channel ratio by subscriber use when such use does not affect the cost of the plant. 39. Furthermore, we deny Viacom's request that we extend from 12 months to 24 months the time period within which excess capacity must be used and useful in order to be included in ratebase. For business purposes, operators commonly project how much capacity will be used within the given year as part of their annual operating budgets. We believe that the 12 month period therefore permits plant associated with all reasonably foreseeable improvements in or additions to service to be included in ratebase. Allowing inclusion of excess capacity which is not expected to be used within the coming year increases the likelihood that current customers would pay for plant from which they may never enjoy the benefits. In addition, we believe that even a good faith prediction that plant will be used and useful within 24 months is too speculative to permit associated costs to be included in the current ratebase. For these reasons, the Commission adopts the interim one year rule as its final rule. IV. RATEBASE - INTANGIBLES A. Background 40. When a cable operator purchases an existing cable system, the purchase price often exceeds the book value of the tangible assets (the initial cost of the assets minus any depreciation). This was particularly true of transactions consummated prior to implementation of the 1992 Cable Act. At that time, the absence of rate regulation presumably would have increased the overall value of any particular cable system, but would have had no effect on the book value of the tangible asset Thus, the increased value attributable to a lack of regulation would have to be allocated to intangible assets. Previously, we have termed the amount paid for the system above the book value of the plant "excess acquisition cost."102 For accounting purposes, the excess of the purchase price over the book value of the assets is typically recorded as "intangibles" or "goodwill." 41. There are many reasons that a prudent business person might pay more than the book value of the plant for a cable system. For example, a prudent business person might also be willing to pay more than the book value of the assets because of efficiencies the purchaser might bring to the acquired system as part of a larger multisystem operator ("MSO"). Thus, a system purchaser could reasonably allocate a part of the purchase price to start up losses and expect to recover this expense from subscribers, to the extent such costs were necessary to establish a system capable of providing regulated services to subscribers.103 102 Cost Order, 9 FCC Red at 4566. 103 Such assets are usually recorded as "goodwill" and as such would not generally be allowed as part of ratebase. To the extent that such costs were recorded as start-up losses, 2238 42. On the other hand, a purchaser might be willing to pay a higher price in expectation of monopoly profits. Traditional principles of rate of return regulation prohibit a business from including hi its ratebase goodwill or other intangible costs that represent monopoly expectations.104 Likewise, excess acquisition costs attributable to an expectation of revenues from unregulated services, or that simply were the result of improvident business decisions, generally should not be included in the ratebase, since to do otherwise would result hi subscribers of regulated services subsidizing investments from which they are not reasonably likely to receive a benefit. 43. In the Cost Order, we distinguished between intangible costs on which operators presumptively were entitled to a return on their investment and intangible costs on which operators presumptively were not entitled to a return on then- investment from subscribers to regulated services.105 Intangible costs which were legitimately necessary in order to allow the operator to provide regulated service to subscribers, and thus were incurred in order to benefit subscribers to regulated services, were recognized as presumptively includable in the regulated ratebase.106 We recognized organizational costs, franchise costs and customer lists as presumptively permissible, subject to certain restrictions.107 44. Organizational costs represent the costs of establishing the legal business entity.108 These costs were incurred to provide benefits to subscribers and should be included in the ratebase.109 Franchise costs represent the cost of acquiring the franchise rights through direct transaction with the franchising authority by the original system owner and are likewise includable in the ratebase.110 For acquired systems, franchise costs represent any unamortized franchise costs on the books of the seller. Customer lists may also be included in the ratebase they would be allowed. 104 Charles F. Phillips, Jr., The Regulation of Public Utilities 351 (1993). 105 Id. at 4575-84. Presumptively impermissible intangible costs would not be included in the ratebase and could not be recovered as part of the rates for regulated services. However, we noted that such intangible costs could be recovered from rates for unregulated services. 106 Id. at 4575-76. We also noted that such costs would most likely be incurred even if the services were provided hi a competitive environment 107 Id. at 4576-77. 108 Id. 109 Id. 110 Id. at 4577. 2239 to the extent that they reflect costs capitalized during prematurity, as defined by FASB 51,m and are useful in the provision of regulated cable service.112 Customer lists consist of the active accounts that the purchaser takes over when it acquires the system. The acquiring system may include in its ratebase a cost attributable to customer lists to the extent that subscribsersbip development costs are avoided at acquisition. Other intangible costs associated with the acquisition of a cable system are generally presumed to be excluded from the ratebase.113 B. Comments 45. Cable operators oppose our treatment of most intangible costs in the interim rules. Their arguments generally fall into one of two categories. Some commenters maintain that all costs allocable to intangible assets should be included in the ratebase.114 These commenters argue that such costs originated in arms-length transactions entered into in good faith in an unregulated environment According to these commenters, exclusion of these assets from the ratebase would constitute an impermissible taking without just compensation in violation of the Fifth Amendment to the United States Constitution. Other commenters begin by arguing that all intangibles should be included in the rate base, but go on to argue in the alternative that while intangible costs may include some expectation of monopoly profits and should be excluded from the ratebase, these excludable intangible assets must be distinguished from legitimate intangible assets.115 These commenters propose various methods to separate legitimate intangible costs from those which should not be included in the ratebase. 46. TCI argues that the presumptive disallowance of excess acquisition costs from ratebase is based on an incorrect assumption that acquisition prices represent amounts 111 FASB 51 refers to Statement of Financial Accounting Standards No. 51, Financial Reporting by Cable Television Companies. FASB 51 defines the prematurity phase during which a cable system is partially under construction and partially in service. In the prematurity phase, the operator must partially capitalize and partially expense costs related to current and future operations. 112 Id. at 4577. 113 Id. at 4578-84. However, we do allow operators to rebut the presumption that these intangible costs could not be included in ratebase. In making such a showing, the burden is on the operator to demonstrate that the costs benefitted subscribers to regulated services. Id. at 4583. 114 See, e.g., TCI Comments at 23-32; NCTA Comments at 29-32; Avenue TV Reply Comments at 3. 115 See, e.g., Continental Comments at 8-9; Viacom Comments at 8-11. 2240 paid in expectation of supracompetitive profits, growth premiums for unregulated services and simple overpayments.116 TCI claims that this presumptive disallowance ignores efficiency gains obtained through system acquisitions.117 In addition, TCI states that the price paid to a seller of a cable system typically includes losses, earning deficiencies, and opportunity costs incurred by the seller.1" TCI also notes that there is a real problem of documentation and quantification of amounts attributable to legitimate intangible assets because there were no business or accounting reasons for them to be separately valued and recorded at the time of the transaction.119 Further, TCI asserts that the presumptive disallowance of intangibles is contrary to the Commission's conclusion that the 1992 Cable Act's objective is to set prices that reflect the costs of competitive systems because in a competitive market, prices will include a normal return on capital, including the acquisition of intangibles.120 Accordingly, TCI proposes that the ratebase be the value of invested capital less depreciation reflected on the cable operator's existing audited books, subject to adjustment only where those books are inaccurate or incomplete.121 TCI states that this would be analogous to the "fair value" approach to ratebase valuation common in the early part of this century.122 47. The National Cable Television Association ("NCTA") also opposes the exclusion of excess acquisition costs from the ratebase.123 NCTA states that, at a minimum, all preregulation acquisition costs should be included in the ratebase.124 NCTA argues that the Commission's decision to exclude excess acquisition costs from the ratebase was based on several erroneous assumptions.125 First, NCTA states that any premium paid for a cable system before regulation did not necessarily reflect the expectation of monopoly profits but rather could have been the result of a variety of factors.126 Second, NCTA argues that the 116 TCI Comments at 23-32. 117 Id. at 26. 118 Id. at 26-27. 119 Id. at 28. 120 Id. at 28^29. 121 Id. at 30-32. 122 Id. at 31. 123 NCTA Comments at 29. 124 Id. 125 Id. at 30. 126 Id. 2241 Commission bases its decision to exclude certain acquisition-related assets on its view of traditional public utility concepts, but those concepts are simply not appropriate for an industry that has only recently been made subject to rate regulation.127 NCTA also argues that excluding excess acquisition costs* that were incurred prior to regulation may be violative of the basic tenet of law against retroactive ratemaking.128 Avenue TV asserts that the proposed disallowance of intangible assets unfairly discriminates against older cable systems whose assets have been substantially depreciated.129 48. Continental and Viacom both argue that intangible should be included hi ratebase but also offer alternative arguments. Continental urges that we reject the presumption against recognizing most intangible costs in the ratebase.130 Continental argues that prices paid for cable systems appropriately reflect the real investments made in those systems, including investments represented by the prior owners' continuing efforts to develop and expand those systems over the long term despite recurring losses and low earnings.131 Therefore, Continental recommends that 100% of the purchase price be allowed in the ratebase.132 Viacom also opposes the Commission's presumptive exclusion of intangible assets from the ratebase because the record does not support any presumption or expectation that monopoly profits were the exclusive, or even the most likely, reason that cable systems were sold hi excess of their book value.133 Viacom asserts that the difference between competitive and historical costs is not a result of manipulation or expectation of monopoly rents, but a recognition of the true perceived value of the assets.134 49. As an alternative to its recommendation that we eliminate entirely our current presumptions concerning intangible costs, Continental suggests that where adequate documentation exists, the current owner can calculate an "accumulated return deficiency" 127 Id. at 31. 128 Id. at 32. 129 Avenue TV Reply Comments at 3. 130 Continental Comments at 3. 131 Id. at 11-13. 132 Id. at 13-15. 133 Viacom Comments at 8-11. 134 Id. 2242 associated with the system just as the prior owner would.135 Under another alternative, the Commission could develop or accept evidence relating to an "average schedule" of per- subscriber losses and low earnings that could reasonably be included as intangible assets in the ratebases of acquired systems. 136 50. If it is not possible to develop an average schedule of subscriber losses, Continental recommends that the Commission disallow a limited portion of intangibles by using the economic analysis underlying the benchmark system.137 Continental asserts that to the degree that a particular purchase price reflected an expectation of monopoly profits, that expectation would be limited by the cash flow of the particular system since cash flows are the primary basis for cable system valuations.132 Because the usual ratio of revenues to cash flows is 2:1, Continental proposes applying the same ratio to determine the amount of a purchase price that might reflect an expectation of monopoly profits.139 Under this proposal, the average 17% benchmark rate reduction would dictate a disallowance of acquisition-related intangibles equal to 34% of the gross purchase price of the system.140 The remaining 66% comprising both tangible and intangible assets would be presumptively included in the ratebase.141 To the extent that the Commission does not allow intangibles in the ratebase, Continental urges the Commission to allow operators to amortize these assets.142 51. Since Viacom believes that it is impossible to establish that no portion of a cable system's purchase price reflects monopoly rents, Viacom recommends that the Commission disallow a portion of goodwill.143 Viacom proposes that the Commission presumptively exclude 10% of acquisition costs, determined on the basis of fair market value 135 Continental Comments at 8-9. See infra at ff 64-66 (discussion of accumulated return deficiency). 136 Id. at n. 16. 137 Id. at 4-5. 138 Id at 4 (citing Declaration of Colleen Millsap). 139 Id. at 4-5. 140 Id. at 5. 141 Id. at 6. 142 Id. at 23-26. 143 Viacom Comments at 8-11. 2243 of the assets.144 C. Discussion 52. In the Cost Order, we presumptively excluded from the ratebase those costs commonly referred to as excess acquisition costs in this proceeding. Our reasoning there was that the prices paid for cable systems, especially during the period when those systems possessed market power, are not a reliable or reasonable basis for ratemaking.145 Indeed, we concluded that one reason we should not rely on acquisition prices for ratemaking was that it appeared that those prices often include an expectation of supra-competitive profits that market power of cable systems not operating hi a fully competitive market might expect \AŁto generate. 53. We continue to reject the argument that operators are entitled to include 100% of their intangible costs in the ratebase. Contrary to commenters' arguments, exclusion of some amount of these costs from the ratebase does not result hi an impermissible taking without just compensation hi violation of the Fifth Amendment. As has been recognized by courts since the Supreme Court's decision hi Hope,147 establishing reasonable rates involves the balancing of consumer and investor interests.148 Thus, there is a zone of reasonableness, bounded on the one end by investor interest against confiscation and at the other by consumer interest against exorbitant rates, within which rates must fall.149 In determining whether rates are confiscatory, we must look at whether the rates established under a methodology "jeopardize the financial integrity of the companies-, either by leaving them insufficient operating capital or by impeding men- ability to raise future capital." Moreover, we must consider whether the rates fail to compensate investors for the risk associated with then* investments. However, the Court has made clear that it is "not theory but the impact of the rate order which counts."150 Indeed, the Court stated that "fixing of prices . . . may reduce the value of the property being regulated. But the fact that the value is reduced does not 144 Id. at 10. 145 Cost Order, 9 FCC Red at 4578, para. 91. 146 Id. 147 Federal Power Comm'n v. Hope Natural Gas Co. 320 U.S. 591 (1943). 148 Id. at 603. 149 Washington Gas Light Co. v. Baker, 188 F.2d 11, 15 (D.C. Or. 1950), cert.denied, 340 U.S. 952 (1951). 150 Hope, 320 U.S. at 602. 2244 mean that the regulation is invalid."151 Thus, we have no constitutional duty to ensure full recovery of these acquisition costs, we must only ensure that the end result of our ratemaking decisions here is reasonable.152 54. We continue to believe that the ratebase should not include costs resulting from any expectation of monopoly profits or expectation of a return on emerging and unregulated services, which we believe the presumptive exclusion of such acquisition costs ensures. However, upon further reflection and based upon our review of cost of service filings, we believe this presumption can be modified, without sacrificing this conclusion. 55. Therefore, we will adopt a new rule, applicable to systems conveyed prior to the effective date of the interim cost rules, with respect to the treatment of intangible assets. We find the model proposed by Continental, pursuant to which 34% of the purchase price of a system is presumed to be attributable to monopoly expectations, to be the one best suited to these goals. For explanatory purposes, we will recast this model as follows, using hypothetical figures. Assume a purchaser with monopoly expectations buys a cable system for $1,000, based on a system valuation often times cash flow.153 This means that the operator anticipates an annual cash flow of $100 and annual revenues of $200 based on an assumption of a 2:1 ratio between revenues and cash flow. According to our benchmark survey, 17% of annual revenues, or $34, reflects the system's monopoly revenues. Because expenses should remain the same before and after rate regulation, this $34 must be removed from the cash flow side of the revenue stream. Thus, had mere been effective competition, the same system would be expected to generate only $66 in annual cash flow.154 If, as we have assumed, the purchase price is ten times cash flow, we can conclude that the system would have been purchased for $660 in a competitive environment, not the $1,000 paid based on its monopoly status. Therefore, $340 of the actual purchase price, or 34%, is attributable to monopoly expectations. 56. The two major variables in this analysis are the 17% competitive differential and the 2:1 revenue-to-cash flow multiple. We have confidence hi the reliability 151 Id. at 601. See also Illinois Bell v. FCC, 988 F.2d 1254, 1262 (D.C. Cir. 1993) ("the FCC has no obligation to maintain the current market value of investors' property"). 152 Duquesne Light Company v. Barasch, 488 U.S. 299 (1989); Hope, 320 U.S. 591 (1943). 153 For purposes of mis approach, the particular ratio of purchase price-to-cash flows does not affect the analysis. We have used a 10:1 ratio solely for convenience. 154 In other words, the presence of effective competition would have forced the operator to reduce rates to this extent The full $17 hi monopoly rents is attributable to cash flow, since by definition it is being exacted solely because of the system's monopoly status, not to cover system expenses. 2245 of tiie competitive differential, as it is the basis for our primary regulatory scheme and has been found reasonable upon judicial review.155 The 2:1 multiple is a generalization, but rules of broad applicability often depend upon such approximations and there is clearly support in the record for this particular estimate.156 The multiple of cash flow that a purchaser would use to value a system depends upon whether the system is subject to effective competition, given the impact of competition on revenues. That is, if the purchaser hi our example paid 10 times cash flow for the monopoly system, it might be expected to pay a reduced multiple (times lower cash flows) if the system were subject to effective competition. Our analysis assumes lower cash flows because of competition, but not a reduced multiple. However, we do not have sufficient evidence to conclude that the multiple would be significantly affected by a 17% reduction in revenues157. Based on the limited information available at this time, we conclude that the effect would be minimal. Therefore, we do not believe any adjustment to the multiple is necessary. 57. We find the mechanism proposed by Continental to be more persuasive than simply disallowing 10% of intangibles as proposed by Viacom. The Continental proposal is based on a reasonable model of the incentives that might have motivated an operator to pay more for a particular system rather than a simple admission that some portion of the "excess acquisition cost" resulted from an expectation of monopoly profits. Furthermore, Continental's proposal follows from our previous finding mat systems able to exercise monopoly power charge rates which exceed the rates charged by competitive systems by 17%.158 We also find, however, that Continental's proposal should be refined somewhat Because we are only concerned with expectations of monopoly profits which are derived from regulated services, we believe that this adjustment should only be applied to that portion of the purchase price that can be allocated to services which are now rate regulated. 58. Therefore, our final rule will presume, rebuttably, that 34% of the purchase price associated with regulated services of systems purchased prior to regulation represents monopoly expectations and must be removed from the regulated ratebase. Put differently, the ratebase presumptively shall not exceed 66% of that portion of the system price allocable to assets used to provide regulated services. The 34% adjustment must be applied to the entire purchase price associated with regulated services, not just the portion of the price allocable to intangibles, because cable operators derive revenues, including monopoly revenues, from the employment of both tangible and intangible assets. Applying the 34% adjustment to all assets associated with regulated services, rather than only to the 155 Time Warner Entertainment Co., LP. v. FCC, 56 F.3d 151, 164-71 (D.C. Cir. 1995). 156 See, e.g. Paul Kagan and Associates Cable TV Financial Databook, at 9 and 92, July 1995. 157 Between 1991 and 1994, the revenue-to-cash flow multiple varied only 6.43%. Id. 158 See supra at f 3. 2246 associated intangibles, should remove all expectations of monopoly profits. 59. As noted, we recognize that this approach necessarily involves the use of industry-wide averages with respect to certain variables that, while reasonable, will not always reflect with perfect accuracy the circumstances of particular operators. To the extent the 34% adjustment is inexact for certain operators, we are particularly concerned that this adjustment could be used to raise rates unreasonably, given our statutory mandate to guard against unreasonable rates. Therefore, we will allow use of the 34% adjustment only for the purpose of justifying rates hi effect as of the effective date of these rules. We believe that this represents a reasonable compromise between the overall integrity of the analysis used to arrive at the 34% adjustment and the concern we have that hi some cases this adjustment could prove overly generous to operators. Accordingly, in cost of service cases to which the 34% adjustment is applicable, the operator may include in the ratebase up to 66% of the purchase price allocable to assets used to provide regulated services, but only to the extent necessary to justify rates hi effect as of the effective date of these rules. If the current rate can be justified by including in the ratebase less than the 66% amount, then in no event shall the operator seek to use a higher percentage for purposes of any cost of service showing. Given our refined approach to allowing these acquisition costs into the rate base, as well as the alternative ratemaking methodologies available to operators (such as hardship relief), we are convinced that exclusion of some acquisition costs will not result hi unreasonable rates. 60. This adjustment shall be applied only to the purchase price of systems sold prior to May 15, 1994, the effective date of the Cost Order. The interim rule is made permanent with respect to systems sold after this date. Operators who acquired systems after May 15, 1994 were aware of the interim rule strictly limiting the ability to recover the cost of intangible assets. Thus, to the extent such operators recorded substantial intangibles, we presume those intangibles are associated with investment in unregulated services. As such, they cannot be included hi the regulated ratebase. 61. Generally, operators using the cost of service to justify current rates for the first time, will be able to do so using the 34% adjustment In some rare cases, however, this adjustment may not be adequate. For instance, if an operator acquired a system with tangible assets equal to 70% of the purchase price, obviously allowing a ratebase equal to 66% of the purchase price may not allow the operator to recover reasonably incurred costs. Similarly, if the tangible assets represent 64% of the purchase price, the remaining 2% may not adequately compensate the operator for reasonably incurred intangible assets. Therefore, where the tangible assets approach 66% of the purchase price, the operator may justify rates using 100% of the tangible assets and such intangible assets as are permissible using the interim rules. 62. We further believe it appropriate to adjust our interim rule concerning deferred income taxes. Deferred income taxes represent the tax benefit enjoyed by regulated entities that depreciate ratebase assets on an accelerated basis, but that establish rates based on the regulatory presumption that they use a straight-line depreciation method. As compared to 2247 accelerated depreciation, the straight-line method produces a lower amount of expenses to offset against revenues and thus a higher tax liability which is passed through to subscribers. The operator using straight-line asset depreciation for rate regulation purposes, as our rules presume, but using accelerated depreciation for tax purposes, receives revenues from subscribers today for tax liability it will not incur until some later date, i.e., when the asset is more fully depreciated. Because it may earn a return on those revenues until it actually incurs the tax liability, we require that this amount, the deferred tax liability, be deducted from the ratebase so as to preclude a double recovery by the operator. As noted, however, this deduction is premised on the regulatory presumption that rates reflect the operator's use of straight-line depreciation. Obviously, such a presumption could not have existed in the absence of rate regulation. Therefore, we will require operators to deduct deferred income taxes from the ratebase only to the extent that amount was accrued after the date the operator became subject to rate regulation. 