Dominion Power 2005 Annual Report Download - page 64

Notes to Consolidated Financial Statements, Continued
nonregulated gas operations is valued using the weighted-average
cost method.
Gas Imbalances
Natural gas imbalances occur when the actual amount of natural
gas delivered from or received by a pipeline system or storage facility
differs from the contractual amount of natural gas delivered or
received. We value these imbalances due to or from shippers and
operators at an appropriate index price, subject to the terms of our
tariff for regulated entities. Imbalances are primarily settled in-kind.
Imbalances due from others are reported in other current assets and
imbalances owed to others are reported in other current liabilities
on our Consolidated Balance Sheets.
Derivative Instruments
We use derivative instruments such as futures, swaps, forwards,
options and financial transmission rights to manage the
commodity, currency exchange and financial market risks
of our business operations.
SFAS No. 133, Accounting for Derivative Instruments and
Hedging Activities, requires all derivatives, except those for which
an exception applies, to be reported on our Consolidated Balance
Sheets at fair value. Derivative contracts representing unrealized
gain positions and purchased options are reported as derivative
assets. Derivative contracts representing unrealized losses and
options sold are reported as derivative liabilities. One of the excep-
tions to fair value accounting
— normal purchases and normal
sales
— may be elected when the contract satisfies certain criteria,
including a requirement that physical delivery of the underlying
commodity is probable. Expenses and revenue resulting from
deliveries under normal purchase contracts and normal sales
contracts, respectively, are included in earnings at the time of
contract performance.
As part of our overall strategy to market energy and manage
related risks, we manage a portfolio of commodity-based derivative
instruments held for trading purposes. We use established policies
and procedures to manage the risks associated with the price fluc-
tuations in these energy commodities and use various derivative
instruments to reduce risk by creating offsetting market positions.
We also hold certain derivative instruments that are not held for
trading purposes and are not designated as hedges for accounting
purposes. However, to the extent we do not hold offsetting posi-
tions for such derivatives, we believe these instruments represent
economic hedges that mitigate exposure to fluctuations in com-
modity prices, interest rates and foreign exchange rates.
Statement of Income Presentation:
•Derivatives Held for Trading Purposes: All changes in fair
value, including amounts realized upon settlement, are
presented in revenue on a net basis as nonregulated electric
sales, nonregulated gas sales and other energy-related
commodity sales.
•Financially-Settled Derivatives — Not Held for Trading Pur-
poses and Not Designated as Hedging Instruments: All unreal-
ized changes in fair value and settlements are presented in
other operations and maintenance expense on a net basis.
•Physically-Settled Derivatives — Not Held for Trading
Purposes and Not Designated as Hedging Instruments: Effective
October 1, 2003, all unrealized changes in fair value and settle-
ments for physical derivative sales contracts are presented
in revenue, while all unrealized changes in fair value and
settlements for physical derivative purchase contracts are
reported in expenses. For periods prior to October 1, 2003,
unrealized changes in fair value for physically settled derivative
contracts are presented in other operations and maintenance
expense on a net basis.
We recognize revenue or expense from all non-derivative
energy-related contracts on a gross basis at the time of contract
performance, settlement or termination.
Derivative Instruments Designated as Hedging Instruments
We designate a substantial portion of our derivative instruments as
cash flow or fair value hedges for accounting purposes. For all deriva-
tives designated as hedges, the relationship between the hedging
instrument and the hedged item is formally documented, as well as
the risk management objective and strategy for using the hedging
instrument. We assess whether the hedging relationship between
the derivative and the hedged item is highly effective at offsetting
changes in cash flows or fair values both at the inception of the hedg-
ing relationship and on an ongoing basis. Any change in fair value of
the derivative that is not effective at offsetting changes in the cash
flows or fair values of the hedged item is recognized currently in earn-
ings. Also, we may elect to exclude certain gains or losses on hedging
instruments from the measurement of hedge effectiveness, such as
gains or losses attributable to changes in the time value of options or
changes in the difference between spot prices and forward prices,
thus requiring that such changes be recorded currently in earnings.
We discontinue hedge accounting prospectively for derivatives that
have ceased to be highly effective hedges.
•Cash Flow Hedges — A significant portion of our hedge strate-
gies represents cash flow hedges of the variable price risk asso-
ciated with the purchase and sale of electricity, natural gas and
oil. We also use foreign currency forward contracts to hedge the
variability in foreign exchange rates and interest rate swaps to
hedge our exposure to variable interest rates on long-term debt.
For transactions in which we are hedging the variability of cash
flows, changes in the fair value of the derivative are reported in
accumulated other comprehensive income (loss)(AOCI), to the
extent effective at offsetting changes in the hedged item, until
earnings are affected by the hedged item. For cash flow hedge
transactions, we discontinue hedge accounting if the occur-
rence of the forecasted transaction is determined to be no
longer probable. We reclassify any derivative gains or losses
reported in AOCI to earnings when the forecasted item is
included in earnings, if it should occur, or earlier, if it becomes
probable that the forecasted transaction will not occur.
•Fair Value Hedges — We also use fair value hedges to mitigate
the fixed price exposure inherent in certain firm commodity
commitments and natural gas inventory. In addition, we have
designated interest rate swaps as fair value hedges to manage
our interest rate exposure on certain fixed rate long-term debt.
For fair value hedge transactions, changes in the fair value of
the derivative are generally offset currently in earnings by the
recognition of changes in the hedged item’s fair value.
•Statement of Income Presentation — Gains and losses on
derivatives designated as hedges, when recognized, are
included in operating revenue, operating expenses or interest
and related charges in our Consolidated Statements of Income.
Specific line item classification is determined based on the
nature of the risk underlying individual hedge strategies. The
portion of gains or losses on hedging instruments determined to
be ineffective and the portion of gains or losses on hedging
instruments excluded from the measurement of the hedging
62 Dominion 2005