63. Finally, we reject Continental's assertion that the excluded intangibles should be amortized since our analysis is based on the reasonable assumption that these excluded intangibles derive from an expectation of monopoly profits from regulated services. Thus, these costs should not be recovered from regulated rates. V. RATEBASE-START-UP LOSSES A. Background 64. In the course of starting a business, losses can be reasonably expected before the business begins to show a profit These losses can be considered to be part of the necessary cost of providing cable service to subscribers and as such should be recoverable by the cable operator. To the extent mat such losses can be considered used and useful, they can legitimately be included hi the ratebase. Financial Accounting Standards Board Statement No. 51 ("FASB 51") allows that certain expenditures, which are normally expensed, may be subsequently capitalized when incurred during a prematurity period which is generally expected to be no more than two years.159 65. In the Cost Order, we concluded that some accumulated start-up losses, to the extent that they reflect operating losses in the early years of the system, should be included hi the ratebase.160 Our current cost of service rules permit cable operators to include accumulated start-up losses occurring during a prematurity period as defined by FASB 51.161 Such losses derive exclusively from the original franchisee (also often referred to as a "build 159 Statement of Financial Accounting Standards No. 51, Financial Reporting by Cable Television Companies ("FASB 51"). 160 Cost Order, 9 FCC Red at 4563. 161 Id. at 4563-65. 2248 and hold system"). The FASB 51 standard is a rebuttable presumption and cable operators are tree to demonstrate that a longer start-up period is appropriate. Cable operators may rebut the presumption of the two year prematurity phase by demonstrating that losses beyond this period were reasonably necessary to develop the cable system and provide cable service and thus benefitted current subscribers.162 B. Comments 66. Continental argues that operators should be allowed an "accumulated return deficiency" which includes start-up losses and accumulated "low earnings," i.e., earnings below a reasonable level.163 FASB 51 should not artificially limit the amount of start-up losses included in the ratebase, according to Continental.164 Continental states that losses and low earnings should be allowed commensurate with amounts necessary to provide incentives for operators to build systems.165 According to Continental, investors in cable systems assume long periods of losses or low returns before obtaining higher returns in later years. Thus, Continental maintains that we should allow the total amount of losses and "low earnings" in the early years of the system's life into the ratebase. Under this scenario, low earnings would be earnings below a "reasonable" level, perhaps returns below 11.25%, the Commission's prescribed rate of return. Eventually, when earnings exceed this "reasonable level," the excess is credited against the ratebase amount attributable to losses and low earnings of prior years. Continental argues mat we should discard all presumptive limits on start-up losses because a system seller will always regard such losses as part of his total investment and seek recovery from an acquiring entity.166 67. TCI asserts that FASB 51 allows more man two years of start-up losses.167 TCI states that two years is a general guideline for the prematurity period, but FASB 51 itself recognizes that a longer period may be justifiable in major urban markets.168 TCI also notes that FASB 51 only concerns itself with particular accounting issues; it does not 162 Id. at 4564, n. 131. 163 Continental Comments at 7-11. 164 Id. 165 Id. 166 Id. at 11. 167 TCI Comments at 32-33. 168 Id. 2249 address all the various costs that give rise to start-up losses.169 Accordingly, TCI argues that the cost of service methodology must take cognizance of start-up losses beyond two years.170 68. NCTA Triaiirtajps th^ all start-up losses in the early years of a system should be allowed in the ratebase.171 According to NCTA, FASB 51 is an insufficient basis to limit start-up loss inclusion since it does not address itself to a cost of service regulatory system.172 69. Media General argues that all reasonably incurred start-up losses should be allowed in the ratebase.173 According to Media General, FASB 51 was not intended to serve as a vehicle for cost of service regulation. Media General asserts that it sustained losses well beyond two years for a variety of legitimate reasons, including fidelity to its franchise agreement, unexpected costs incurred to build 1,100 more plant miles than originally planned, and rate pressure from local franchise officials. Media General argues that such losses should be allowed without a 2-year presumptive limit174 C. Discussion 70. Based upon many of the actual cost of service showings submitted in rate complaint proceedings before the Commission and the comments and petitions for reconsideration that have been filed in this proceeding, we are persuaded that the treatment of prior year losses in the Cost Order should be amended. Cable operators have made a convincing case that they experience a wide range of prematurity, periods and that start-up losses will vary widely depending upon the particular circumstances in each cable system.175 For example, Media General cites a number of factors particular to its situation, including a significant miscalculation of the extent of plant needed to serve the franchise area in the County's pre-bid representation, that illustrate how specific franchise history can differ widely 169 Id. 170 Id. 171 NCTA Comments at 34-35. 172 Id. 173 Media General Petition for Reconsideration at 5. 174 Id at 5-8. Continental endorses Media General's position, arguing that FASB 51 is an accounting rule that does not address a cable investor's expectations of earnings over time from an investment in a cable system. Continental Comments at 10. 175 Media General Petition for Reconsideration at 5-7. 2250 from the FASB 51 Standard.176 We find therefore that we should not prescribe a specific prematurity phase, rather we find that we should define the prematurity phase as the actual period during which expenses exceed revenues. Although we find that the interim rule should be modified, for the reasons stated in the Cost Order, we continue to reject the claims of commenters who argue that the wholesale inclusion of start-up losses in the ratebase is warranted. We also reject Continental's assertion that we should allow deferred earnings into ratebase. To do so would artificially inflate the ratebase. 71. Thus, we find it appropriate to redefine our current definition of prematurity so as to account for the specific circumstances experienced by individual operators rather than continuing to use the FASB 51 standard. We are persuaded by the arguments that limitations on start-up losses should be governed by the history of individual operators. For capitalized start-up losses, build and hold operators should be permitted to recover reasonably incurred cumulative net losses, plus any unrecovered interest expenses connected to funding the regulated ratebase, over the unexpired life of the longest lived asset in the regulated ratebase, commencing with the end of the loss accumulation phase. In most cases acquired systems will have recorded accumulated start-up losses as goodwill or as some other form of intangibles. To the extent that purchased systems can demonstrate that start-up losses have been recorded as goodwill or some other category of intangibles, these losses shall be allowed just as if they had been recorded as start-up losses and the system must itemize its assets instead of using the 66 % purchase price allowance methodology described above. In allowing this however, we must emphasize this should not be interpreted as authority for the wholesale inclusion of goodwill. The burden remains on the operator to demonstrate that any portion of a class of assets is derived from start-up losses. 72. The end of the accumulation phase (i.e., the prematurity phase) will vary from system to system, depending upon the experience of the particular system at issue. By allowing the recovery to occur over the unexpired life of the longest lived asset in the regulated rate base rather than the remainder of the franchise life, the amortization period for purchased systems will realistically reflect the expected period during which the operating losses can be recovered. VL RATEBASE - TANGIBLES A. Background 73. In the Cost Order, the Commission concluded that operators should use 176 Id at 6-7. Because of these factors Media General reports that its operation in Fairfax County did not reach the breakeven point until 1991 or eight years after initiation of construction. Id 2251 original cost to determine the value of plant in service that may be included in the ratebase.177 Original cost was defined as the "actual money cost (or the money value of any consideration other than money) of property at the time it was first used to provide cable service."178 The Commission decided against other valuation approaches, including methods based on market value, replacement cost, or reproduction cost, because they may be difficult to apply and could include excess acquisition costs.179 The Commission chose original cost because it is the traditional method used for public utility valuation and because it produces reliable and fair valuations of plant in service.180 Unlike the other valuation approaches, original cost does not require estimates of current values, which may be speculative or subjective.181 Consistent with the dictates of the 1992 Cable Act, an original cost approach reduces administrative burdens because it relies on cost information that is constant, verifiable, and in most cases, readily available.182 If adequate records do not exist, operators may estimate original cost, provided the basis for the estimate is supported by accompanying documentation.183 In such cases, if an operator can show that book value approximates original cost, the operator may value tangible plant in service at the book value recorded by the operator at the time of • *>» Ift4acquisition. B. Comments 74. Several commenters argued for an approach based on market value instead of original cost Viacom believes that an operator's ratebase should be valued at its market value minus any putative monopoly rents.185 Viacom claims that an original cost approach "would disserve the public interest by frustrating the Congressional intent that cable rates be set at the same levels that would exist in a competitive environment"186 Viacom 177 Cost Order, 9 FCC Red at 4554-55. 178 Id at 4555. 179 Id at 4557-59. 180 Id at 4554-55. 181 Id at 4555. 182 Id at 4556. 183 Id at 4559. 184 Id 185 Viacom Comments at 6. 186 Id at 5. 2252 argues that prices in competitive markets are not related to historical book values but instead reflect inflation, technological changes, relative productivity, and potential opportunities.187 Since historical costs are not affected by such factors, Viacom concludes that they cannot be used to derive competitive rates.188 Similarly, NCTA supports a valuation approach based on what the market value of the assets would be if the cable system were subject to competition.189 Arguing that the Commission's method ignores intangible assets, NCTA suggests an approach which involves computing a competitive cash flow based on the Commission's 17% competitive differential and applying it to the historical cash-flow-to- market-value multiple in the cable industry.190 Finally, Continental contends that, regardless of whether the cable system was acquired or constructed and notwithstanding the availability of original cost data, operators should be able to include in their ratebases the actual amounts they paid for their tangible assets, without having to prove that the value approximates original cost191 Continental avers that the fair market value of acquired tangible assets, purchased at arms-length, is more accurate than the book value listed by the seller, since depreciation rates are subject to "a fair degree of variability."192 C. Discussion 75. We continue to believe that original cost is a reliable and fair measure of the value of tangible assets. In addition to eliminating monopoly profits, it is a method that is both practical and familiar. However, our review of cost of service filings reveals that in many instances it could be difficult, if not impossible, to determine the original cost of a tangible asset To accomodate this reality, for cable systems constructed before May 15, 1994, we will allow operators to use the book value that was recorded as of May 15, 1994, regardless of whether the system was built or acquired by the current operator. Although in balancing consumers' and operators' interests, we continue to believe original cost reaches the better balance, we recognize that the pragmatic adjustment we are allowing is equally reasonable. We will continue to require that original cost be used for cable systems constructed after May 15, 1994. Also, an operator that acquires individual cable assets, such as converters or remotes, at arms' length after May 15, 1994 may use its original cost for those items, rather than its seller's original cost 187 Id. at 6. 188 Id. at 6-7. 189 NCTA Comments at 25. 190 Id. at 27-28. 191 Continental Comments at 22-23. 192 Id. at 22. 2253 76. An exception may apply to the original cost rule in the case of assets acquired in an arms-length transaction and without subscribership. In such instances, assets may be recorded at fair market value. Thus, where a cable operator sells converters, for example, to an unaffiliated operator to be used in a different franchise location, it is acceptable for the acquiring operator to record such converters at fair market value, that is, at the price the acquiring operator paid for them. VH RATE OF RETURN A. Background 77. In the Cost Order, we established a single overall rate of return for cable cost of service proceedings. The presumptive rate was set at 11.25% after taxes. Operators are not foreclosed from justifying different rates of return, however, if they believe their circumstances warrant such a filing. We noted that an operator seeking a higher rate of return bears a heavy burden in attempting to justify the higher rate and that local franchising authorities can counter the operator's request with evidence that the justifiable rate of return is lower than the presumptive 11.25% rate.193 In choosing a single rate, the Commission determined that individualized rates of return would impose significant administrative burdens on franchising authorities, operators and the Commission.194 B. Comments 78. In its reconsideration petition, Comcast argues for the elimination of the 11.25% presumptive rate of return. Comcast contends that operators must be free to justify higher rates of return and that the presumptive 11.25% rate does not adequately reflect the risks of providing cable service. The 11.25% rate mirrors the rate of return for telephone companies subject to cost of service regulation, according to Comcast, who suggests cable operators deserve a higher rate because they present a higher investment risk than telephone companies. According to Comcast, the lower risk associated with telephone companies is manifested by their historic profitability, their routine payment of dividends to shareholders, and their issuance of investment grade bonds. Moreover, Comcast argues, telephone service is an essential utility while cable service is not195 Comcast points out that cable penetration is 65% while telephone penetration is approximately 95% of all households. Cable also faces competition from direct broadcast satellite ("DBS") and multichannel multipoint distribution services ("MMDS").196 Cablevision Industries, Inc. ("Cablevision") in its petition, also argues 193 Id. at 4616, n.327. 194 Id. at 4615. 195 Comcast Petition at 19-20; Avenue TV Cable Reply Comments at 3. 196 Comcast Comments at 4-5. 2254 that telephone companies face lower risks and are nevertheless eligible for rates of return three percentage points above the 11.25% rate under price cap regulation.197 NCTA asserts a unitary rate of return is inappropriate for the cable industry because cable operators face significantly higher business risks that are not represented hi a unitary rate.198 Comcast and Cablevision Industries reject suggestions mat common rates of return for telephone companies and cable operators are needed to ensure regulatory parity. They argue business realties in the cable industry should control the rate of return calculation.199 79. TCI challenges the propriety of an industry average unitary rate of return. It argues that the rate of return cannot be based on industry averages because cost of service filings, as a general matter, are initiated by companies with costs above average, rendering cost of service regulation the appropriate alternative to the benchmark approach. In addition, TCI argues, the cable industry consists of companies of varying risk profiles which makes unitary treatment untenable. Unitary rates may make sense hi the telephone context, but the cable industry is too diverse to justify uniform treatment, according to TCI. Telephone companies, on the other hand, possess similar capital structures, operating assets, credit ratings and management heritage, TCI contends.200 As an example of unworkable unitary rates, TCI cites the experience of the Federal Energy Regulatory Commission which abandoned a mandatory unitary rate approach for electric utilities because regulated entities were not sufficiently homogenous. 80. Telephone companies argue that the business risks of the cable industry do not exceed the risk of providing telephone service. Bell Atlantic asserts that competition in the local telephone service market is increasing as competitive access providers, interexchange carriers and wireless companies enter the local services market Moreover, universal service obligations force telephone companies to overprice services to then- best customers, leaving this customer base particularly vulnerable to offerings from competitors, according to Bell Atlantic.201 GTE argues that a unitary 11.25% rate for cable operators is appropriate to ensure regulatory parity between cable operators and telephone companies.202 C. Discussion 81. We continue to believe that an 11.25% rate of return for the provision of regulated cable service is within the zone of reasonableness and we are supported in that 197 Cablevision Petition at 13, n.11. 198 NCTA Reply Comments at 14. 199 Comcast Reply Comments at 8-9. 200 TCI Comments at 36-38. 201 Bell Atlantic Comments at 3-4; USTA Comments at 5-6. 202 GTE comments at 8. 2255 conclusion by the fact that in individual cost of service filings a large number of operators did not attempt to overcome the presumptive reasonableness of that rate. The presumptive unitary rate sets a rate of return in a manner that minimizes the administrative burdens of determining the various components of the rate of return calculation for individualized operators. In light of these significant administrative benefits and the Commission's institutional experience with the presumptive 11.25% rate, we will retain the 11.25% figure as an option that operators may use in recovering capital costs. If the operator believes that this rate fails to provide adequate compensation for genuine capital costs, the operator may seek to overcome the presumption consistent with the approach set forth in the initial Cost Order. 82. We recognize, however, that reliance on a unitary rate of return does not offer a precise estimation of capital costs for every operator making a cost of service filings. For this reason, we are adopting in this item a Further Notice of Proposed Rulemaking to explore alternatives to a unitary rate of return. As set forth in the Further Notice of Proposed Rulemaking, infra at para. 194, the Commission, in an effort to design a rate of return formula that adjusts more accurately to the individual capital market circumstances of various operators, proposes to establish an alternative methodology for setting an operator's rate of return. This alternative approach stems from comments that have argued that the appropriate return for individual operators will vary from the 11.25% rate. We will therefore address the comments in the context of the proposal set forth in the further notice of proposed rulemaking in Section XVII, infra. Although some commenters have provided documentation to support alternative methods of setting the rate of return, we will nevertheless seek additional comment to solicit a broader range of input and to address additional questions that arise when alternative methodologies are considered. Vm. DEPRECIATION A. Background 83. In adopting the interim rules, we declined to prescribe any specific depreciation rates or schedules to be used in determining a cable operator's allowable ratebase.203 Instead, we decided that the reasonableness of depreciation rates claimed by operators would be subject to case-by-case review.204 At the time, we observed that there was no record evidence that "operators' use of depreciation methodologies or rates has been abusive or even questionable."205 Thus, we concluded that the imposition of a specific depreciation methodology "would impose unjustified burdens without providing a balancing 203 Cost Order, 9 FCC Red at 4603. 204 Id. at 4603-04. 205 Id. at 4603, n. 282. 2256 benefit to subscribers."206 We left open the possibility of revisiting the issue after having had an opportunity to monitor industry practices,207 and sought comment on whether to adopt the interim treatment of depreciation as part of our final cost rules.208 B. Comments 84. Most of the comments we received concerning depreciation schedules come from telephone companies. However, these commenters do not oppose the interim depreciation rule adopted for cable operators; rather, they argue that in a separate docket the Commission should eliminate the specific depreciation schedules that are currently applicable to telephone companies.209 BellSouth argues that depreciation "is an area where regulatory parity between cable television and telephone companies is critical."210 Bell Atlantic suggests that maintenance of such schedules in either the telephone or cable context "departs from the economically correct result," yet urges us to impose such schedules upon cable operators if they continue to be a part of our common carrier rules.211 85. The comments of cable interests are largely silent on the specific issue of depreciation schedules, although cable operators generally urge the Commission not to pursue the goal of "regulatory parity." Fred Williamson & Associates ("Williamson") urge the adoption of deprecation schedules to prevent abuses and suggest that a range of useful life periods should provide flexibility needed to address the circumstances of individual operators.212 C. Discussion 86. The telephone companies do not argue that regulatory parity is of particular importance when it comes to depreciation. They offer no specific suggestions as to the depreciation methods that should be employed if we decide to adopt some type of depreciation scheme. Rather, the telephone companies simply include depreciation as one of the general areas in which, they contend, parity is required. By the same token, the cable 206 Id. at 4603. 207 Id. 208 Id. at 4681. 209 Bell Atlantic Petition at 4-5; GTE Comments at 3-4; BellSouth Comments at 8-9. 210 BellSouth Comments at 9. 211 Bell Atlantic Petition at 5. 212 Williamson Comments, Attachment A at 2. 2257 industry is largely silent concerning depreciation, except to argue that the idea of parity, by itself, does not justify the adoption of depreciation schedules. For example, cable operators offer no analysis of the impact of adopting depreciation schedules and provide no basis on which we can conclude that one method of depreciation is superior to another. 87. The applicability of specific regulatory schemes and policies to telephone companies does not compel then- application to cable operators. We indicated in the Further Notice that industry practices with respect to depreciation would shape our ultimate resolution of the issue. Since release of tile Further Notice, we have had the opportunity to review numerous cost of service filings. As described below, these filings demonstrate that some operators often do not follow any industry standards or other specific guidelines in establishing the useful lives of their assets for purposes of depreciation, or with respect to other aspects of their cost of service filings. As a result, the claimed useful life of a particular asset category can vary significantly among cable operators, even though they all use the same type of equipment and hence should be claiming roughly the same useful life in most instances. Some variation hi the claimed useful lives is to be expected since, for example, management plans to replace equipment affect its useful life and will vary among operators. Thus, when we adopted the interim rules with respect to depreciation, we expressly provided for case-by-case review of filings. However, we neither intended nor expected the substantial variations that the Form 1220s reveal. Our experience since adoption of the Cost Order now convinces us that the benefits of standardizing the useful lives of assets underlying depreciation rates outweigh any resulting burdens. 88. The absence of specific standards or guidelines with respect to useful lives creates uncertainty for operators and regulators alike and, at the local level, creates the risk of inconsistent treatment of similarly situated operators, given the varying practices of the operators and the discretion given to franchising authorities. These factors necessitate heightened scrutiny of cost of service cases before the Commission, as our staff endeavors to ensure that the rates charged for regulated services are the product of reasonable estimations of useful lives. To provide for consistent treatment of these issues and to ease burdens on operators and regulators, we believe it prudent to establish some certainty and uniformity with respect to several issues. 89. Depreciation schedules. A staff survey of cost of service filings reveals significant disparities hi the useful lives claimed by cable operators with respect to specific assets.213 Although for each particular asset category there are a substantial number of filers claiming useful lives within a relatively small range, there are also a significant number of outliers whose claimed useful lives appear to be inappropriate. With respect to headends, for example, 22% of filers claimed a useful life of between seven and nine years while 18% claimed between 15 and 16 years. For transmission facilities, 33% of filers set the useful life at five to six years, while 23% claimed lives of between 15 and 16 years. Numerous 213 See Appendix B. 2258 additional examples of such disparities are set forth in Appendix B. 90. The variations in the useful lives of various assets, as claimed by cable operators, are due hi part to the absence of depreciation schedules in the interim cost rules, which forces operators to establish the useful lives of their assets on some other basis. Thus, it appears that operators do not have a great deal of specific guidance from any source in this regard, resulting in the variations described above and in Appendix B. 91. Local franchising authorities face a similar lack of guidance when they attempt to determine the reasonableness of the useful lives that their cable operators claim. And the Commission staff that reviews the cost of service filings, in an effort to ensure equal treatment of similarly situated cable operators, must attempt to reconcile the substantial differences reflected in the individual filings. 92. To eliminate the uncertainty described above, and to facilitate more uniform depreciation practice for use in computing rates for regulated cable services, we will adopt a flexible range of useful lives for use by cable operators seeking to justify depreciation rates in cost of service filings. Appendix B describes the method by which the depreciation schedules have been calculated. In general, we have used the data available from these filings to develop a range of years defining the useful life of each of the relevant asset categories identified hi Section C, Item 9 of Form 1220, as follows: Category Useful life (years'} a. Headend 8-13 b. Transmission Facilities and Equipment 6-14 c. Distribution Facilities 10-15 d. Circuit Equipment 7-14 e. Maintenance Facilities 17-35 f. Maintenance Vehicles and Equipment 3-7 g. Buildings 18-33 h. Office Furniture and Equipment 9-11 93. As described more particularly hi Appendix B, these figures are derived from 600 cost of service filings. Such filings, including the depreciation data, are required to be made in accordance with generally accepted accounting principles ("GAAP"). GAAP does not dictate specific useful lives, but rather provides general guidelines. Thus, the useful lives 2259 reported on the cost-of service filings reflect, to some extent, the subjective judgments of the operators making the filings. To the extent certain aspects of particular filings raise concerns, we have made adjustments accordingly, as described in Appendix B. For example, we excluded from the observation pool as facially unreasonable the filings of a number of systems that claimed a useful life of one year for all of their assets. 94. Having made such adjustments, staff arrived at an average useful life for each asset category.214 Staff then established a range, by taking one standard deviation from the average useful life for each asset category. Each end of the range was then rounded to the nearest whole number. We have chosen a range of years, rather than dictating the use of a unitary figure, to provide operators with flexibility in determining depreciation rates for their particular systems, although still within reasonable bounds. By prescribing a range of years, we will permit operators to take into account factors that reflect characteristics of their individual systems. For example, the useful life of a cable distribution system might vary depending upon the presence and nature of a competing multichannel video programming distributor ("MVPD"). Depending upon whether the competing MVPD offers interactivity and other advanced features, the cable operator reasonably might determine that these factors will alter the obsolescence, and hence change the depreciation period, of the operator's assets that do have such features. Thus, while the ranges we have prescribed will provide for more consistent depreciation practices between cable operators, we do not believe it is necessary or prudent to deprive cable operators of all discretion to judge the appropriate useful life of their own property. However, operators seeking to establish useful lives mat fall outside the prescribed ranges will have to justify such claims on a case-by-case basis. 95. Given the number of filings, the requirements of GAAP, the ability of operators to adjust for their individual circumstances, and the refinements and adjustments made by the staff, we are confident that the survey captures a representative sampling of data and produces a fair and reasonable range of years for each asset category. 96. For any asset category, we will presume the reasonableness of the useful life claimed by an operator if it falls within the range prescribed above. An operator may seek to depreciate assets over a period of time other than that which we have prescribed, but hi that case the operator will have the burden of establishing the reasonableness of the period it has chosen. Thus, while furthering the goals of certainty and uniformity in the area of depreciation rates, our approach will be flexible enough to account for those unique circumstances in which an operator can demonstrate the reasonableness of a rate that falls outside of the prescribed range. 214 This averaging process included the claims of some operators reporting useful lives that, while not facially unreasonable, were at the extremes. However, the impact of these outlier claims is, at it should be, minimal, given the substantial number of operators claiming a useful life within a relatively small range for each asset category. 2260 97. In addition, we will require the operator to depreciate its assets in accordance with the straight-line methodology. Our review of the Form 1220s on file with the Commission suggests that some operators are using accelerated depreciation methodologies to increase the amount of their depreciation expense and thus to increase rates. While there are contexts in which accelerated deprecation is a legitimate practice, we have been presented with insufficient justification to show that it would be appropriate for purposes of establishing rates under our cable cost of service rules. 98. Test-year data. Our cost of service rules establish a maximum permitted rate based on the operator's costs and ratebase as established during the test year, which is the operator's most recent fiscal year.215 In some instances, an operator will be able to time the filing of its 1220 such that the test year will be one in which unusually high depreciation write-offs were taken. Higher depreciation expenses translate into higher permitted rates, since rates must cover expenses. Thus, to the extent the operator can control the timing of its filing, it can justify rates that are higher than would be permitted were the operator to use data from a more representative 12 month period. The staff review of the Form 1220s suggests that some operators are pursuing precisely this strategy and thus artificially inflating rates. 99. Our new rules prescribing depreciation schedules and requiring straight- line depreciation should help to curb this practice. Where it nevertheless appears that the test- year data include unreasonably high depreciation write-offs, the operator should determine the extent to which the depreciation claimed for the test year exceeds normal depreciation and exclude the excess from the ratebase. 100. Relevance of Franchise Life in Defining Useful Life of Assets. The cost of service filings indicate that operators often claim that the useful life of cable system assets cannot exceed the term of the cable franchise, based on the proposition that the termination of the franchise renders the assets useless. However, this presumes that operators generally are unsuccessful at renewing the franchise, a premise for which there is no evidence and which conflicts with the general experience of the industry. Even in the event of a non-renewal, the operator might sell its asset to the new cable franchisee and thereby realize the value associated with its actual remaining life. For these reasons, we will presume that the term of the franchise is not relevant for purposes of determining the useful life of cable system assets, again subject to rebuttal by the operator if it can show, for example, some threat that its franchise will not be renewed and that in the event of non-renewal the operator will not be able to recover the value of its assets. DC TAXES A. Background 215 47 C.F.R. § 76.922(g). 2261 101. In the Cost Order, we provided for the recovery of income taxes as an expense incurred by operators as a consequence of providing regulated cable services. We provided that Chapter C corporations would be allowed to include as an annual expense all taxes on the provision of regulated services. For other entities such as Subchapter S corporations, partnerships and sole proprietors, we allowed an expense for taxes after an adjustment for amounts distributed by such entities to the individual owners of the operating enterprises. This approach comports with the principle that taxes related to the provision of regulated service may be recovered from subscribers, but taxes on dividends paid to owners may not be recovered from subscribers.216 B. Comments 102. Continental argues that, consistent with traditional utility ratemaking theory, the capital structure used to calculate the amount of the tax gross up should be consistent with the structure assumed in the calculation of the allowed rate of return. If, for example, a 50% hypothetical capital structure is used to set the rate of return, a similar structure should be presumed in estimating the equity portion subject to the tax gross up. In the alternative, Continental would support calculation of the tax allowance based on system- specific capital structures and define equity as the actual equity infusions received by the operators over the course of their operations.217 103. Continental also challenges the Cost Order's approach to the calculation of the income base subject to the gross up. Continental argues that the Commission should not adjust the income base by distributions to owners because such distributions cannot be presumed as corporate income. A portion, if not all, of the distribution, for example, may be devoted to tax liabilities of the owner.218 In any event, Continental challenges the presumption that a distribution to the owner of a non-Chapter C corporation is a distribution of income earned by the operating entity. C. Discussion 104. We agree that use of an actual capital structure is the appropriate method of estimating the equity portion subject to tax recovery if actual capital structure is used to establish the rate of return. Reliance on the actual capital structure in such cases would ensure that the method of calculating an operator's tax liability is consistent with capital structure assumptions used to estimate the allowed rate of return. Accordingly, if we adopt the proposed alternative to use actual capital structures when calculating the rate of return, we will rely on actual capital structures derived from the rate of return analysis to 216 Cost Order, 9 FCC Red at 4607, n. 296. 217 Continental Comments at 36-37. 218 Continental Comments at 41-42. 2262 determine the amount of tax recovery for operators using the alternative to the presumptive 11.25 percent rate. When hypothetical capital structures are used to set the rate of return, however, we will employ the same capital structures to determine the equity portion of total capital subject to income tax recovery. Because the presumptive rate of return relies on a hypothetical debt range of 40 to 70 percent of capital, we will use the average of that range, or 55 percent, as the hypothetical debt proportion. This approach also ensures consistency between the method of calculating return on equity and the tax obligations flowing from that calculation. 105. With respect to distributions to individual owners of non-Chapter C entities, we will continue to adjust the income calculation for estimating allowed taxes. We recognize that entities other than Chapter C corporations may pass through income directly to the individual owners and that this income may have been derived from the provision of regulated cable services. Nevertheless, we will adhere to the traditional principle of adjusting the income tax amount to ensure that ratepayers do not pay the taxes of individuals who are structurally separate from the entity providing the regulated service. Because income and deductions from cable operations would be combined with income and deductions for activities unrelated to cable operations, the tax recovery built into cable rates may bear little if any relationship to actual tax liabilities incurred by the owner of the non-Chapter C operator. Rather than engage in a review of the tax impact of other non-cable businesses conducted by the owner of the non-Chapter C entity, we will limit recovery of taxes in such cases by the adjustment mechanism described above. X. COST ALLOCATION A. Background 106. In the Rate Order, we established cost allocation rules which apply to regulated cable operators that elect cost of service regulation, as well as to operators that seek to adjust their rates to reflect changes in external costs. In general, the rules require operators that aggregate their expenses and revenues at a level other than at the franchise level (e.g., system or regional) to allocate expenses and revenues to the franchise level.219 The cost allocation to the franchise level is to be calculated using the ratio of the total number of subscribers served in the franchise area to the total number of subscribers served in the larger area.220 At the franchise level, the rules generally require that costs identified at or allocated to the franchise level must be allocated amongst the BST and each CPST using the ratio of channels on each tier to the total number of channels offered in the franchise area.221 219 See Rate Order, 8 FCC Red at 5973-76. 220 Rate Order, 8 FCC Red at 4645. 221 Id, at 4646. 2263 107. The rules established by the Rate Order also require direct allocation of programming and retransmission consent fees to the tier upon which the programming is offered.222 Franchise fee costs must be allocated among program service tiers in a manner that is most consistent with the methodology of assessment of franchise fees by local franchising authorities.223 In addition, costs associated with public, educational and governmental ("PEG") access must be directly assigned to the basic tier whenever possible.224 108. Finally, the Rate Order required common costs that are not directly assigned to be allocated based on direct analysis of the origin of the costs.225 When direct analysis was not possible, common costs were to be allocated to service cost categories based on an indirect, cost-causative linkage to other costs that are directly assigned or allocated to the service cost category.226 When neither direct or indirect measures of cost allocation could be found, costs are to be allocated to each service cost category based on the ratio of all other costs directly assigned and attributed to the category over the total of all costs directly assigned and allocated by direct analysis and by indirect linkage.227 109. In the Cost Notice, we proposed five service cost categories that cable operators would be required to use when allocating costs: BST activities, CPST activities, other cable programming services activities, other cable activities, and non-cable activities.228 We proposed that all costs be directly assigned whenever possible. The Cost Notice also sought comment on whether different cost allocation rules should be adopted for cost allocation between regulated cable service and unregulated activities.229 110. In the Cost Order, we determined that allocation of costs to non- regulated service categories is necessary to ensure that allocations to regulated services are fair 222 See 47 C.F.R. § 76.924(f)(2). 223 See 47 C.F.R. § 76.924(f)(3). 224 See 47 C.F.R. § 76.924(f)(4). Furthermore, 47 C.F.R. § 76.924(f)(5) requires Commission regulatory fees to be directly assigned to the BST. See Fourth Order on Reconsideration, MM Docket 92-266, FCC 94-254, 9 FCC Red 5795 (1994). 225 See Rate Order at 5976. 226 Id. 227 Id. 228 Notice, Appendix A at 4-6. 229 Id. at 159. 2264 and reasonable.230 Accordingly, the Cost Order amended the rules to require that in addition to the BST and each CPST, costs must also be allocated to non-regulated programming service activities, other cable activities, and non-cable activities.231 As proposed in the Notice, the Cost Order established five service cost categories that cable operators are required to use when allocating costs for cost of service showings and for allocating external costs: BST activities, CPST activities, other cable activities, and non-cable activities.232 These cost allocations take place after revenues and costs are initially identified at the appropriate organizational level. The Cost Order requires that the BST and CPST cost categories include only the allowable costs as defined under Section 76.922(g) through (k) of our rules.233 111. The Cost Order also mandates that, to the extent possible, all costs must be directly assigned amongst the equipment basket and service cost categories.234 In so doing, we found that direct assignment was preferable to a standard allocator because direct assignment more accurately reflects cost causality. For costs that cannot be directly assigned, the Cost Order requires operators to assign such costs amongst the service cost categories and the equipment basket using methodologies consistent with Section 76.924(f)(7) of our rules.235 These rules require the operator to first attempt to allocate such costs through direct analysis of the origin of the costs. In addition, the Cost Order requires that where such direct analysis is not possible, operators must attempt to establish cost causative linkage to other costs directly assigned or allocated by direct analysis.236 Where no direct or indirect linkage can be made, the Cost Order requires operators to allocate on the basis of the totals of all costs directly assigned and allocated using direct analysis or indirect linkage.237 The Commission declined to adopt specific allocators or rigid allocation schemes, stating that local franchising authorities and the Commission would review the allocators proposed by cable operators on a case-by-case basis.238 230 Cost Order at 4650. 231 Cost Order at 4650; 47 C.F.R. § 76.924(e). 232 Id. 233 Id at 4652. 234 Id at 4653. 235 Id at 4653-54. 236 Id at n. 476. 237 Id 238 Id at 4654. 2265 112. After costs have been directly assigned to and allocated among the service cost categories and the equipment basket, the Cost Order amended the rules to specify the particular procedures for allocations to the franchise level for operators who aggregate costs at a higher level.239 Recoverable costs that have been aggregated at the highest organizational level at which costs have been identified shall be allocated to the next lowest organizational level at which recoverable costs have been identified on the basis of the ratio of the total number of subscribers served at the lower level to the total number of subscribers served at the higher level.240 The Cost Order requires this procedure to be repeated at every organizational level at which recoverable costs have been identified until all costs have been allocated to the franchise level.241 B. Comments 113. Tune Warner argues that the cost allocation rules should not be applied to cable operators seeking external cost adjustments under the benchmark system.242 Time Warner claims that the import of these rules in the context of the limited external cost category is very unclear and will create controversy and expensive litigation.243 Time Warner recommends that the Commission clarify that all external costs are to be directly assigned and otherwise abandon cost allocation rules beyond the requirements of GAAP.244 114. Time Warner claims that the Commission does not have jurisdiction to require cable operators to allocate costs for pay-per-channel and pay-per-program offerings, billing and collection services, studio and nonregulated equipment engineering and rental services and sale and maintenance of nonregulated equipment to the three nonregulated service cost categories: other cable programming activities, other cable activities and non-cable activities.243 Time Warner states that it is neither necessary nor lawful to allocate nonregulated costs to various nonregulated service categories in order to ensure mat allocation of costs to regulated services is fair and reasonable in relation to the allocation of costs to 239 Id. 240 Id; see also 47 C.F.R. § 76.922(g)(l). 241 Cost Order, 9 FCC Red at 4655; see also 47 C.F.R. § 76.924(g). 242 Time Warner Comments at 16-17. 243 Id at 17. 244 Id 245 Id at 17-18. 2266 nonregulated services.246 According to Time Warner, once costs are found to be nonjurisdictional, the Commission's legal authority to track these costs is extremely limited.247 Time Warner asserts that the Commission's joint cost rules for telephony separate costs between regulated and nonregulated activities, but do not further disaggregate purely nonregulated costs.248 115. Continental recommends that the Commission continue to take a flexible approach to cost allocation issues when permanent rules are adopted, provided that cable operators comply with the key principles set out in the Cost Order™9 Continental also states that it would greatly improve the operator's ability to assess the reasonableness of their rates under cost-of-service principles if the Commission indicated in advance that one or more approaches to allocating costs are reasonable.250 Continental contends that one key issue is how to allocate the costs of cable plant, and related maintenance and depreciation costs, among service baskets.251 Continental recommends that the Commission specify that one acceptable method of allocation is "weighted channels," with weighting performed on the basis of the number of households subscribing to the service at issue.252 According to Continental, this approach represents a fair middle ground between the strict "cost causation" approach and a simplistic capacity-based allocation that takes no account of the usage.253 116. Similarly, Avenue TV argues that operator costs should be more heavily weighted toward the BST because (1) BST channels are more valuable and are required under must-carry; (2) CPST service could not be offered without the BST; and (3) most of Avenue TV's costs are necessary to provide BST service.254 117. Continental urges that advertising revenues be assigned to the nonregulated "Other Cable Activities" category because (1) cable operators are under no 246 Id. at 18. 247 Id. 248 Id. at 18-19. 249 Continental Comments at 26. 250 Id. 251 Id. at 27. 252 Id. 253 Id. at 27-28. 254 Avenue TV Reply Comments at 14. 2267 obligation to carry advertising of their own (as opposed to advertising contained in broadcast signals obtained from others); (2) cable-specific advertising represents an improved customer service, because advertisers are better able to reflect the likely interests and needs of cable subscribers with cable-specific advertising; and (3) cable operators provide this service to consumers and advertisers because it is profitable to do so (if the sole reason for providing advertising were to lower rates, then operators would have no incentive to continue providing this service).255 118. Continental also recommends that revenues received from home shopping services on regulated tiers be allocated to the nonregulated "Other Cable Activities" category because if the effect of using a valuable slot for a home shopping service is to reduce the cable operator's regulated rates from the level that would result if some other service were offered, that would create a regulatory disincentive to carrying home shopping service.256 C. Discussion 119. While our current rules require direct assignment of costs, the rules also allow for operator flexibility in determining specific allocators and allocation schemes. Accordingly, we affirm our current cost allocation requirements set forth in the Cost Order, as amended, with the exception of our rule which requires cost allocation of non regulated costs to specific non regulated service categories, which we remove by this Order.257 We also take this opportunity to clarify that, within our current cost allocation methods which we affirm today, revenues must be matched with underlying expenses between related lines on FCC Form 1220, and that allocators need to be consistent For example, advertising expenses on line 33 of FCC Form 1220 and advertising revenues on line 51 of Form 1220 should be allocated similarly. We find that accuracy is sacrificed if operators are not consistent with their use of allocators between related lines on FCC Form 1220 (i.e., differing methods are used between the revenue and expense sides of the same category), and are not consistent with their use of allocators between forms such as the 1205 and 1220. 120. The general propositions upon which we continue to base our cost allocation requirements are as follows: (1) costs shall be directly assigned among the equipment basket and service cost categories whenever possible; (2) costs that cannot be directly assigned and which no allocator has been specified by the Commission are to be allocated based on direct analysis of the origin of the costs, and where allocation based on direct analysis is not possible, operators must attempt to make a cost causative linkage to other costs directly assigned or allocated to the service cost categories and the equipment 255 Id at 32-33. 256 Id. at 33-34. 257 See 47 C.F.R. § 76.924(e)(l)(iii),(iv),and (v); § 76.924(e)(2)(iii),(iv),and (v). 2268 basket; and (3) for costs that cannot be directly assigned and for which no indirect measures of cost allocation can be found, such costs shall be allocated to each service cost category based on the ratio of all other costs directly assigned and attributed to a service cost category over total costs directly or indirectly assigned and directly or indirectly attributable.258 121. We agree with Tune Warner that the Commission should not require cost allocation of non-regulated costs to specific non-regulated service categories. While the requirement may in some limited instances enable us to more readily ascertain the bases for cost allocations to regulated categories, we believe that it would be overly burdensome to continue to include this requirement in our rules. Therefore, we amend our rules to remove the requirement that non-regulated costs must be allocated among the non-regulated programming service categories, other cable activities, and non-cable activities categories, and replace these categories with a single "all other" service cost category.259 Accordingly, operators electing cost of service regulation and cable operators seeking an adjustment to external costs shall allocate costs among the equipment basket and the following service cost categories: (1) BST, (2) CPST, and (3) all other. The "all other" service cost category shall include all costs not included in the BST or CPST service cost categories. We find that so long as the "all other" service cost category reflects both direct and indirect assignments to regulated categories, we need not require that costs be allocated amongst the non-regulated categories. As with other aspects of our cost rules, however, our rules regarding allocation of costs associated with services not subject to cable rate regulation are likely to be revisited in the near future in light of developing circumstances, including in particular the convergence of the telephone and cable industries. 122. We concur with Tune Warner that external costs should continue to be directly assigned to the extent practicable. We disagree that we should otherwise abandon our rules in favor of GAAP, inasmuch as we believe that our current rules are already in confbrmance with GAAP. Our external cost category consists of retransmission consent fees, programming costs, cable specific taxes, franchise related costs, franchise fees and Commission regulatory fees.260 Our rules specify that retransmission consent fees and programming costs are to be directly assigned to the tier upon which they are associated.261 Likewise, Commission regulatory fees are to be directly assigned to the basic tier because these fees are assessed on a per subscriber basis and all subscribers receive the basic tier.262 Finally, our rules require that PEG related franchise costs be assigned directly to the basic tier 258 47 C.F.R. § 76.924(f). 259 See 47 C.F.R. § 76.924(e). 260 47 C.F.R. § 76.924 (f). 261 Id. 262 Id. 2269 (because PEG channels appear on the BST).263 We believe that in most cases, non-PEG franchise related costs should be assigned directly to the tier associated with the costs. Therefore, the only external costs which cannot generally be directly assigned are franchise fees and cable specific taxes. Our rules require that franchise fees be assigned in accordance with the method most consistent with the method of assessment of the fees by local franchising authorities.264 Usually this involves a percentage of tier fees, therefore corresponding tier assignment would involve a reasonable cost causative linkage in accordance with GAAP. Also in accordance with GAAP, certain cable specific taxes should likewise be assigned using the method of assessment most consistent with the assessment method of the cable specific tax. 123. While we agree with Continental's general recommendation that the Commission should continue to take a flexible approach to cost allocation based on our Cost Order, we decline to adopt the "weighted channel" approach suggested by Continental and Avenue TV. As we stated in Section IH, supra, we believe that in many cases a reasonable measure of the costs of tangible plant would be a straight channel ratio. The weighted channel approach suggested by Continental and Avenue TV creates a bias towards the BST when, in fact, plant usage is most often directly attributable to the number of channels supported. Generally, incremental increases in plant investment are driven by the number of channels added, irrespective of subscribership to BST channels. The number of subscribers does not impact costs in most cable equipment categories. Accordingly, we believe that in most cases, a straight channel ratio would be a reasonable approach to the allocation of plant costs amongst service baskets. 124. We also reject Continental's suggestion that advertising revenues and home shopping services be assigned to the "other cable services" category. The allocation approach for cost of service showings reflected in FCC Form 1220 indicates that revenues received for advertising and home shopping on a regulated tier should be allocated to that tier, and used as an offset to providing service on that tier. We adopted this approach because advertising and home shopping shown on regulated channels employ regulated assets and, consequently, these revenues should be distributed as offsets to the regulated tier revenue requirements. XL ACCOUNTING REQUIREMENTS A. Background 125. In the Cost Order, we stated that we would adopt a uniform system of 263 Id. 264 Id. 2270 accounts for those cable operators that elect cost of service regulation.265 We believed that a uniform accounting system would ensure that operators accurately record their revenues, operating expenses, depreciation expenses, and capital investments. In addition, a uniform system of accounts presumably would simplify cost of service proceedings, since variations in operators' accounting practices would be minimized. Therefore, we proposed and sought comment on an accounting system we felt would be workable and reliable.266 126. We concluded that until a uniform system of accounts could be finalized, operators electing cost of service regulation should use an interim summary accounting system.267 Under the interim system that we adopted, operators using FCC Form 1220 identify costs in 55 summary level accounts, and small operators using FCC Form 1225 identify costs in 32 summary level accounts. Operators are required to identify all amounts associated with each revenue and cost category at the franchise, system, regional and/or company level, depending on the organizational level at which the operator identified revenues and costs for accounting purposes as of April 3, 1993.268 Local franchising authorities and the Commission may require operators to provide any additional financial data and explanations necessary to substantiate a cost of service filing and may order appropriate disallowances if an operator fails to provide a reasonable response. B. Comments 127. Several cable operators argue that adopting a uniform system of accounts would be overly burdensome and costly for both the cable industry and the Commission. Comcast claims that it is not feasible for cable operators that are part of larger organizations to create new accounting systems for only those systems that opt for cost of service regulation.269 According to Comcast, such operators would have to convert all of their systems to the new accounting system, which would be expensive, time-consuming, and wasteful.270 Similarly, Avenue TV opposes a uniform accounting system because the expense of converting to such a system would effectively preclude some operators, especially small 265 Cost Order, 9 FCC Red at 4641. We decided, however, not to require operators that are regulated under the benchmark system to maintain then- accounts in accordance with a uniform accounting system since the benchmark system is primarily concerned with an operators' prices, rather man costs. Id 266 See id at 4714-58. 267 Id at 4643. 268 See 47 C.F.R. § 76.924(c). 269 Comcast Petition for Reconsideration at 22. 270 Id 2271 operators, from electing cost of service regulation.271 Falcon Cable TV ("Falcon") claims that a uniform system would necessitate hiring new professional staff and expanding the company's computer capacity.272 According to Falcon, the heterogeneity of the cable industry would complicate the implementation of a uniform system, which would be an extremely involved and time-consuming process.273 Time Warner argues that the many years it took the Commission to develop a workable accounting system for the telephone industry demonstrates the futility of trying to design a comparable system for cable companies within the time period that most cable systems will be subject to rate regulation.274 Comcast is also skeptical that the Commission could devise a uniform system of accounts in time for it to be applied to most cost of service cases.275 128. Cable operators contend that adopting a uniform system of accounts would violate Congress' intent to simplify cable rate regulation as much as possible. Comcast argues that requiring cable operators to use an accounting system akin to the model designed specifically for common carriers would contravene the Congressional mandate that cable rate regulation not duplicate common carrier regulation.276 Falcon avers that imposing a uniform accounting system would conflict with Congress' directive to minitniyfl regulatory burdens on cable operators.277 Falcon notes that Congress did not grant the Commission explicit authority to adopt a uniform system; to the contrary, Congress determined that cable companies should not be subject to regulation as common carriers.278 Continental argues that the fact that the telephone industry is subject to a uniform system of accounts is not a sufficient reason for imposing one on the cable industry.279 129. In addition, Continental asserts that FCC Form 1220 already provides the Commission with the uniformity it is seeking, and thus the benefits to be gained by uniform accounting requirements are outweighed by the burden and expense involved in 271 Avenue Comments at 8. 272 Falcon Comments at 7. 273 Id. at 8-11. 274 Time Warner Comments at 21. 275 Comcast Petition for Reconsideration at 23. 276 Comcast Reply Comments at 14. 277 Falcon Comments at 5. 278 Id. at 6. 279 Continental Reply Comments at 16. 2272 converting to a uniform system.280 Comcast agrees that sufficient uniformity is achieved through the use of FCC Form 1220 and a uniform system of accounts would not increase the accuracy of cost of service filings.281 130. Bell Atlantic supports the Commission's decision to adopt a uniform accounting system and believes it should be applied to all regulated cable systems regardless of whether they submit cost of service or benchmark filings.282 Bell Atlantic argues that the cable industry should be subject to standardized accounting rules that are comparable to those applicable to the telephone companies, especially in light of the impending convergence of the two industries.283 Williamson also agrees with Hie Commission's proposal to establish a uniform accounting system because it is similar to the one currently applicable to the telephone industry.284 In addition, GTE favors the adoption of a uniform system of accounts, which it states is a "typical and expected component of utility regulation."285 C. Discussion 131. We conclude that a uniform system of accounts would be unnecessarily burdensome for cable operators at this time. Our review of the cost of service filings has shown that FCC Forms 1220 and 1225 generally provide a sufficiently detailed basis for evaluating operators' rates. The additional detail provided by a uniform system of accounts would be of limited value since most of the filing defects we have discovered thus far are company-specific and would not have been prevented by a uniform accounting system. Our practice of issuing deficiency letters when questions arise has proved to be an adequate means of clarifying data. Therefore, we agree that investing the time required to develop a uniform system would be counter-productive to achieving our objective to process cases as expeditiously as possible. We are also persuaded that imposing a different accounting system on the relatively few systems filing cost of service justifications may create administrative inefficiencies for cable operators. Therefore, we will not adopt a uniform accounting system but will require operators electing cost of service regulation to follow the accounting standards required by FCC Forms 1220 and 1225, thus making permanent our interim accounting 280 Continental Comments at 64; Continental Reply Comments at 16. 281 Comcast Reply Comments at 14. 282 Bell Atlantic Reply Comments at 14-15. 283 Bell Atlantic Reply Comments at 14-16; Bell Atlantic Opposition to Petitions for Reconsideration at 6. 284 Williamson Comments at 3. 285 GTE Comments at 11. 2273 standards.286 XII. AFFILIATE TRANSACTIONS A. Background 132. In the Cost Order, we promulgated rules for valuing transactions between cable operators and affiliated companies.287 These rules were designed to prevent favorable self-dealing between affiliated companies in order to manipulate our rate rules. We defined an affiliated entity as one that shares a 5% or greater ownership interest with the cable system operator.288 The interim rules require an affiliated transaction to be valued at the "prevailing company price," if the provider has sold the same kind of asset or services to a substantial number of third parties at a generally available price.289 If the provider has not been engaged in similar transactions with a substantial number of third parties, the rules between the sale of an asset and the sale of a service.290 If the transaction involves an asset, the cable operator is required to value the transaction at the higher of cost or fair market value when the cable operator is the seller and the lower of cost or fair market value when the cable operator is the purchaser.291 If the transaction involves a service and no prevailing company price can be established, the cable operator is required to value the service at the service provider's cost292 133. In the Further Notice, we sought comment on whether the interim rules should be adopted as our final rules, including: (1) requiring cable operators that do not meet the prevailing company price test to value the assets at the higher of cost or fair market value when the cable operator is the seller and the lower of cost or fair market value when the cable operator is the purchaser and (2) whether the current definition of affiliate should be retained. 286 Although we will not establish a uniform system of accounts at this time, we may revisit the issue in the future if events, such as convergence of the cable and telephone industries, create an environment where it would make sense to adopt a uniform system of accounts for cable companies. 287 Cost Order, 9 FCC Red at 4658-68. 288 Id. at 4667-68. 289 Id. at 4665-66. 290 Id. For the purposes of evaluating affiliate transactions, programming is considered an asset Id. at 4666-67. 291 Id. at 4665-66. 292 Id. at 4666. 2274 Other issues to be resolved include: (1) whether our final affiliate transaction rule should be included in the uniform system of accounts, should we adopt one for cable operators and (2) whether the cable services affiliate transaction rule should conform with the affiliate transaction rule being considered with regard to common carriers.293 This final proposal would have prevented cable operators from valuing assets or services at the operators' prevailing company prices unless the providing affiliates sell more than 75% of their total output to nonaffiliates. B. Comments 134. The most common issue addressed in the comments concerns the proposal that would prevent cable operators from valuing assets or services at the operators' prevailing company prices unless the providing affiliates sell more than 75% of their total output to nonaffiliates. The majority of the commenters oppose this amendment of the interim rules arguing that it is unnecessary in the context of the cable industry.294 These commenters argue that while the affiliate transaction rules are necessary in the context of telephone regulation, that need arises as an outgrowth of the faulty incentives created by rate of return regulation of the telephone industry where there has been a long history of cross- subsidization.295 According to these commenters, no such history of abusive affiliate transactions exists for the cable industry so there is no need for such rules.296 The telephone companies argue that the current rules are appropriate for both the cable industry and the telephone industry, but in any case whatever rules are ultimately adopted for telephone companies should apply to cable as well.297 Williamson supports the Commission's affiliate transaction proposals because they conform with the Commission's proposed rules for telephone companies.298 293 Further Notice 9 FCC Red at 4683-86. 294 See, e.g., Liberty Media Comments at 4-9; Time Warner Comments at 23-24; TCI Comments at 45-50; IBS Comments at 4-15; Rainbow Comments at 3-6; Discovery Communications Comments at 2-7; Jones Education Networks, Inc. Comments at 3-4; NCTA Reply Comments at 3-5. 295 Id 296 Id 297 Bell Atlantic Comments at 10-11; BellSouth Comments at 4. GTE states that Congress has specifically found mat cable operators frequently act to undermine the very programming distribution objective. GTE Reply Comments at 5. GTE states that it was for this reason that the Cable Act protects video programming vendors from anticompetitive actions of multichannel video programming distributors. 298 Williamson Comments at 5. 2275 135. Time Warner argues that the record does not justify any affiliate transaction rules, since the affiliation between programmers and cable operators in the cable industry has been driven purely by market forces.299 According to Time Warner, while the affiliate transaction rules are an outgrowth of the faulty incentives created by rate of return regulation in the telephone industry where there has been a long history of cross-subsidization, rules covering transactions between cable operators and their affiliates are not warranted because no such history exists for the cable industry.300 136. Jones Education Networks, Inc. ("Jones") argues that we should provide a window for new services, i.e., a period of looser regulation during which programmers will have an opportunity to market their new services to a substantial number of third parties.301 Jones states that the Commission should adopt a presumption that, during this window, the price that is paid for programming by affiliated systems comports with the prevailing company price that has been established by the programmer where the programmer is marketing the service to nonaffiliated operators.302 If at the end of two years the programmer has not reached a significant number of unaffiliated parties, Jones notes, then alternative costing tests would be applicable.303 Even then, Jones states, the operator should have an opportunity to show that the programming is being priced at its estimated fair market value.304 Absent such a showing, Jones recommends that the offset be based on the programmers' overall costs and not their net book costs.305 137. Bell Atlantic states that while there are strong arguments for less restrictive requirements than those contained in the Further Notice, the Commission correctly recognizes that whatever rules are ultimately adopted for telephone companies should apply to cable as well.306 299 Time Warner Comments at 23. 300 Id. at 24-25. 301 Jones Comments at 10. 302 Id. 303 Id. 304 Id. 305 Id. 306 Bell Atlantic Comments at 10-11. See also BellSouth Comments at 4; Bell Atlantic Reply at 4-5; USTA Reply Comments at 3-5. USTA opposes the Commission's proposal to change the affiliate transaction rules. USTA suggests that it would be costly and extremely difficult to estimate the fair market value of services in affiliate transactions. Moreover, 2276 C. Discussion 138. Once again we reject the arguments of those petitioners and commenters which assert that there is no need for an affiliate transaction rule in the context of cable rate regulation. These arguments rely on the assertion that there is no history of abusive affiliate transactions in the cable industry and thus no need for an affiliate transaction rule. These arguments fail simply because the history upon which they rely is a history absent rate regulation. In such an environment no incentive exists for abusive affiliate transactions. We need not wait for abuse before providing ratepayers with reasonable protection. 139. The affiliate transactions issue was previously addressed, in part, in the Sixth Order on Reconsideration, Fifth Report and Order, and Seventh Notice of Proposed RulemaJdng.3*" There, we declined to amend the current rule to prevent cable operators from valuing assets or services at the operators' prevailing company prices unless the providing affiliates sell more than 75% of their total output to nonaffiliates.30* We specifically reserved the discretion to monitor and revisit this issue should the current rule prove inadequate or unworkable.309 140. We reject the arguments made by Jones to permit a window for new services, i.e., until they can market their services to a substantial number of third parties. In a competitive market, programmers would not be able to subsidize new services with higher rates for competitive services. Similarly, in a regulated industry, programmers cannot expect regulated ratepayers to subsidize new programming ventures. 141. Beyond the problem of determining the prevailing company price, we requested comment on an appropriate method of valuing an asset absent a prevailing company price. The interim rules require cable operators that do not meet the prevailing company price test to value assets at the higher of cost or fair market value when the cable operator is the seller and the lower of cost or fair market value when the cable operator is the purchaser. Ruling that cable operators are permitted to value services at the provider's cost is consistent with the current rules for telephone companies and there appears to be no reason to distinguish the two industries in this particular context This is especially true in light of the more liberal definition of prevailing company price in the cable services regulatory scheme. USTA states that by suggesting this fair market value requirement for cable companies, the Commission may have pre-judged the merits of the proposal for telephone companies. 307 Sixth Order on Reconsideration, Fifth Report and Order, and Seventh Notice of Proposed Rulemaking, MM Docket No. 92-266, MM Docket No. 93-215, 10 FCC Red 1226 (1995). 308 Id. at 1269-70. 309 Id. at 1270. 2277 142. The current definition of "affiliate" is consistent with the definition used elsewhere in the cable services regulatory scheme.310 There appears to be no compelling reason to amend the definition and we decline to do so at this time. 143. Finally, we requested comment as to whether the interim affiliate transaction rules should be incorporated into a uniform system of accounts. Since we have found that no need exists at this time to adopt a uniform system of accounts, this point is moot311 XIIL SOCIAL CONTRACTS A. Background 144. In the Cost Order, we adopted an experimental program designed to give operators incentives to upgrade their systems and services. Specifically, we invited operators to propose upgrade incentive plans, also known as social contracts, with their subscribers, pursuant to which operators would be given substantial flexibility in setting rates for new regulated services, in exchange for which customers would be guaranteed that existing services, or their equivalent, would remain in place at stable and reasonable rates.312 The operator also would commit to otherwise maintaining or improving the quality of its services.313 The Commission would oversee implementation of the contract and would review the operator's compliance before the end of the contract term.314 We proposed to review such plans in the fifth year of operation.315 145. In general, our review of the rates of an operator that had implemented a valid social contract would be limited to determining whether the operator continued to provide existing services at rates no higher, and quality no lower, than obtained prior to the implementation of the plan.316 Rates for the additional regulated services added pursuant to 310 In the Rate Order we adopted a 5% threshold for defining an affiliate for purposes of determining the extent to which cable operators could pass programming charges through to ratepayers. 8 FCC Red at 5788, n. 601. 311 See infra at f 121. 312 Cost Order, 9 FCC Red at 4678. 313 Id. 314 Id. 315 Id. at 4680. 316 Id. at 4679. 2278 the contract would not be subject to review unless shown to be outside a wide range of reasonableness.317 146. In the Further Notice, we proposed refinements to the social contract approach as described hi the Cost Order. For example, we suggested that operators would have to receive approval for the contract hi advance of any upgrade if it sought to claim the full flexibility offered by such plans.318 We proposed permitting local franchising authorities to establish certain guidelines with respect to the basic tier that the operator would have to observe in order to qualify for a social contract319 We also sought comment on ways to ensure that existing services did not suffer, La terms of price and quality, as the operator established its new services under the terms of the contract320 B. Comments 147. Cable commenters generally urge that we restrict the role of franchising authorities hi the development and oversight of social contracts.321 The National Association of Telecommunications Officers and Advisors ("NATOA") urges the Commission to ensure that cable operators are not able to increase the rates, or decrease the quality, of regulated services under the guise of implementing a social contract322 Continental contends that NATOA's comments indicate the need to clarify Commission policy with respect to such contracts.323 Several commenters concur hi this conclusion.324 Cable Telecommunications Association ("CATA") seeks clarification regarding the level of upgrade that the operator must propose in order to qualify for the social contract, suggesting that such plans should be available "for any level of upgrade."325 CATA also argues mat our intention that an operator's rates be subject to review after some period of time will discourage operators from 317 Id. 318 Id. at 4690. 319 Id. 320 Id. at 4690-91. 321 Time Warner Comments at 37; NCTA Reply Comments at 19. 322 NATOA Comments at 2-3. 323 Continental Reply Comments at 19. 324 CATA Comments at 5-6; Falcon Reply Comments at 2. 325 CATA Comments at 6. 2279 pursuing social contracts.326 148. Commenters emphasize the need to maintain flexibility given the varying needs and circumstances of individual cable operators,327 although Continental urges us to articulate any particular priorities that will guide Commission review of proposed contracts.328 Falcon suggests that we prescribe certain requirements that generally must be included in every upgrade plan proposed in a social contract, such as minimum bandwidth capacity, fiber- to-the-node, and free wiring of public schools.329 Falcon also suggests the adoption of standardized cost information concerning the cost of constructing a mile of plant meeting the minimum requirements of the contract.330 Under this approach, operators would have to report their actual costs, but those costs would be accepted on their face if they did not exceed the standardized costs developed by the Commission. Falcon further asks for retroactive application of the social contract approach such that operators could use such plans to recover the costs of upgrades commenced or completed hi 1992, to the extent such costs were not reflected in prior rate increases.331 149. With respect to prospective upgrades that are the subject of social contracts, Falcon recommends that the operator be able to start recovering the cost of an upgrade upon completion of construction and certification to the Commission of the amount of those costs and that the upgrade conforms with the approved plan.332 Costs would then be amortized over seven to eight years, a figure which Falcon claims is based on the physical life of plant, obsolescence, and generally accepted accounting principles relating to depreciation.333 Costs would be allocated among regulated and unregulated services based on the percentage of bandwidth devoted to each type of service as a result of the upgrade, under Falcon's proposal.334 Falcon contends that the limitation on when an operator can adjust equipment rates via Form 1205 is inappropriate in the context of a social contract, because the upgrade 326 Id. 327 Continental Reply Comments at 19; Tune Warner Comments at 35. 328 Continental Reply Comments at 20. 329 Falcon Reply Comments at 3-4. 330 Id. at 4. 331 Id. at 3. 332 Id. at 5. 333 Id. 334 Id. 2280 schedule might not be synchronized with the window in which the operator has the opportunity to adjust such rates.335 150. Continental'contends that operators will have no incentive to commit to upgrades within the parameters of a social contract unless they are given the flexibility to raise rates for regulated services to the extent necessary to fund such upgrades.336 Continental encourages the use of a single social contract and upgrade plan for all of the systems of an MSO.337 151. Bell Atlantic supports the idea of social contracts, contending that they "not only will spur innovation by creating an incentive to develop and introduce new services, but will also promote infrastructure development"338 C. Discussion 152. Since the close of the comment period in this proceeding, the Commission has pursued the social contract experiment in several contexts. In one case, the Cable Services Bureau granted a joint petition by a cable operator and its franchising authority seeking approval of an upgrade incentive plan. Since then, the Commission has entered into social contracts with two large MSOs. This experience convinces us to adopt the social contract approach as part of our final rules. In addition, the terms of these specific arrangements should provide the guidance that commenters found lacking in our earlier discussions regarding social contracts. 153. For example, early this year the Cable Services Bureau approved a joint petition filed by Horry County, South Carolina and Horry Telephone Cooperative, Inc., a cable operator serving just under 15,000 subscribers in that county.339 Under the plan, the operator agreed to invest more than $8 million in a system upgrade designed to increase channel capacity and signal quality. The upgrade consisted of the installation of about 200 miles of fiber optics throughout its cable system so as to upgrade the system bandwidth from 220 MHz to 550 MHz, increasing the number of available program services from 22 to 47. In response to subscriber demand, the upgraded system would include a BST with fewer channels than on the old system at a substantially lower price. The plan also dictated rates for 335 Id. at 7. 336 Continental Reply Comments at 21-26. 337 Id. at 22. 338 Bell Atlantic Comments at 12. 339 In the Matter of Horry Telephone Cooperative, Inc. and Horry County, South Carolina, Memorandum Opinion and Order, DA 95-68, 10 FCC Red 2110 (1995). 2281 the new, expanded CPST and froze subscribers' existing rates until they were switched to the upgraded system. The four year agreement also addressed rate increases to be taken after the completion of the upgrade and equipment rates. 154. On August 3, 1995, the Commission adopted a social contract with Continental.340 The contract requires Continental to invest at least $1.35 billion to rebuild and upgrade all of its domestic systems between 1995 and 2000 and to make refunds to subscribers in settlement of pending BST and CPST cases. Continental will reduce BST rates by 15% to 20% and offset this reduction in a revenue neutral manner via adjustments to CPST tiers. Local franchising authorities will have the authority to review the restructured BST rates to ensure that they comply with the terms of the social contract and the Commission's rules. Local authorities also could opt out of the social contract with respect to certain terms affecting the BST. The social contract also governs the creation and rate regulation of migrated product tiers ("MPTs") and new product tiers ("NPTs"). 155. We have entered into a similar social contract with Time Warner.341 This contract requires Tune Warner to invest $4 billion in system rebuilds and upgrades between 1995 and 2000, including deployment of fiber optics technology, increased channel capacity and improved system reliability and signal quality. The Time Warner contract also calls for over $4 million in refunds to subscribers, the creation of a low-cost BST, free service connections to public schools and permits the creation of MPTs. This contract resolves 946 pending CPST cases and allows local franchising authorities to resolve pending BST cases. 156. Our experience with the plans and contracts described above supports the view of commenters who contend that the Commission should remain flexible with respect to the scope and terms of such arrangements. The Horry County plan involves the operator of a single system who serves fewer than 15,000 subscribers and who will be making an upgrade investment of about $8 million. By contrast, each of the two other agreements described above involve MSOs that serve millions of subscribers and that have agreed to invest billions of dollars in the upgrade. Likewise, while the two MSO agreements involve provisions for resolving existing rate cases, we have not limited social contracts to operators who are the subject of such cases. Therefore, while the social contracts that have been adopted or are pending establish some precedent in this area, we will remain flexible and invite operators to propose upgrade plans appropriate for their circumstances. For this reason, we will not adopt specific conditions that must be a part of every social contract, such as those proposed by Falcon. 340 In the Matter of Social Contract for Continental Cablevision, Inc., Order, FCC 95-335 (rel. Aug. 3, 1995). 341 In the Matter of Social Contract for Time Warner Cable, FCC 95-478 (rel. Nov. 30, 1995). 2282 157. We also decline to adopt specific restrictions on the role of franchising authorities with respect to social contracts. We agree with NATOA regarding the need to ensure that existing regulated service is maintained or improved in terms of price and quality, and local franchising authorities may play an important role in this regard. A comparison of the Continental and Time Warner social contracts demonstrates that the appropriate role of local franchising authorities will vary. Moreover, we expect and welcome the submission of plans that the operator has first to the franchising authority before even coming to us, as in the case of Horry County. In any event, we see no reason, or even avenue, for establishing general rules governing the role of franchising authorities. 158. We appreciate CATA's concern that a general threat of rate review at some point in the future could inhibit some operators from proposing social contracts. By the same token, however, we do not believe that a cable operator's compliance with the terms of a social contract, by itself, relieves the Commission of its continuing obligation to regulate the BST and CPSTs of any cable system that is subject to regulation under the 1992 Cable Act342 The solution lies in specifying the terms of such review in advance, as part of the social contract The plans and agreements that we have adopted to date provide an appropriate level of certainty for the operators, while allowing the Commission and local franchising authorities to protect subscribers from unreasonable rates for regulated services. Future agreements will contain similar provisions. 159. Establishing a standardized schedule of costs for installing a mile of plant, as Falcon suggests, would introduce an unnecessary layer of regulation. Adoption of such a proposal could require us to make a number of distinctions, such as between underground and overhead plant, and to make allowances for variations in the cost of labor and materials in different portions of the country. Moreover, any prescribed cost schedule would have to be updated periodically to take account of inflation and other variables affecting costs. We are not persuaded that the availability of such schedules would simplify matters for a sufficient number of operators to justify their adoption. 160. We will adopt, however, our proposal to require operators to seek advance approval of upgrades proposed for social contract treatment This condition should not burden operators since a prudent operator presumably would verify its eligibility for the incentive plan before committing to the upgrade, as opposed to waiting until after completion of the upgrade to determine the regulatory impact of its investment Moreover, requiring pre- approval will provide certainty to subscribers that the operator will be maintaining or improving current rates and quality with respect to existing services. In addition, we believe that retroactive application of the social contract approach is unwise. The purpose of this approach is to give operators incentives to commit to upgrades that they might not otherwise undertake, rather than to provide additional rewards for upgrades that the operator deemed necessary independent of our rules. As to such upgrades, our existing rules should permit 342 Communications Act, § 623(a)(2). 2283 operators to recover their costs in any event XIV. HARDSHIP RATE RELIEF A. Background 161. In the Cost Order, the Commission recognized that, in certain extraordinary cases, rate regulation under either the benchmark or cost of service mechanisms would threaten an operator's financial health or ability to provide service.343 In such situations, an operator may obtain special rate relief by demonstrating that rate regulation using either of the two standard rate-setting options would cause such financial harm that the operator would be unable to attract capital or maintain credit necessary to operate, despite prudent and efficient management344 The operator must show that the requested rate relief would not be unreasonable or exploitative of customers.345 In other words, rates cannot be excessive compared to competitive rates of similarly situated systems.346 Hardship showings must be made for the MSO level, or the highest level of the operator's cable system organization.347 Operators that submit an adequate initial showing of facts which, if proved, might warrant special relief, are subsequently given the opportunity to prove the facts alleged in the showing.348 B. Comments 162. Cablevision Industries Corporation ("CVT) argues that the hardship rule delays adequate relief because it requires that the standard rate-setting approaches be exhausted first349 CV1 complains that further delay is caused by requiring an initial showing as part of a two-step process.350 CVI claims that such delays in the process could be critical 343 Cost Order, 9 FCC Red at 4676. 344 Id at 4677. 345 Id 346 Id 347 Id 348 Id 349 CVI Petition for Reconsideration at 5. 350 Id at 5-6. 2284 for an operator that is suffering financial difficulties sufficient to warrant hardship relief.351 Since hardship relief is a safety net to prevent confiscatory rate regulation, CVI notes that undue burdens on its use have Fifth Amendment repercussions.352 CVI believes a one-step hardship process without the exhaustion requirement would cure this constitutional deficiency.353 163. CVI argues that the hardship rule suffers other defects as well. Hardship showings based on total revenues from cable operations at the highest organizational level sweep unregulated revenues into the assessment of hardship, which CVI claims is outside the Commission's jurisdictional authority.354 In addition, CVI asserts that operators should be able to make hardship showings at whatever level of the organization is most appropriate given the specific circumstances of the company.355 Not only does the 1992 Cable Act contemplate rate regulation at the franchise or system level, but hardship showings at the MSO-wide level will force operators to divert resources from healthy systems to unhealthy ones, jeopardizing service quality of the otherwise healthy systems.356 Finally, CVI argues that competitive rates prevailing at similarly situated systems should not be a regulatory ceiling on rates sought in a hardship application.357 CVI contends that if hardship rates cannot exceed competitive rates, the hardship process is rendered meaningless because operators seeking special relief have already determined mat they cannot survive by charging rates permitted under the Commission's standard rate-setting approaches.358 C. Discussion 164. It appears that CVI misunderstands the requirement mat an operator applying for hardship relief must first demonstrate the insufficiency of rates permitted by the benchmark or cost of service schemes. Contrary to CVTs apparent misperception, an operator applying for hardship relief is not expected to "proceed through the regular regulatory 351 Id. at 6. 352 Id. at 3-4. 353 Id. at 7-8. 354 Id. at 8-9. 355 Id. at 9-10. 356 Id. at 10. 357 Id. at 11. 358 Id. 2285 processes"359 in any formal manner by first filing benchmark or cost of service forms. It is true that the operator, in order to demonstrate eligibility, must determine what its rates would be using standard rate-setting methods, but such an exercise is necessary in order for the operator to conclude that the resulting rates would have severe financial consequences. We do agree with CVI, however, that the process could be shortened by eliminating the requirement of an initial showing. We will therefore allow operators to combine the requirements of the initial factual showing and the subsequent evidentiary showing into one pleading. 165. We disagree with CVI that we are not authorized to consider an operator's unregulated revenues when determining eligibility for hardship relief. An evaluation of an operator's financial health that is based on only a portion of the operator's revenues would be incomplete and inaccurate. Similarly, it is appropriate to consider a hardship pleading in light of an operator's revenues measured at the highest level of the operator's organization. Hardship relief is an extraordinary relief measure reserved for operators whose overall financial health would be seriously threatened under the standard rate regulation mechanisms. It is not designed to bail out struggling cable systems that are owned and operated by prosperous MSOs. Lastly, the requirement that rates cannot be excessive compared to competitive rates of similarly situated systems does not mean that rates cannot exceed competitive rates. Rather, we expect operators to show that their rates would not exceed competitive rates to a degree that would be unreasonable. XV. PROCEDURAL ISSUES A. Background 166. In the Cost Order, we sought to adopt procedural requirements and options that would minimize regulatory burdens for operators and regulators, while ensuring the accuracy of the rate-setting process. We provided generally that after setting initial regulated rates under either the benchmark or cost of service approach, cable operators may not use the cost of service rules to set a new rate for two years.360 This limitation provides for rate stability and minimizes regulatory burdens, while allowing operators the ability to make a reasonable return. The two-year period is measured from the effective date of the rates set in a franchising authority or Commission order.361 Operators who believe it necessary to file a cost of service showing before the end of two years may seek a waiver in accordance with our general rules governing such relief.362 359 Id. at 5. 360 Cost Order, 9 FCC Red at 4541. 361 Id. at 4541, n. 42. 362 Id. 2286 167. Other than the two-year limitation, we placed no restrictions on a system's eligibility to make a cost of service showing.363 Moreover, we declined to give franchising authorities the option to initiate cost of service proceedings.364 B. Comments 168. Cable operators suggest a number of adjustments to the procedures by which cost of service filings are reviewed. Some argue that operators should be entitled to notice from regulators of specific perceived defects in their cost of service filings and be given an opportunity to correct those defects.365 For cost of service cases, operators seek to extend the 30 day period following the initiation of regulation hi which they are required to make their filing.366 Operators also seek the right to obtain and respond to consultants' reports or other analyses upon which a regulator proposes to rely hi setting the cable operator's rates.367 169. Continental urges the Commission to clarify that regulators may approve maximum reasonable rates below which a cable operator would be granted pricing flexibility without being subject to a new rate review each time a price is changed.368 For example, Continental maintains that a cable operator whose rates have not increased more man inflation since the beginning of deregulation under the 1984 Cable Act should not be put to the burden of a full cost of service defense in the absence of some specific evidence not merely a complaint that its current rates are too high.369 Continental also recommends that the Commission clarify mat the two year limit on filing cost of service cases does not apply when the operator has been called upon to justify existing rates.370 170. Continental also urges the Commission to clarify the level of detail 363 Id. at 4543. 364 Id. at 4543-44. 365 Continental Comments at 73-74; Avenue TV Comments at 12-13. 366 Continental Comments at 76; Avenue TV Comments at 12-13. 367 Continental Comments at 74-75; Avenue TV Comments at 12-13. 368 Continental Comments at 66-69. 369 Id. 370 Id. at 77-79. 2287 required of operators with respect to various data called for by Form 1220.371 Operators should be permitted, or even required, to file electronically, according to Continental.372 Continental asks us to clarify that Commission staff and an operator that is the subject of a pending rate case are free to make inquiries of each other concerning the matter.373 Continental also suggests that Commission staff meet with the operator before issuing a decision, if necessary to ensure the completeness of the record.374 Continental asks that we not deem cost of service cases as restricted proceedings for purposes of our ex parte rules, such that any party to the proceeding may submit unsolicited filings and otherwise initiate contact with the Commission, subject only to the requirement that all parties be served with notice of the contact375 171. Finally, Continental argues that when making judgments in individual cost of service cases, franchising authorities and the Commission should exercise discretion in the cable operator's favor.376 First, Continental contends that the Commission's relatively recent entry into the area of cable rate regulation suggests that it should be reluctant to question the discretionary judgment of cable operators. Second, rate regulation burdens cable operators in the exercise of their First Amendment rights and therefore the Commission must ensure that such regulation is "narrowly tailored to implement a significant governmental purpose," according to Continental.377 In particular, Continental contends, the First Amendment requires that operators be permitted to charge the highest reasonable rate available since mandating any lower rate would impermissibly burden protected speech.378 172. Tune Warner states that the Commission should allow cable companies to readily switch between cost of service and benchmark elections.379 Time Warner claims that such flexibility is necessary hi order to permit the most efficient pricing by cable 371 Continental Reply Comments at 27. 372 Id. at 28-29. 373 Id. at 29. 374 Id. at 31. 375 Id. at 33. 376 Continental Comments at 70-73. 377 Id. at 71, citing Riley v. National Federation of the Blind, 487 U.S. 781, 790 (1988). 378 See also Public Interest Petitioners Petition for Expedited Reconsideration at 13-14. 379 Time Wamer Comments at 15-16. 2288 companies.380 TCI argues that the cost of service rules are exceptionally burdensome and asks the Commission to search for ways to lessen the burden of such showings, for the benefit of operators, regulators, and subscribers.381 173. Avenue TV also supports regulations that ease the burden on operators who may be called upon to justify rates through a cost of service showing.382 Avenue TV proposes that any operator who has made such a showing and has not made any subsequent rate increase not be required to make any additional showings as a result of a complaint.383 In the alternative, Avenue TV proposes that any cost of service -filing in response to a complaint should relieve the cable provider of the obligation to file further cost of service filings in response to future complaints for two years.384 On the other hand, Avenue TV believes that if an operator deems it necessary, it should be permitted to make a cost of service showing within two years of initially setting its rates.385 174. Avenue TV argues that smaller cable systems are substantially different from both larger cable systems and telephone companies.386 Avenue TV maintains that these differences create different difficulties for small cable providers and warrant a different regulatory scheme.387 C. Discussion 175. We believe the current procedures generally strike the appropriate balance between minimiring regulatory burdens and achieving rates that are both fair to the operator and reasonable to subscribers. Most of the changes urged by commenters would disrupt this balance either by complicating and delaying the manner in which rates are set, or by compromising our efforts to protect consumers from unreasonable rates. 176. In particular, we will not require franchising authorities to produce 380 Id. 381 TCI Reply Comments at 11-12. 382 Avenue TV Reply at 11. 383 Id. ™Id. 3K Id. 386 Id. at 2. 387 Id. 2289 reports or analyses on which they rely in making their decisions. When an operator has made a cost of service showing and has submitted any additional data that the franchising authority requests, the franchising authority should then be in a position to determine the reasonableness of the rate that the operator has sought to justify.388 Moreover, sufficient justification for a franchising authority's decision should be provided in its written order. We see no reason to add to the administrative process by prohibiting the issuance of a decision until the franchising authority has shared its reasoning and analyses with the operator and given the operator an opportunity for rebuttal, particularly given our obligation to minimise regulatory burdens.389 177. Moreover, we have imposed upon the operator the burden of proving the reasonableness of its rates.390 We believe its position should stand or fall on the merits of the filing it has chosen to make. Forcing franchising authorities to turn over their analyses and reports essentially would permit operators to be less than exact when making their initial showing. We decline to adopt a procedure that might encourage inaccurate reporting and that would inevitably slow the ratemaking process. Of course, this does not preclude an operator from challenging a rate decision and its underlying analysis, since the operator can appeal to the Commission from a decision of a local franchising authority.391 178. There may be situations in which some dialogue between the operator and the franchising authority, including the sharing of data and analyses, may be useful in resolving differences and avoiding an appeal. Franchising authorities are free to pursue such a course when they deem it appropriate and we encourage them to do so. However, we believe that the franchising authority is in the best position to determine whether such a resolution is realistic in any given case. Therefore, we will not mandate the production of data by franchising authorities, but will leave that decision to the discretion of the franchising authority.392 179. Contrary to Continental's suggestion, we do not believe that serious 388 By requesting authority to regulate rates, a franchising authority certifies that it can and will regulate rates in accordance with our rules. Communications Act, § 623(a)(3). 3g9 Communications Act, § 623(b)(2)(A). 390 47 C.F.R. § 76.937(a). 391 47 C.F.R. § 76.944. 392 The Cable Services Bureau exercises analogous discretion when reviewing cost of service filings submitted directly to it, such as in response to a CPST complaint For the reasons stated above with respect to local franchising authorities, we will not require that operators be notified of errors or deficiencies in their filings to the Bureau as a matter of course. 2290 First Amendment concerns are raised by our cost of service rules, including the associated presumptions and the imposition upon operators of the burden of establishing the reasonableness of their cost of service showings. Our rate rules are subject to an intermediate standard of review under the First Amendment, and not strict scrutiny as Continental contends.393 Therefore, the government's interest in promulgating the rules "must be important or substantial and the means chosen to promote that interest must not substantially burden more speech that necessary to achieve the government's aims . . . "m The importance of the government's interest in regulating cable rates has been established.395 Thus, the remaining issue is whether the cost of service rules "substantially burden more speech than necessary,"396 or, to put it differently, whether the government's interest "would be achieved less effectively absent the regulation."397 180. We have no doubt that the cost of service rules survive this test First, the rules apply only when, and for so long as, there is an absence of effective competition.398 Second, in adopting the individual provisions of the rules, we have explained why our restrictions and presumptions are necessary to ensure the reasonableness of rates. In other words, we believe that the interests underlying the 1992 Cable Act "would be achieved less effectively" were we to recast the rules hi the manner suggested by Continental. More specifically, we reject the contention of Continental that we must permit operators to establish rates "at the very top of the zone of reasonableness,"399 since Continental bases that conclusion on the incorrect premise that our rules are subject to strict scrutiny. We believe our rules allow for rates well within the zone of reasonableness and therefore do not substantially burden more speech than necessary. We therefore reject Continental's argument that we must adopt rules that will set rates at the top of the zone of reasonableness hi order to avoid unconstitutionally impinging on operators' First Amendment rights. Finally, despite Continental's claims to the contrary, we believe that requuing operators to rebut the presumed 393 Time Warner, 56 F.3d at 184. In Time Warner, the court specifically rejected the argument, made by Continental here, that the Supreme Court's decision hi Riley mandates the application of strict scrutiny to cable rate regulation: "The analogy of this case to Riley fails at several critical junctures." Id. at 182. 394 Id., citing Turner Broadcasting Sys., Inc. v. FCC, 114 S.Ct 2445, 2469 (1994). 395 Time Warner, 56 F.3d at 184. 396 Id., citing Turner, 114 S.Ctat 2469. 397 Time Warner, 56 F.3d at 184, citing United States v. Albertini, 472 U.S. 675, 689 (1985). 398 See Time Warner, 56 F.3d at 185-86. 399 Continental Comments at 71. 2291 applicability of our uniform rules on a case-by-case basis is a necessity if the goals of the 1992 Cable Act are to be achieved.400 The alternative would be tantamount to allowing individual operators to dictate the presumed parameters of their cost of service showings, which would be "unworkable in light of administrative burdens such a scheme would entail."401 181. The issue of deficient filings by cable operators was addressed in the context of benchmark showings in a previous order.402 In that order, we concluded that when a cable operator files a facially incomplete form, the franchising authority or the Commission may order the operator to file the supplemental information necessary to determine the reasonableness of the operator's rates.403 While the franchising authority is waiting to receive the additional information, the deadlines applicable to its authority to rule on the rates are tolled.404 The operator must be given a reasonable time in which to supply the requested data.405 An operator that fails to meet the deadline can be deemed in default and be subject to sanctions.406 We adopt the same guidelines with respect to incomplete cost of service showings.407 182. We decline to adopt the alternative rate-setting methods proposed by Continental, such as mandating that operators be permitted to set rates at the highest reasonable rates permitted by traditional cost of service principles or allowing greater pricing flexibility to operators that have had no rate changes since 1984. The cost of service rules establish a uniform procedure that enables cable operators to cover their operating expenses and to make a reasonable return on their investment, while protecting consumers from 400 See Rate Order, 8 FCC Red at 5798. 401 Time Warner, 56 F.3d at 186. 402 Third Order on Reconsideration in MM Docket Nos. 92-262 & 92-266 ('Third Reconsideration Order"), FCC 94-40, para. 86-92 (rel. March 30, 1994). 403 Id. at para. 88. 404 Id. at para. 88. 405 Id. at para. 90. 406 Id. 407 We have drawn a distinction between an incomplete filing and a filing that is complete and submitted in good faith but as to which the regulating authority reasonably decides it needs additional information or clarification. Third Order on Reconsideration at para. 89. In the latter case, a request for more data will not automatically toll the franchising authority's deadlines. Id. 2292 unreasonable rates. While we could permit operators to attempt to show that these same goals can be achieved by a variety of other methods, possibly including those proposed by Continental, we believe that confusion and lack of uniformity would outweigh any benefits that might result 183. With respect to timing issues, we will maintain the requirement that the operator justify its rates within 30 days of receiving notice from the franchising authority. There is no evidence that operators are unable to comply with this deadline. Moreover, extending the deadline would simply slow the ratemaking process and postpone the implementation of the reasonable rates to which subscribers are entitled. Likewise, we do not believe operators should be permitted to make filings, or switch between the benchmark and cost of service methodologies, more often than our current rule permits. Given the ability of operators to adjust rates pursuant to the price cap mechanism, we cannot envision that a prudent operator would need to re-establish rates more often than is currently permitted. More frequent filings will only confuse subscribers and increase the burden on regulators. 184. However, we agree with commenters who cite the inefficiency of requiring a cable operator that has made one cost of service showing in response to a CPST complaint to make a separate showing every time an additional complaint is filed. Since the maximum permitted rates generated by an initial cost of service showing often are based on data from the most recent fiscal year, a subsequent showing within the next 12 months could be based on the same test year data and would generate the same permitted rate, exclusive of any adjustments made under our price cap requirements or the going forward rules. While a subsequent cost of service showing in the second year following rate regulation might generate lower rates, it might also generate higher rates. Either way, in most cases the difference would likely be minimal, particularly in comparison to the effort that operators and the Commission must expend to go through the rate review process. Any possible advantage of requiring such repetitive filings would be outweighed by the associated administrative costs. Moreover, we note that except in hardship cases, operators are prohibited from making a cost of service showing more than once every two years.408 It seems unfair to subject operators to the threat of having to submit multiple cost of service filings within that two year period in response to complaints, while we prohibit operators from using the cost of service rules to adjust rates upward during that period. Accordingly, regulatory approval of a rate generated by a cost of service showing will be dispositive of all complaints filed with respect to that rate for the two year period beginning when the rate is instituted. Of course, this does not exempt the operator from having to justify any rate increase taken during the two year period upon the filing of a valid complaint concerning that increase. 185. As for smaller cable systems and operators, in the Sixth Report and Order and Eleventh Order on Reconsideration we adopted a streamlined cost of service approach for small systems owned by small cable companies. We believe this approach 408 47 C.F.R. § 76.923(k). 2293 adequately responds to the comments raised in this proceeding with respect to such entities. XVL OTHER MATTERS 186. There are five remaining issues that were raised in the Cost Order and/or the Further Notice which, for various reasons, we can dispose of with relatively little discussion. First, the Further Notice proposed adoption of a productivity offset409 The purpose of such an offset is to take account of efficiency gains enjoyed by cable operators that reduce the impact of inflation. To the extent cable operators enjoy such gains, the productivity offset would limit the ability of operators to adjust rates to reflect inflation. We resolved this issue in a previous order by declining to adopt a productivity offset.410 We will address a pending petition for reconsideration of that order411 in the near future. 187. Second, in the Cost Order we adopted an abbreviated cost of service procedure for use by independent small systems and small systems owned by small MSOs, as those terms were then defined.412 As with all other aspects of the interim cost rules, we proposed to adopt this treatment of small systems as part of our final cost rules.413 In a subsequent order, we redefined a small system as one serving 15,000 or fewer subscribers,414 created a new class of operator, known as the small cable company, consisting of operators that serve 400,000 or fewer subscribers over all of their systems,415 and established a new rate-setting scheme, known as the small system cost of service methodology, mat gives small systems owned by small cable companies greater flexibility to establish rates in accordance with their particular needs and hardships via a simplified cost of service showing.416 With the adoption of the Sixth Report and Order and Eleventh Order on Reconsideration, we have established a comprehensive scheme of rate regulation for small systems, including the new small system cost of service methodology, thus resolving all of the issues raised in this 409 Further Notice, 9 FCC Red at 4686-89. 410 Memorandum Opinion and Order, MM Docket No. 93-215, FCC 94-226, 9 FCC Red 5760 (1994). 411 Petition for Reconsideration of Bell Atlantic in MM Docket No. 93-215 (filed Nov. 14, 1994). 412 Cost Order, 9 FCC Red at 4671. 413 Further Notice, 9 FCC Red at 4681. 414 Sixth Report and Order and Eleventh Order on Reconsideration, 10 FCC Red at 7406. 415 Id. 416 Id. at 7418-28. 2294 rulemaking with respect to small systems. Pending petitions for reconsideration of that order shall be addressed separately. 188. Third, the Cable Services Bureau recently issued a Public Notice soliciting comment on proposed Form 1235, an abbreviated cost of service form to be used to recover the cost of significant network upgrades.417 In the Cost Order, the Commission delegated to the Bureau the authority to develop such a form and prescribed the conditions in which a cable operator could use the form.418 In general, this approach permits operators to raise rates by reporting only the cost of a system upgrade, rather than all current costs. The recoverable amount of such capital improvements may be added to a system's benchmark rate, as adjusted by the price cap, to generate a maximum permitted rate.419 Continental recommends that the Commission clarify that all operators are permitted to make streamlined cost of service showings to reflect major upgrade costs in rates, regardless of whether the initial permitted rate is established under the benchmark or cost of service principles.420 In addition, Continental requests that the Commission allow cable operators to justify and implement rate increases to cover the cost of a system upgrade according to a reasonable schedule provided by the operator, and not force a delay until the entire upgrade is completed.421 Other commenters contend mat it would be simpler and more reasonable to permit upgrade costs as external pass-throughs, at least for those systems whose capped rates have been determined pursuant to a cost of service showing because these operators already have shown that the costs for the existing system justify more than the benchmark rate.422 NATOA opposes proposals to treat upgrade costs as external costs.423 NATOA states that treating upgrade costs as external costs would give cable operators an opportunity to undermine rate protections granted cable subscribers.424 According to NATOA, permitting external cost treatment of upgrade costs would make a mockery of the Commission's 417 Public Notice, DA-1893 (September 19, 1995). 418 Cost Order, 9 FCC Red at 4674-76. 419 Id. at 4676. 420 Continental Comments at 57-58. 421 Id, at 58-62; see CATA Comments at 4. 422 CATA Comments at 2; see Public Interest Petitioners Petition for Reconsideration at 13-14; Office of Communication of the United Church of Christ Reply Comments at 2-3. 423 NATOA Opposition to Petitions for Reconsideration at 3-5. 424 Id. at 4. 2295 benchmark system because substantial rate increases would likely follow.425 The Public Interest Petitioners respond that regulators would be in a position to ensure that unreasonable rates will not result because regulators can examine rate increases and only allow the pass- through of legitimate upgrade costs.426 Time Warner recommends that the role of franchising authorities be limited to that of implementation.427 As noted, the Cable Services Bureau, acting on delegated authority, has sought comment on a proposed form to be used by operators seeking to recover the cost of network upgrades. Since that form is currently subject to review by the Office of Management and Budget, and in the interests of administrative efficiency, we will resolve all outstanding issues concerning network upgrades and Form 1235 at a later time. 189. Fourth, in the Report and Order and Further Notice of Proposed Rulemaking, the Commission proposed the development of average cost schedules428 for regulated cable services and equipment429 We stated that an "average schedule" regulatory scheme had been adopted for the provision of interstate access by some telephone companies, and suggested that a similar scheme may be appropriate for the purposes of cable rate regulation. The Commission tentatively concluded that average cost schedules should be established for the provision of regulated cable service and equipment430 The Commission has stated that an average cost schedule could "reduce administrative burdens by obviating the need for identification of individual system costs."431 However, the Commission also noted that the feasibility of establishing such a schedule would depend on the "availability of sufficient representative cost data for the determination of average costs."432 Accordingly, we have recently initiated a cost survey, and we will address the issue of the creation of average cost schedules following our analysis of the data we receive. 425 Id. 426 Public Interest Petitioners' Reply at 5. 427 Time Warner Comments at 34-35. 428 These cost schedules would allow cable operators to justify rates based on the average costs reported by all systems, or categories of systems with similar characteristics, as opposed to justifying rates based on the costs associated with running one particular system. 429 Further Notice, 9 FCC Red at 4691-93; see also Cost Notice at f 74. 430 Cost Order, 9 FCC Red at 4692. 431 Cost Notice at 1 74. 432 Id 2296 190. Finally, Media General seeks reconsideration of our interim cost rules to the extent they require an operator to offset operating expenses by an amount equal to the revenues earned for cable advertising operations.433 Media General argues that expenses should be offset against revenues on a channel-by-channel basis, thereby limiting the amount of revenues allocated to a particular channel to the amount of the expenses allocable to that channel.434 This would be consistent with two decisions of the Cable Services Bureau regarding revenue offsets in the context of external costs, according to Media General.435 In addition, Media General asserts that the offset requirement should apply only to the BST, to ensure that operators have sufficient incentive to add channels to the CPST.436 With respect to the amount of the offset, we first note that after Media General filed its petition for reconsideration, we eliminated the requirement that when adding a channel an operator must offset its permitted per channel mark up by the amount of revenues earned as a result of that addition.437 We determined that requiring operators to offset the mark up with home shopping sales commissions created a disincentive for operators to add home shopping services.438 However, there was and is good reason to distinguish between offsets in the context of channel additions and offsets in the context of overall rate justifications. When setting or justifying regulated rates initially, the goal of our cost of service rules is to allow an operator to earn a reasonable return on its investment, after covering the expenses associated with regulated services. Offsetting the aggregate expense of providing those regulated services by the aggregate amount of revenues associated with those services falls squarely within this approach. On the other hand, when adding a single channel, we have eliminated any revenue offset to the amount of the cost of adding that channel. By reducing or eliminating the operator mark-up when home shopping channels raise sales commissions for operators, the offset requirement effectively penalized the operator, and home shopping channels indirectly, by taking away the mark-up simply because many customers in the operator's territory purchase products from the home shopping service. As for limiting the scope of the offset requirement to revenues associated with the BST, we believe that the going forward rules, adopted hi the Sixth Order on Reconsideration after the filing of Media General's petition, create the incentive to add channels advocated by Media General. 433 Media General Petition for Reconsideration at 9. 434 Id, at 10. 435 Id., citing Letter from Chief, Cable Services Bureau to Home Shopping Network (May 6, 1994); Letter from Chief, Cable Services Bureau to QVC Network, Inc. (May 6, 1994). 436 Id. at 10-11. 437 Thirteenth Order on Reconsideration, MM Docket Nos. 92-266 & 93-215, FCC 95-343 (rel. Aug. 8, 1995). 438 Id. 2297 XVIL APPLICABILITY OF THE FINAL RULES GENERALLY 191. For pending cost of service cases, we will allow operators to choose between the interim rules and the final rules, except hi cases where there has been a final rate decision made by the franchising authority before the effective date of the final rules. Although in the Cost Order we stated our intention to apply our interim rules to proceedings relating to rates during the period in which such rules were in effect,439 upon further reflection we believe that giving operators a choice is warranted under these circumstances. Since the final rules reflect our refined view of where rates should fall within the zone of reasonableness, we believe it is fair to offer operators a choice. Moreover, we believe *h?t, because both sets of rules result hi reasonable rates, offering operators this choice will give them a degree of flexibility that may have a favorable impact on their infrastructure plans. In addition, we wish to minimize the possibility of imposing upon operators with two or more systems the burden of applying one set of rules to some systems and another set of rules to other systems, particularly given that in some instances our rules permit system rates to be based on data applicable to a higher level of operations, such as MSO-wide data.440 However, we do not intend for cable operators with pending cases to make entirely new showings based on the new rules. Rather, we simply direct the Cable Services Bureau and local franchising authorities to follow the final cost rules in reviewing pending submissions to the extent possible, requiring the minimum additional information necessary to apply the new rules. 192. The notion of administrative finality suggests mat we review cases already decided by a final decision of the franchising authority in accordance with the rules in effect when those decisions were made, i.e., the interim rules. Notwithstanding this conclusion, we note mat most of our interim rules, including those governing treatment of start-up losses, intangible assets and rate of return, are presumptions which can be rebutted by an adequate showing by the operator. Those presumptions were derived from previous observations that we have now refined in the course of adopting final rules. Therefore, hi any case decided by a local franchising authority according to the interim rules and then appealed to the Commission, the operator may seek to overcome one or more of the interim presumptions by citing the Commission's refined analysis of the particular issue, as set forth herein. In addition, in pending cases, operators mat made cost showings in accordance with the interim rules and that would prefer to have their cases decided accordingly should be permitted to do so, rather than revisiting their filings to decide whether to make a supplemental showing hi light of the revised final rules. Rather than creating uncertainty or 439 Cost Order, 9 FCC Red at 4532, n. 5. 440 In view of the differences between the final and the rnteTrrnfrules, some operators with pending cases may be inclined to make supplemental filings, while some regulators may deem it appropriate to make requests for additional data. We expect such matters to be resolved on a case-by-case basis, in accordance with our standard procedures. 2298 additional burdens for such operators, we believe it more reasonable simply to let them elect to have their showings decided in accordance with the interim rules. 193. In pending cases in which an operator must make an election (i.e., any case in which a franchising authority has not issued a final decision), an operator must submit written notice of its election, either to the franchising authority or to the Commission, only if the operator chooses to have its cost of service showing decided in accordance with the interim rules. This notice should be submitted within 30 days of the effective date of this Order. An operator need not take any action if it elects to have the final rules applied to a pending rate proceeding, since the failure to submit a written notice shall be deemed an election to have the final rules applied to the case. XVm. FURTHER NOTICE OF PROPOSED RULEMAKEVG A. Non-Unitary Rates of Return 194. Our experience with rate regulation of the cable industry and the record in this proceeding leads us to consider exploring an alternative to the presumptive unitary rate of return for cost of service filings by cable operators. We continue to recognize that a unitary rate applied to all cable operators making a cost of service filing simplifies administrative burdens. It may do so, however, at the cost of squeezing a wide variety of risk profiles into the same regulatory box. We tentatively conclude that risk variables among cable operators may be widespread enough to justify consideration of an alternative rate of return methodology tailored more closely to the financial circumstances of individual cable operators. At the same time, we continue to recognize that more individualized rates of return pose the risk of more detailed and potentially more burdensome capital cost determinations in cable rate cases. These burdens can impact operators as well as regulators. Accordingly, if we adopt a more tailored rate of return methodology, we will nonetheless retain the current presumptive rate, and its concomitant procedures for overcoming that presumption, as an alternative to any new methodology. By retaining the presumptive rate alternative, we allow operators the flexibility of keeping the cost of service proceeding as simple as possible. 195. An overview of cable industry capital costs indicates that the capital markets themselves recognize a significant measure of risk within the cable industry. Cable stocks trade at significant premiums relative to overall markets, and have high debt costs due to low investment grades. To some degree, this is a consequence of the substantial leverage mat characterizes the cable industry generally. Nevertheless, it is a risk factor that the markets do not overlook. Furthermore, a fair proportion of homes passed by cable do not subscribe to the service, underscoring consumer and business perception of cable as a service that is not essential in a traditional utility sense. Against this backdrop, cable industry investors recognize a significant range of risk associated with the purchase of cable equity. 196. Under these circumstances, we believe it may be necessary to recognize the risk diversity within the cable industry. Recognition of such risk may require that we 2299 evaluate the implicit capital cost assumptions that are used to establish the regulatory rate of return for cable operators. Moreover, given the differences in critical risk variables within the cable industry itself, we no longer presume that a single rate of return should be administered across the spectrum of cable operators making cost of service filings. These differences may become more pronounced as non-cable entities begin their entry into markets that would otherwise be served by traditional cable operators. If, for example, a large telephone company sought capital to build a cable system that would eventually compete against a highly leveraged incumbent operator, we question the reasonableness of presuming that the capital cost of the entering telephone company would mirror the capital cost of the incumbent operator. At the same time, we remain mindful of the difficult burdens individualized estimations of capital cost would entail. Accordingly, we seek comment on an alternative to the presumption that an 11.25% rate of return appropriately establishes the capital cost for providing regulated cable service. This alternative method, discussed in more detail below, would provide an equity cost estimate that recognizes the historic growth orientation of cable investors. This alternative method would also allow actual debt cost, and use capital structures based on actual debt and the market value of cable equity. Several comments were filed in this proceeding regarding the rate of return calculation, and we will address these comments in the context of the following methodology discussion. B. Cost of Equity 1. Background 197. The cost of equity represents the investment return necessary to entice investors to take an ownership interest hi the company. For purposes of the interim rule, we determined equity cost under a discounted cash flow (DCF) methodology. Under this method, the S&P 400 was used as a general surrogate for estimated risks of regulated cable service. The equity cost range reflected risks in the third quartile of the S&P 400, leading to an equity cost range of 12% to 15%.441 This range was incorporated in the calculation of the overall rate of return. The Commission declined to use the capital asset pricing model (CAPM) as an alternative method of calculating equity cost Based on information available to the Commission during consideration of the interim cost rule, the Commission determined that the estimation of cable equity risk premiums (betas) essential to implementation of the CAPM approach were not reliable indicators of risk associated with providing regulated cable service. This determination was based on potential distortions in the assessment of cable equity volatility due to insider transactions and the anticipated exercise of monopoly power by cable companies.442 Comments 441 Cost Order, 9 FCC Red at 4626. 442 Cost Order, Attachment D at 8-10. 2300 198. Commenters have raised several issues regarding the equity cost calculation. Principally, these arguments focus on the propriety of the DCF methodology for estimating equity cost and whether an alternative method of calculating equity cost would prove more reliable. Continental, for example, challenges the propriety of the DCF method, arguing that it is an inappropriate measure of equity cost because the DCF method relies on dividends as an integral part of its formula. According to Continental, equity investors in the cable industry seek added value through stock price appreciation rather than consistent return in the form of dividends. The capital asset pricing model (CAPM), Continental suggests, would be a superior method of estimating equity cost for cable companies.443 Continental has submitted an expert analysis by Dr. A. Lawrence Kolbe that compares the equity cost impact of dividend payments. The analysis concludes that dividend-paying stocks in the S&P 400 achieve similar equity rates of return when calculated under either the DCF model or CAPM approach. On the other hand, Kolbe estimates mat non-dividend-paying stocks have equity costs two to three points higher than stocks that pay dividends. Applied to the cable industry, Kolbe estimates that cable stocks should receive an equity return of 17.5% with a capital structure that is 50% equity. He further asserts mat, as a practical reality, the equity return should be higher because the cable operators as a whole have higher proportions of debt in their capital structures than the proportion assumed in his analysis.444 Kolbe also concludes that the degree of insider holdings or transactions do not distort cable company betas. He asserts that insider holdings do not impact cable stock prices when the behavior of cable equities is adjusted for variations in financial risk caused by debt burdens.445 199. NCTA also challenges the use of the DCF method. It argues that alternative methods of estimating equity cost were inappropriately dismissed by the Commission. According to NCTA, there is insufficient data to support the assumption that the covariance of cable stocks with the overall market is related to monopoly profit expectations or the degree of insider holdings. In addition, NCTA asserts that the performance of small stocks would serve as a better surrogate for cable company stocks than the S&P 400 because the investment orientation of smaller stocks generally mirrors the growth orientation of cable equities.446 443 Under the capital asset pricing model (CAPM), equity cost is calculated by assigning an equity premium to a company's stock mat is commensurate with the stock's systematic risk (risk that cannot be avoided through equity diversification). Under this model, a stock's equity rate of return is equal to the risk-free rate (obtainable on a risk-free government debt instrument) plus a premium based on the systematic risk of a given security. See J. Van Home and J. Wachowicz, Fundamentals of Financial Management at 112 (1992). 444 Continental Comments at 49-51. 445 Continental Comments, Exhibit G at 39-43. 446 NCTA Comments at 43-44. 2301 3. Discussion 200. We tentatively conclude that the CAPM represents a reliable method of calculating the cost of cable equities as an alternative to the DCF approach employed in the Cost Order. The use of the CAPM avoids reliance on equity class surrogates for an analysis of cable industry returns. Instead, it appears that the CAPM may constitute a more direct method of measuring the risk premium that investors place on cable company equities due to risks inherent to the industry itself. Moreover, use of the CAPM can more accurately reflect the investor orientation that drives individuals and institutions to purchase the stocks of cable companies. As a general matter, the DCF method employed in the Cost Order depends heavily on the consistent payout of dividends as a key component of its formula, a factor that simply does not apply to cable equities. We believe the absence of dividends may reflect fundamental differences in the strategic nature of cable business operations and the operation of companies whose stocks make up the broad S&P 400 stock index. We believe the equity cost formula applied to the cable industry should recognize any such differences and how they impact the risk-reward ratio of cable investments. Thus, if an operator chooses to forgo the 11.25% presumptive rate of return in favor of the more tailored alternative to capital cost calculation proposed in this Further Notice of Proposed Rulemaking, we propose to apply an equity cost estimated under CAPM principles, as described below. 201. On the record before us, we believe that the DCF method may suffer major shortcomings when applied to the cable industry. Under the DCF method, the cost of equity equals the current dividend yield (dividend divided by current stock price) plus the long-term estimated growth rate of a company's earnings and dividends. Although cable equities as a general matter do not pay dividends, the Commission nonetheless relied on the DCF method by default, basing selection of this approach on what were perceived to be insufficiencies in alternative methods of equity cost calculation. Specifically, the Commission was concerned that the extent of insider holdings and expectations of monopoly profits would distort measurements of the systematic risk of providing regulated cable services.447 202. Based on data submitted in response to the Further Notice, we tentatively conclude that the concerns that led us originally to dismiss alternative equity cost methodologies for cable no longer justify the wholesale rejection of these methodologies. In the Cost Order, we expressed the concern that large insider positions may distort the risk premium assigned to cable equities. Because a major theoretical assumption of the CAPM is that equity markets are efficient, the model coirelatively assumes that no single investor is large enough to affect the market price of the stock.448 Examining the proportion of voting shares held by cable company insiders with respect to publicly traded equities, the 447 Cost Order, Attachment D at 8-10. 448 J. Van Home and J. Wachowicz, Fundamentals of Financial Management at 113 (1992). 2302 Commission determined that betas, quantitative measures that express the risk premium assigned to cable equities, may incorporate insider decisions. In turn, these insider decisions can overstate the size of the risk premium because insiders control large proportions of the voting stock among the publicly traded cable companies.449 This determination was based, however, on a review of insider holdings available in SEC filings and other publicly available materials such as the Value Line Investment Survey. Our conclusion represented a concern that the degree of insider ownership and control could account for substantial stock price fluctuations. A systematic review of the relationship between insider holdings and movements in stock price, however, was not conducted and data submitted in response to the Further Notice do not support the assertion that cable insiders, in fact, exaggerate the stock prices of their companies. 203. In response to the Further Notice, Continental's expert, Dr. Kolbe, examined the relationship between cable stock betas and the proportion of stock held by cable company insiders. He concluded that differences in betas corresponded with the extent of financial risk resulting from high leverage. When comparisons of cable stock betas are controlled for such leverage, he concluded that no relationship existed between the betas and the size of insider holdings, indicating mat the financial risk resulting from substantial debt burdens, rather than the degree of insider ownership, best explains the fluctuations in cable stock prices (also referred to as stock price volatility). As an example, according to Kolbe, Cablevision's Class A stock has a beta of 1.99 (indicating a systematic risk of nearly twice the broad market). When the company's balance sheet is "relevered" to a hypothetical capital structure of 50% debt, however, the beta drops to 1.48, a level close to the average for cable equities, according to Kolbe's calculation. Kolbe's analysis indicates a relationship between leverage and price volatility, but suggests no evident relationship between the volatility of cable stock prices and the proportion of insider holdings.450 204. The Commission, in the Cost Order, also noted its concern that price movements of thinly-traded cable equities could be exaggerated by insider transactions. Like the concern related to proportions of insider holdings, the potential impact of infrequent trading was not studied or assessed in data submitted to the Commission. Nevertheless, the issue of thin trading was also addressed in Kolbe's analysis. Citing studies of other analysts who have researched the impact of thin trading, Kolbe concludes that the impact of infrequent trading, if it has any impact at all on stock prices, is to nudge beta estimates downward. In other words, the research cited by Kolbe suggests that infrequent trading reduces rather than exaggerates stock price volatility.451 205. Finally, Kolbe examines the assertion mat cable betas could reflect 449 Cost Order, Attachment D at 8-9. 450 Continental Comments, Exhibit B at 43. 451 Id. at 45. 2303 investor expectations of monopoly profits. Although this assertion is not subjected to a statistical review in his analysis, he asserts that the risk of increasing competition in the provision of multichannel video services should only raise the beta. We simply do not have sufficient data to determine the extent of the relationship, if any, between the existence of monopoly power and the stock price volatility premiums assigned to cable company stocks. 206. Based on information submitted to the Commission in this proceeding, and given the absence of countervailing data, we are unable to conclude that the assumptions that led us to dismiss the CAPM remain a valid basis for rejecting its application to the calculation of cable equity cost At the same time, we must recognize that the DCF method, despite its proven utility in the context of other Commission rulemakings, depends on dividend features that are largely absent from cable equities.452 The DCF formula measures the cost of equity as the current dividend yield plus the projected perpetual growth of the dividend yield. The resulting figure represents the discounted value of all the cash dividends provided by a common share of a company's stock.453 The utility of this model is limited when a company does not pay dividends. A formula designed to measure a future income stream may not be an appropriate model for estimating the rate of return demanded by investors who are willing to forgo an income stream in favor of growth through reinvested cash flow. Unlike the investor who buys dividend-paying stocks, a growth investor forgoes immediate cash return (dividends) and takes the risk that cash flow that could have been used to pay dividends will be better invested by the company in its internal growth. The growth investor assumes the risk that the company's business operations may not vindicate the investor's decision to delay the receipt of immediate income. The incentive to take this risk is the potential reward of a higher stock price in the long run. 207. The CAPM attempts to quantify the risk necessary to induce an investor to follow this kind of growth-oriented strategy. As explained in the Cost Order, the CAPM uses a general risk premium which is calculated as the difference in return between a general, diversified portfolio of stocks, such as the S&P 400 or S&P 500, and a risk-free investment, such as U.S. Treasury securities. This risk premium is adjusted for the variance in return assignable to the target company's stock.454 This variance, or beta, is multiplied by the market risk premium for an estimation of the equity premium. When added to the risk-free rate of return, this estimate constitutes the return on equity necessary to entice investment in 452 Continental Comments, Exhibit G at 12. 453 J. Van Home and J. Wachowicz, Fundamentals of Financial Management at 81 (1992). 454 A stock's "beta" expresses the volatility relationship between a target company's stock price fluctuations and uie fluctuations of the broad stock market as measured through an index such as the S&P 500. The greater the volatility of the target company's stock price, the higher the beta. Thus, stocks with high betas are viewed as riskier than the stocks with lower betas. At the same time, these higher risk equities promise higher appreciation potential than low beta stocks. 2304 the target company's stock. The formula provides: COE = RF+ (beta'RP) Where COE is the cost of equity, RF is the current yield on risk-free investment, RP is the risk premium that compensates for the difference in the risk of a diversified stock portfolio and risk-free investment, and beta is the measure of a stock's unavoidable variance in return (i.e., non-diversifiable risk).455 208. In establishing an equity cost for cable companies, we propose to rely on data from the cable industry itself rather than forgo such direct evidence of industry cost in favor of some other surrogate industry or stock group. In the Cost Order, we developed an equity cost estimate based on a selected quartile of the S&P 400. As set forth above, however, we do not believe it necessary to eschew reliance on betas of publicly-traded cable stocks as part of the cable equity cost calculation. 209. Continental's expert, Dr. Kolbe, submitted an estimate of betas applicable to several publicly-traded cable companies. He studied "pure play" cable companies, i.e., cable operators whose dominant business was traditional cable television service during the study period. Based on data estimating betas for 11 "pure play" cable companies over periods varying from one to five years, Kolbe calculated that cable industry betas justify an equity cost for cable companies of 17.5% to 18.5% at a hypothetical capital structure of 50 % equity. Continental further asserts mat this estimate is conservative because cable operators tend to be leveraged above the hypothetical 50% figure.456 NCTA asserts mat investments in cable stocks are 30% to 50% more risky than the overall market, justifying equity premiums that would incorporate this level of risk According to NCTA, an 455 Unavoidable risk, or systematic risk, is the variability of return on stocks associated with factors that affect the overall market This risk is unavoidable hi that it cannot be eliminated by portfolio diversification. J. Van Home and J. Wachowicz, Fundamentals of Financial Management at 112. 456 Id. at 51. 2305 appropriate cost figure for cable equities would be 17.6%.457 210. We propose to adopt the CAPM to establish equity cost for cable operators. Pursuant to the CAPM formula, we would establish a risk-free rate of return tied to investment in U.S. Treasury debt securities. We would determine the general equity market premium above the risk free rate. We would then determine the "beta" or added risk premium for investment hi cable equities and multiply the beta times the general equity market premium. The resulting figures would be added to the risk-free rate for the final cost of equity. 211. Kolbe provides an analysis of betas for investment in pure play cable companies from 1987 through 1994, relying on stock price data pulled from CompuServe.458 We propose to rely on this data to establish betas for cable equities. We note, however, that investment in the cable industry has focused in recent years on the long term revenue potential that could be derived from expanding plant use be'yond traditional regulated services. Therefore, we propose to limit our analysis of the betas provided in the Kolbe Report to the years 1987 through 1992. We further note that by incorporating 1992 into our analysis, we would include hi the equity calculation the increased volatility hi cable stocks recognized by the equity market as legislative proposals to regulate cable services were enacted. Although the betas rise significantly following 1992, we are reluctant to incorporate these added measures of volatility at this time because they coincide with a rising focus on potential growth hi unregulated services and the record suggests no method we could use to adjust for this increased volatility. Applying the Kolbe analysis to the years 1987 through 1992, the average beta for cable industry equity investment is 1.42.459 212. Because we propose to examine an investment period of several years, we propose to use the risk-free rate the average yields on five-year U.S. Treasury Notes after 1987. We selected this period to reflect a time period similar to that assumed in estimating the cable equity premium. Based on data supplied by the Federal Reserve, the average yield on five year U.S. Treasury Notes from 1987 through the third quarter of 1995 is 7.27%.460 Although this yield exceeds the current yield on five-year notes, this figure is an average that accounts for numerous rate fluctuations over an extended time period. We believe an average risk-free rate may be appropriate for selecting a cost of equity for cable because the equity 457 NCTA Comments at 41-44. 458 Those companies are Adelphia, Cablevision, Century, Comcast, Jones Intercable, Jones Spacelink, TCA Cable, and TCI. Continental Comments, Exhibit G at 41. 459 Kolbe estimates the annual betas for pure play cable entities as follows: 1.37 for 1987; 1.43 for 1988; 1.45 for 1989; 1.45 for 1990; 1.37 for 1991; and 1.46 for 1992. 460 U.S. Federal Reserve, 5-Year Constant Maturity Yield, Monthly Averages of Daily Figures, October 3, 1995. 2306 cost estimate would be relied upon in cost of service filings for at least the period preceding an operator's next major rate filing. Moreover, we propose to update periodically the risk- tree rate used in the CAPM to account for subsequent interest rate changes. 213. Consistent with the CAPM approach, we would have to estimate the average return on an investment in the general stock market in order to determine the final cost of equity for cable. As the general equity market, we propose using the most widely used barometer of broad stock market performance the S&P 500. From 1987 through the third quarter of 1995, the average compounded market return, as measured by the S&P 500, has been IS.53%.461 214. Based on the above figures, application of the CAPM formula would result in the following estimate: The general equity market premium above the risk-free rate of return is 6.26% (13.53% - 7.27%). The 1.42 beta for cable equity investment multiplied by 6.26% provides a cable equity premium of 8.89 percentage points above the average risk- free rate. When the risk-free rate is added to the cable equity premium, the final cost of equity can be established. That figure is 16.16%. We propose that the average cost of equity for investment in cable operators providing regulated cable services is 16.16%. We propose to adjust periodically the figures used for the risk-free rate of return, the cable industry beta and the broad equity market return to account for inevitable changes in capital market conditions. We ask comment on this approach. 215. Although the above analysis indicates that, based on data in the record, the equity cost of providing regulated cable averages 16.16%, we also acknowledge that the equity cost is likely to be higher in a case where an operator has a proportionally higher percentage of debt than that of the companies on which we base our cost of equity analysis.. If the operator has been forced to renegotiate loan covenants or has a loan service history that further restricts the availability of affordable debt, the operator's risk level may be higher which would raise the cost of attracting equity investment On the other hand, the cost of equity could be lower for less leveraged operators. We therefore request comment on a vehicle that would, consistent with the goal of maintaining administrative feasibility, provide a mechanism to adjust the equity cost to reflect extraordinary financial risk. For example, should the Commission consider debt-to-cash flow multiples as the mechanism to quantify risk levels? We seek in this further notice sufficient data to establish equity cost figures above and below the proposed 16.16 % average equity cost estimate for operators with debt burdens significantly above and below the average in our sample. If sufficient information becomes available to establish such figures hi a manner consistent with administrative feasibility, we will consider adoption of higher and lower equity cost figures that would be applicable to operators facing debt burdens well above or below that average. C. Cost of Debt 461 Investor's Business Daily, October 2, 1995; S&P Directory (1994). 2307 1. Background 216. The other principal component of the overall cost of capital is the cost of debt In the Cost Order, we relied on debt cost estimates for the cable industry specifically and concluded that the range for the average cost of fixed rate debt established by information submitted in the cost of service proceeding was 7.8% to 8.65%. The Commission noted the substantial proportion of floating rate debt among cable entities and determined that a cautious estimate would place average debt cost at S.5%.462 2. Comments 217. Comcast argues that the cost of cable debt is significantly higher than the cost of debt issued by telephone companies. Comcast notes that cable industry debt does not, as a general matter, qualify for investment grade status, another aspect of cable debt that is unlike the debt of telephone companies. In addition, Comcast argues that the difference in yields between cable and telephone debt ranges from 100 to 157 basis points, depending on the maturity of the debt.463 218. TCI argues that the use of average capital costs for the cable industry is inappropriate for cost of service filings because such filings will be made by cable operators whose costs are above average. Thus, the use of average costs of equity and debt will lead to a rate of return below an adequate level for these particular operators. In addition, TCI contends that the regulatory predisposition for using average capital costs in cost of service proceedings is rooted in telephone regulation of the regional Bell companies who possess a common managerial, business and capital heritage. Cable, on the other hand, has a more diverse heritage, and TCI suggests that a lack of common heritage vitiates the reliability of exporting regulatory assumptions for the telephone industry to the cable industry. Diversity of heritage among cable operators, according to TCI, justifies operator-specific treatment of cable system costs. *" 3. Discussion 219. Consistent with the analysis above concerning the application of unitary rates to all cable operators, we seek to provide greater accuracy to the rate of return calculation by using an operator's actual debt costs to determine the overall estimation of capital costs. Accordingly, if an operator forgoes the presumptive 11.25% overall rate of return in favor of the alternative set forth in this Order, we propose to rely on more direct estimates of capital costs by gauging an operator's debt cost to its actual debt cost This debt 462 Cost Order, 9 FCC Red at 4628. 463 Comcast Comments at 10, n.12. 464 TCI Comments at 37-38. 2308 cost would encompass fees or other premiums that the operator may pay to obtain debt financing. We invite comment on this proposal. 220. We believe the task of estimating debt cost from actual interest costs borne by operators can be conducted without imposing significant administrative burdens. The cost of debt, or interest payments on debt by cable operators, is readily verifiable by operators themselves. We propose to require simply that operators submit an independent evaluation of debt cost and incorporate the resulting interest figure into our rate of return calculation. To ensure, however, that the debt costs claimed by the operator reasonably reflect debt incurred under market conditions, we propose having debt issued by "insiders" or other affiliated entities listed separately in the submission of debt cost This precaution should ensure that affiliations between the operator and insider lenders do not unreasonably magnify the amount of interest cost borne ultimately by ratepayers. To the extent this debt cost exceeds debt cost that would have been incurred in the open market, we propose making appropriate adjustments to the allowed debt cost amount D. Capital Structure 1. Background 221. In the Cost Order, we decided against using embedded capital structures and market equity values to establish the capital structure used to calculate the overall rate of return. We indicated that a capital structure range may be more appropriate for the debt-laden cable industry and set that range at 40% to 70% debt and used that range in setting the overall capital cost.465 2. Comments 222. Continental suggests that the Commission should rely on individual capital structures of operators in setting the overall rate of return, but acknowledges that the separate components of the calculation, particularly the equity component, can be established against any capital structure assumptions. In the alternative, Continental would support a hypothetical capital structure of 50% debt and 50% equity.466 Similarly, Bell Atlantic argues in favor of actual capital structures in setting the overall rate of return, suggesting that such an approach is consistent with principles historically governing cost of service regulation of telephone companies.467 3. Discussion 465 Cost Order, 9 FCC Red at 4632. 466 Continental Comments at 52. 467 Bell Atlantic Comments at 7. 2309 223. We tentatively conclude that actual, i.e., individualized, capital structures should be applied to the estimation of the overall cost of capital. The estimation of debt costs is relatively straightforward because the cost of debt can be documented and certified by independent accounting services. Because debt costs can be measured directly, we tentatively conclude that reliance on the actual percentage of debt in an operator's capital structure will ensure the most accurate estimation of interest costs. Thus, if an operator elected not to rely on the presumptive 11.25% rate of return in favor of the alternative capital cost measure described in this Order, we would look to the actual capital structures of the operator to determine the appropriate overall capital cost. 224. In using actual capital structures to estimate the overall rate of return, we recognize that estimating the amount of outstanding equity is a complex proposition. Because the cable industry has relied heavily on debt financing of its growth and expansion, many operators have a negative net worth at the bottom of their balance sheets. Although we could presume that such operators have 0% equity and 100% debt, we recognize that, in the case of several publicly-traded cable companies, the stock of operators with negative book value trades in significant volumes in the open market While public utility regulation has relied traditionally on book value estimations of equity in determining capital structures for regulated utilities, it may be appropriate to take note of the equity transactions in the cable industry that occur frequently, including the decisions of cable investors to pay multiples of cash flow for cable systems that, based on book value, should be worth less than nothing. 225. In the case of publicly-traded cable equities, we propose estimating the percentage of equity according to market values. Although we declined to use market capitalization to measure the equity portions of capital structures in the Cost Order, we believe such estimates should be relied upon when possible to reflect the simple reality that the investment community places positive value on the equity of cable operators. Indeed, the debt of some of the largest MSOs leads to a negative book value of their publicly traded equity. Nevertheless, equity investors have shown a willingness to purchase the stock of these highly leveraged operators. Our consideration of market capitalization therefore stems from the unique financial circumstances of the cable industry and the actual history of transactions that have occurred within the industry. We do not consider or suggest the application of market capitalization measures in any context beyond that examined in this Order. 226. In order to rely on actual capital structures, however, we must ensure that measurement of the equity proportion filters out a "premium" for anticipated gains in unregulated services. The demand for cable equities may reflect investor perceptions of revenue growth through unregulated services, including local or long distance telephone services. Accordingly, we must develop a discounting mechanism that brings the estimate of equity proportions in line with the expected returns on regulated cable services. Because actual service revenues from unregulated services remain small, a discounting approach based on proportions of revenue derived from unregulated services would not accurately filter out the anticipatory impact of nontraditional cable services. 2310 227. Accordingly, we propose, as part of the proposed rate of return alternative, to utilize actual capital structures in setting the rate of return. As we consider this alternative, however, we recognize that several issues must be addressed and resolved to develop this approach. Moreover, we remain committed to an approach that is administratively feasible. To assist the Commission in this endeavor, we request comment on the following issues: a. What mechanism or analysis should guide the Commission in estimating the equity proportion of an operator's capital structure that is dedicated to regulated services? b. How should the Commission estimate the proportion of equity in an operator's capital structure when that operator is not publicly-traded? c. Should the Commission rely on the book value of debt or the market value of debt in estimating the proportion of debt in an operator's capital structure? d. Can the Commission develop a reasonable estimate of an operator's capital structure by combining the market value of its equity and the book value of its debt? e. If market capitalization is used to measure the proportion of equity in an operator's capital structure, will increases in the operator's stock price drive up subscriber rates by increasing the proportion of equity in the operator's capital structure? If so, how can the Commission ensure that reliance on market capitalization measures for equity will not unduly impact subscriber rates? XDL REGULATORY FLEXIBILITY ANALYSIS A. Final Regulatory Flexibility Act Analysis for the Second Report and Order and first Order on Reconsideration 228. Pursuant to the Regulatory Flexibility Act of 1980, 5 U.S.C. §§ 601-12, the Commission's final analysis with respect to the Second Report and Order and First Order on Reconsideration is as follows: 229. Need and purpose of this action: The Commission, in compliance with Section 3(i) of the Cable Television Consumer Protection and Competition Act of 1992 pertaining to rate regulation, adopts rules and procedures intended to ensure cable subscribers of reasonable rates for cable services with minimum regulatory and administrative burden on cable entities. 2311 230. Summary of issues raised by the public in response to the Initial Regulatory Flexibility Analysis: There were no comments submitted hi response to the Initial Regulatory Flexibility Analysis. The Chief Counsel for Advocacy of the United States Small Business Administration filed comments in the original rulemaking order. The Commission addressed these comments in the Rate Order.468 The Chief Counsel for Advocacy of the United States Small Business Administration also filed comments hi response to the Further Notice of Proposed Rulemaking. Those comments are addressed herein. 231. Significant alternatives considered and rejected. Petitioners representing cable interests and franchising authorities submitted several alternatives aimed at minimizing administrative burdens. In this proceeding, the Commission has attempted to accommodate the concerns raised by these parties. For example, the revised rules regarding action on rate complaints within two years of a cost of service showing are designed to reduce burdens on both industry and regulators. In addition, the revised rules also reduce burdens on both industry and regulators by simplifying certain calculations involved hi producing and reviewing a cost of service showing. B. Initial Regulatory Flexibility Act Analysis for the Further Notice of Proposed Rulemaking 232. Pursuant to Section 603 of the Regulatory Flexibility Act, the Commission has prepared the following initial regulatory flexibility analysis ("IRFA") of the expected impact of these proposed policies and rules on small entities: 233. The proposals, if adopted, will not have a significant effect on a substantial number of small entities. XX. PAPERWORK REDUCTION ACT 234. The requirements adopted in the Second Report and Order, First Order on Reconsideration have been analyzed with respect to the Paperwork Reduction Act of 1995 and found to impose new or modified information collection requirements on the public. Implementation of any new or modified requirement will be subject to approval by the Office of Management and Budget as prescribed by the Act 235. This NPRM contains either a proposed or modified information collection. The Commission, as part of its continuing effort to reduce paperwork burdens, invites the general public and the Office of Management and Budget (OMB) to comment on the information collections contained hi this NPRM, 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 468 See Rate Order, MM Docket No. 92-266, FCC 93-177, 8 FCC Red 5631 (1993). 2312 other comments on this NPRM; OMB comments are due 60 days from date of publication of this NPRM in the Federal Register. 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. XXL PROCEDURAL PROVISIONS 236. Ex parte Rules - Non-Restricted Proceeding. This is a non-restricted notice and comment rulemaking proceeding. Ex parte presentations are permitted, except during the Sunshine Agenda period, provided that they are disclosed as provided in Commission's rules. See generally 47 C.F.R. §§ 1.1202, 1.1203, and 1.1206(a). 237. Interested parties may file comments on or before 60 days after publication in the Federal Register and reply comments on or before 90 days after publication in the Federal Register. To file formally hi this proceeding, you must file an original plus four copies of all comments, reply comments, and supporting comments. If you want each Commissioner to receive a personal copy of your comments and reply comments, you must file an original plus nine copies. You should send comments and reply comments to Office of the Secretary, Federal Communications Commission, 1919 M Street, N.W. Washington, D.C. 20554. Comments and reply comments will be available for public inspection during regular business hours hi the FCC Reference Center, Room 239, Federal Communications Commission, 1919 M Street N.W., Washington D.C. 20554. 23S. In addition to filing comments with the Secretary, a copy of any comments on the information collections contained herein should be submitted to Dorothy Conway, Federal Communications Commission, Room 234, 1919 M Street, N.W., Washington, DC 20554, or via the Internet to dconway@fcc.gov, and to Timothy Fain, OMB Desk Officer, 10236 NEOB, 725 - 17th Street, N.W., Washington, DC 20503 or via the Internet to fain_t@al.eop.gov. 239. For additional information concerning the information collections contained herein contact Dorothy Conway at 202-418-0217, or via the Internet at dconway@fcc.gov. XXH. ORDERING CLAUSES 240. Accordingly, IT IS ORDERED that, pursuant to Sections 4(i), 4(j), 303(r), 612, and 623 of the Communications Act of 1934, as amended, 47 U.S.C. §§ 154(i), 154(j), 303(r), 532, and 543 the rules, requirements and policies discussed in this Second Report and Order and First Order on Reconsideration ARE ADOPTED and Sections 76.922 2313 and 76.924 of the Commission's rules, 47 C.F.R. §§ 76.922 and 76.924, ARE AMENDED as set forth in Appendix C. 241. IT IS FURTHER ORDERED that the requirements and regulations established in this decision shall become effective upon approval by the Office of Management and Budget of the new information collection requirements adopted herein, but no sooner than thirty (30) days after publication in the Federal Register. 242. IT IS FURTHER ORDERED that, pursuant to Sections 623 of the Communications Act of 1934, as amended, 47 U.S.C. § 543, NOTICE IS HEREBY GIVEN of proposed amendments to Part 76, in accordance with the proposals, discussions, and statement of issues in the Second Report and Order, First Order on Reconsideration, and Further Notice of Proposed Rulemaldng, and that COMMENT IS SOUGHT regarding such proposals, discussion, and statement of issues. 243. IT IS FURTHER ORDERED that the Secretary shall send a copy of this Second Report and Order, First Order on Reconsideration, and Further Notice of Proposed Rulemaldng, including the Initial Regulatory Flexibility Analysis, to the Chief Counsel for Advocacy of the Small Business Administration in accordance with paragraph 603(a) of the Regulatory Flexibility Act, Pub. L. No. 96-354, 94 Stat 1164, 5 U.S.C. §§ 601 et seq. (1981). 244. IT IS FURTHER ORDERED that the Petitions for Reconsideration ARE GRANTED hi part, DENIED in part, and to the extent that Petitions raise issues unresolved in this order, they will be disposed of in future orders. FEDERAL COMMUNICATIONS COMMISSION William F. Caton Acting Secretary 2314 APPENDIX A List of Commenters COMMENTS Bell Atlantic BellSouth Corporation Cable Telecommunications Association Comcast Cable Communications, Inc. Continental Cablevision, Inc., et al. Discovery Communications, Inc. Falcon Cable TV GTE Service Corporation Jones Education Networks, Inc. Liberty Media Corporation National Association of Telecommunications Officers and Advisors and the City of New York Rainbow Programming Holdings, Inc. Tele-Media Corporation Turner Broadcasting System, Inc. Viacom International Inc. Fred Williamson & Associates, Inc. REPLY COMMENTS Avenue TV Cable Service, Inc. Bell Atlantic Comcast Cable Communications, Inc. Continental Cablevision, Inc., et al. Falcon Cable TV Liberty Media Corporation National Cable Television Association, Inc. Tele-Communications, Inc. Time Warner Entertainment Company, L.P. U.S. Small Business Administration U.S. Telephone Association Viacom International, Inc. PETITIONS FOR RECONSIDERATION Bell Atlantic Bend Cable Communications, Inc., et al. Cablevision Industries, Inc. Comcast Cable Communications, Inc. 2315 Media General Cable of Fairfax County, Inc. Public Interest Petitioners OPPOSITIONS TO PETITIONS FOR RECONSIDERATION A&E and ESPN Bell Atlantic Discovery Communications, Inc. GTE Service Corporation National Association of Telecommunications Officers and Advisors and the City of New York U.S. Telephone Association REPLIES TO OPPOSITIONS TO PETITIONS FOR RECONSIDERATION Bell Atlantic Cablevision Industries Corporation Comcast Cable Communications, Inc. Consumer Federation of America & National Cable Television Association, Inc. GTE Service Corporation Public Interest Petitioners U. S. West, Inc. United Church of Christ 2316 APPENDIX B Calculation of Depreciation Ranges The following describes the methodology used to compute various measures of the economically useful lives of the following cable-related assets: a. Headend b. Transmission Facilities and Equipment c. Distribution Facilities (trunk, drops, etc.) d. Circuit Equipment (amplifiers, power boosters, etc.) e. Maintenance Facilities (garages, warehouses, etc.) f. Maintenance Vehicles and Equipment g. Buildings (office) h. Office Furniture and Equipment The calculations are based on data reported in Section C, Item 9 of the Form 1220s filed with the Commission by 600 system community units seeking to establish or justify rates for regulated services in accordance with our cost of service rules. Table 1 sets forth the ranges we have established for the assets falling into the listed categories based on the useable data reported in all 600 filings. More detailed data are set forth separately for each individual asset category hi Tables 2 through 9. Although the maximum number of possible observations is 600, operators representing 78 community units either did not provide any information or provided information for all categories that was not useable, for example reporting a single year as the economically useful life for all categories of assets. To avoid double counting, one CUID was excluded from the database because the system data was included in the filing for another CUID. These exclusions reduced the database to a maximum of 521 observations. Partial information was included in the data base. In many instances an operator did not give any information for one or more asset categories or gave inappropriate information, such as reporting an economically useful life of zero (0) years. When this occurred, the useable information associated with the CUID was included hi the data base. As a result, all asset categories have fewer than 521 observations. In some instances we used averaged data hi the categories Maintenance Vehicles and Equipment (f) and Office Furniture and Equipment (h) because a few operators reported only a range of depreciable years. Averaging for these categories is appropriate because the reported range was relatively short, the categories cover a wide variety of assets, and the dollar value of the assets is relatively low. Based on the useable data, we calculated an average useful life for each asset category. 2317 We then created a range of years for each category, by adding a standard deviation to the average. Standard deviation is a commonly used measure of variability. It measures the amount of variance from the average in a sample. The amount of variance is usually expressed in terms of one or more standard deviations from the average. One standard deviation, when applied to the average, generally will capture about two-thirds of the sample, e.g., in this case, two-thirds of the systems in the sample. After thus creating a range of years for each asset category, we men rounded each end of the range to the nearest whole number. Operators that submit cost of service filings presumably believe then- cash flow requirement is greater than what would be allowed as a result of a benchmark filing. This means tbrt, as a group, cost of service filers may have used years of useful economic life that is shorter than what the industry as a whole uses. On the other hand, given the general similarities of the assets for all operators, there is no reason to believe that the operators represented in this study treat the economically useful life of their assets in a different manner from those not included. 2318 TABLE 1 ECONOMICALLY USEFUL LIVES OF VARIOUS CAPITAL ITEMS REPORTED IN FORM 1220 IN SECTION C-9 DATA ARE BY CUD) SUMMARY AVERAGES HEADEND 10.820313 TRANSMISSION FACILITIES & EQUIPMENT 10.110769 DISTRIBUTION FACILITIES (TRUNKS, DROPS, ETC.) 12.480469 CIRCUIT EQUIPMENT (AMPLIFIERS, ETC.) 10.680851 MAINTENANCE FACILITIES GARAGES, ETC.) 26.009901 MAINTENANCE VEHICLES AND EQUIPMENT 4.7586538 BUILDINGS (OFFICE) 25.303785 OFFICE FURNITURE AND EQUIPMENT 9.0696325 MODES HEADEND 10 TRANSMISSION FACILITIES & EQUIPMENT 5 DISTRIBUTION FACILITIES (TRUNKS, DROPS, ETC.) 15 CIRCUIT EQUIPMENT (AMPLIFIERS, ETC.) 10 MAINTENANCE FACILITIES GARAGES, ETC.) 20 MAINTENANCE VEHICLES AND EQUIPMENT 5 BUILDINGS (OFFICE) 25 OFFICE FURNITURE AND EQUIPMENT 10 MEDIANS HEADEND 10 TRANSMISSION FACILITIES & EQUIPMENT 12 DISTRIBUTION FACILITIES (TRUNKS, DROPS, ETC.) 12 CIRCUIT EQUIPMENT (AMPLIFIERS, ETC.) 10 MAINTENANCE FACILITIES GARAGES, ETC.) 25 MAINTENANCE VEHICLES AND EQUIPMENT 5 BUILDINGS (OFFICE) 25 OFFICE FURNITURE AND EQUIPMENT 8 2319 TABLE 2 ECONOMICALLY USEFUL LIVES OF VARIOUS CAPITAL ITEMS REPORTED IN FORM 1220 IN SECTION C-9 DATA ARE BY CUE) HEADEND Statistic Amount Mean 10.820313 Standard Error #N/A Median 10 Mode 10 Standard Deviation 2.5966517 Variance 6.7426003 Kurtosis 0.3867011 Skewness 0.6912564 Range 13 Minimum : 7 Maximum 20 Sum 5540 Count 512 Confidence Level (95%) 0224919 Total number of CUIDs in data base 600 Percent reporting Headend data 853% FREQUENCY DISTRIBUTION 0 TO 6.9 0 7.0 TO 8.9 114 9.0 TO 9.9 0 10.0 TO 10.9 165 11.0 TO 11.9 76 12.0 TO 12.9 62 13.0 TO 13.9 0 14.0 TO 14.9 0 15.0 TO 15.9 90 16.0 TO 16.9 0 17.00 TO19.9 0 20..0 TO 20.9 5 21.0 TO 22.9 0 TOTAL NUMBER OF OBSERVATIONS 512 2320 TABLE 3 ECONOMICALLY USEFUL LIVES OF VARIOUS CAPITAL ITEMS REPORTED IN FORM 1220 IN SECTION C-9 DATA ARE BY CUID TRANSMISSION FACILITIES & EQUIPMENT Statistic Amount Mean 10.110769 Standard Error #N/A Median 12 Mode 5 Standard Deviation 3.9806679 Variance 15.845717 Kmtosis -1.5373778 Skewness -02349715 Range 10 Minimum 5 Maximum 15 Sum 3286 Count 325 Confidence Level (95%) 0.4327746 Total number of CUIDs in data base 600 Percent reporting Transmission Facilities & Equip, data 542% FREQUENCY DISTRIBUTION 0 TO 4.9 0 5.0 TO 5.9 107 6.0 TO 6.9 0 7.0 TO 7.9 6 8.0 TO 8.9 8 9.0 TO 9.9 0 10.0 TO 10.9 20 11.0 TO 11.9 0 12.0 TO 12.9 99 13.0 TO 14.9 9 15.0 TO 15.9 76 16.0 TO 16.9 0 17.0 TO 19.9 0 20.0 TO 21.9 0 22.0 TO 23.9 0 24.0 TO 26.9 0 TOTAL NUMBER OF OBSERVATIONS 325 2321 TABLE 4 ECONOMICALLY USEFUL LIVES OF VARIOUS CAPITAL ITEMS REPORTED IN FORM 1220 IN SECTION C-9 DATA ARE BY CUID DISTRIBUTION FACILITIES (TRUNKS, DROPS, ETC.) Statistic Amount Mean 12.480469 Standard Error #N/A Median 12 Mode 15 Standard Deviation 2.3706476 Variance 5.61997 Kurtosis -0.7713768 Skewness 02297112 Range 13 Minimum 7 Maximum 20 Sum 6390 Count 512 Confidence Level (95%) 02053428 Total number of CUIDs in data base 600 Percent reporting Distribution Facilities data 853% FREQUENCY DISTRIBUTION 0 TO 6.9 0 7 .0 TO 7.9 3 8.0 TO 8.9 5 9.0 TO 9.9 4 10.0 TO 10.9 172 11.0 TO 11.9 0 12.0 TO 12.9 124 13.0 TO 13.9 0 14.0 TO 14.0 0 15.0 TO 15.9 199 16.0 TO 16.9 0 17.0 TO 17.9 0 18.0 TO 18.9 0 19.0 TO 19.9 0 20.0 TO 20.9 5 21.0 TO 21.9 0 TOTAL NUMBER OF OBSERVATIONS 512 2322 TABLES ECONOMICALLY USEFUL LIVES OF VARIOUS CAPITAL ITEMS REPORTED IN FORM 1220 IN SECTION C-9 DATA ARE BY CUD) CIRCUIT EQUIPMENT (AMPLIFIERS, ETC.) _______________Statistic________________Amount Mean 10.680851 Standard Error #N/A Median 10 Mode 10 Standard Deviation 32844271 Variance 10.787461 Kurtosis -1.1488627 Skewness -0.1430946 Range 10 Minimum 5 Maximum IS Sum 3012 Count 282 Confidence Level (95%) 03833386 Total number of CUIDs in data base 600 Percent reporting Circuit Equipment data 47.0% FREQUENCY DISTRIBUTION 0 TO 4.9 0 5.0 TO 5.9 6 6.0 TO 6.9 59 7.0 TO 7.9 0 8.0 TO 8.9 9 9.0 TO 9.9 0 10.0 TO 10.9 78 11.0 TO 11.9 0 12.0 TO 12.9 58 13.0 TO 13.9 0 14.0 TO 14.9 0 15.0 TO 15.9 72 16.0 TO 16.9 0 TOTAL NUMBER OF OBSERVATIONS 282 2323 TABLE 6 ECONOMICALLY USEFUL LIVES OF VARIOUS CAPITAL ITEMS REPORTED IN FORM 1220 IN SECTION C-9 DATA ARE BY CUID MAINTENANCE FACILITIES (GARAGES, ETC.) ______________Statistic________________Amount Mean 26.009901 Standard Error #N/A Median 25 Mode 20 Standard Deviation 9.0916908 Variance 82.658842 Kurtosis -0.7011884 Skewness 0.2548663 Range 33 ^4mununi 7 Maximum 40 Sum 7881 Count 303 Confidence Level (95%) 1.0236955 Total number of CUIDs in data base 600 Percent reporting Maintenance Facilities data 50.5% FREQUENCY DISTRIBUTION 0 TO 6.9 0 7.0 TO 9.9 8 10.0 TO 10.9 1 11.0 TO 11.9 0 12.0 TO 12.9 20 13.0 TO 15.9 1 16.0 TO 16.9 0 17.0 TO 17.9 0 18.0 TO 18.9 0 19.0 TO 19.9 0 20.0 TO 20.9 96 21.0 TO 21.9 0 22.0 TO 22.9 0 23.0 TO 23.9 0 24.0 TO 24.9 0 25.0 TO 25.9 74 26.0 TO 26.9 0 27.0 TO 27.9 0 28.0 TO 30.9 33 31.0 TO 33.9 0 34.0 TO 34.9 0 2324 35.0 TO 35.9 0 36.0 TO 36.9 0 37.0 TO 37.9 0 38.0 TO 38.9 0 39.0 TO 39.9 0 40.0 TO 40.9 70 41.0 TO 41$ 0 TOTAL NUMBER OF OBSERVATIONS 303 2325 TABLE? ECONOMICALLY USEFUL LIVES OF VAWOUS CAPITAL ITEMS REPORTED IN FORM 1220 IN SECTION C-9 DATA ARE BY CUTO MAINTENANCE VEHICLES AND EQUIPMENT Statistic Amount Mean 4.7S86S38 Standard Error #N/A Median 5 Mode 5 Standard Deviation 1.7816562 Variance 3.1742988 Kurtosis 14.912942 Skewness 3.0037623 Range 12 Minimum 3 Maximum IS Sum 2474.5 Count 520 Confidence Level (95%) 0.1531333 Total number of CUIDs in data base 600 Percent reporting Maintenance Vehicles and Equip, data 86.7% FREQUENCY DISTRIBUTION 0 TO 2.9 0 3.0 TO 3.9 134 4.0 TO 4.9 76 5.0 TO 5.9 254 6.0 TO 6.9 2 7.0 TO 7.9 43 8.0 TO 8.9 0 9.0 TO 9.9 0 10.0 TO 10.9 3 11.0 TO 11.9 0 12.0 TO 12.9 0 13.0 TO 13.9 0 14.0 TO 14.9 0 15.0 TO 15.9 8 16.0 TO 16.9 0 TOTAL NUMBER OF OBSERVATIONS 520 2326 TABLES ECONOMICALLY USEFUL LIVES OF VARIOUS CAPITAL ITEMS REPORTED IN FORM 1220 IN SECTION C-9 DATA ARE BY CUID BUILDINGS (OFFICE) Statistic Amount Mean 25303785 Standard Error #N/A Median 25 Mode 25 Standard Deviation 7.5765452 Variance 57.404038 Kurtosis -0.0173992 Skewness 0.6995231 Range 30 Minimum 10 Maximum 40 Sum 12702.5 Count 502 Confidence Level (95%) 0.6627761 Total number of CUIDs in data base 600 Percent reporting Buildings (Office) data 83.7% FREQUENCY DISTRIBUTION 0 TO 9.9 0 10.0 TO 11.9 5 12.0 TO 13.9 20 14.9 TO 15.9 14 16.0 TO 17.9 0 18.0 TO 19.9 1 20 0 TO 20.9 156 21.0 TO 21.9 0 22.0 TO 23.9 0 24.0 TO 24.9 0 25.0 TO 25.9 182 26.0 TO 27.9 0 28.0 TO 29.9 0 30.0 TO 31.9 45 32.0 TO 33.9 0 34.0 TO 35.9 0 36.0 TO 37.9 0 38.0 TO 39.9 0 40.0 TO 40.9 79 41.0 TO 41.9 0 42.0 TO 43.9 0 TOTAL NUMBER OF OBSERVATIONS 502 2327 TABLE 9 ECONOMICALLY USEFUL LIVES OF VARIOUS CAPITAL ITEMS REPORTED IN FORM 1220 IN SECTION C-9 DATA ARE BY CUID OFFICE FURNITURE AND EQUIPMENT Statistic Amount Mean 9.0762548 Standard Error #N/A Median 8 Mode 10 Standard Deviation 22441577 Variance 5.0362436 Kurtosis -0.4713814 Skewness 02902607 Range 12 Minimum 3 Maximum 15 Sum 4701.5 Count 518 Confidence Level (95%) 0.1932573 Total number of CUIDs in data base 600 Percent reporting Office Furniture and Equipment data 863% FREQUENCY DISTRIBUTION 0 TO 2.9 0 3.0 TO 3.9 2 4.0 TO 4.9 0 5.0 TO 5.9 10 6.0 TO 6.9 59 7.0 TO 7.9 78 8.0 TO 8.9 112 9.0 TO 9.9 2 10.0 TO 10.9 155 11.0 TO 11.9 0 12.0 TO 12.9 91 13.0 TO 13.9 0 14.0 TO 14.9 0 15.0 TO 15.9 8 16.0 TO 16.9 0 TOTAL NUMBER OF OBSERVATIONS 517 2328 APPENDIX C RULE CHANGES Part 76 of Title 47 of the Code of Federal Regulations is amended as follows: PART 76 - CABLE TELEVISION SERVICE 1. The authority citation for Part 76 continues to read as follows: AUTHORITY: Sections 2, 3, 4, 301, 303, 307, 308, 309, 48 Stat, as amended 1064,1065, 1066, 1081, 1082, 1083, 1084, 1085, 1101; 47 U.S.C. §§ 152, 153, 154, 301, 303, 307, 308, 309; §§ 612, 614-615, 623, 632 as amended, 106 Stat 1460, 47 U.S.C. § 532; § 623, as amended, 106 Stat 1460; 47 U.S.C. §§ 532, 533, 535, 543, 552. 2. Section 76.922 is amended by revising (g)(6)(i), adding a new (g)(6)(ii), redesigning the existing (g)(6)(ii) - (g)(6)(vii) as (g)(6)(iii) - (g)(6)(viii), and revising (g)(7) as follows: § 76.922 Rates for the basic service tier and cable programming service tiers. (9)(6)(i) Prudent investment by a cable operator in tangible plant that is used and useful in the provision of regulated cable services less accumulated depreciation.- Tangible plant in service shall be valued at the actual money cost (or the money value of any consideration other than money) at the time it was first used to provide cable service, except that in the case of systems purchased before May 15, 1994 shall be presumed to equal 66% of the total purchase price allocable to assets (including tangible and intangible assets) used to provide regulated services. The 66% allowance shall not be used to justify any rate increase taken after the effective date of this rule. The actual money cost of plant may include an allowance for funds used during construction at the prime rate or the operator's actual cost of funds during construction. Cost overruns are presumed to be imprudent investment in the absence of a showing that the overrun occurred through no fault of the operator. (g)(6)(ii) An allowance for start-up losses including depreciation, amortization and interest expenses related to assets that are included in the ratebase. Capitalized start-up losses, may include cumulative net losses, plus any unrecovered interest expenses connected to funding the regulated ratebase, amortized over the unexpired life of the franchise, commencing with the end of the toss accumulation phase. However, losses attributable to accelerated depreciation methodologies are not permitted. (g)(7) Deferred income taxes accrued after the date upon which the operator became subject to regulation shall be deducted from items included in the ratebase. 3. Section 76.924 is amended by adding new paragraphs (e)(1)(iii) and (e)(2)(iii) to read as follows: § 76.924 Allocation to service cost categories. 2329 (e)(1)(iii) All other services cost category. The all other services cost category shall include the costs of providing all other services that are not included the basic service or a cable programming services cost categories as defined in subsections (e)(1)(i) and (ii) of this section. (e)(2)(iii) The all other services cost category as defined by subsection (1)(iii) of this section. •0.8. GOVENMnn mmnw amen 1996-404-711/40012 2330