Dominion Power 2004 Annual Report Download - page 30

D 2004/Page 28
Management’s Discussion and Analysis of Financial Condition and Results of Operations, Continued
Corporate and Other includes:
•Dominion’s corporate, service company and other operations, including
unallocated debt;
•The remaining assets of Dominion Capital, Inc. (DCI), a financial
services subsidiary, which are being divested in accordance with a
Securities and Exchange Commission (SEC) order;
•The net impact of Dominion’s discontinued telecommunications opera-
tions that were sold in May 2004; and
•Specific items attributable to Dominion’s operating segments that are
reported in Corporate and Other.
Accounting Matters
Critical Accounting Policies and Estimates
Dominion has identified the following accounting policies, including cer-
tain inherent estimates, that as a result of the judgments, uncertainties,
uniqueness and complexities of the underlying accounting standards and
operations involved, could result in material changes to its financial condi-
tion or results of operations under different conditions or using different
assumptions. Management has discussed the development, selection and
disclosure of each of these with Dominion’s Audit Committee.
Accounting for derivative contracts at fair value
Dominion uses derivative contracts (primarily forward purchases and sales,
swaps, options and futures) to buy and sell energy-related commodities
and to manage its commodity and financial markets risks. Derivative con-
tracts, with certain exceptions, are subject to fair value accounting and are
reported on the Consolidated Balance Sheets at fair value. Accounting
requirements for derivatives and related hedging activities are complex
and may be subject to further clarification by standard-setting bodies.
Fair value of derivatives is based on actively quoted market prices, if
available. In the absence of actively quoted market prices, Dominion seeks
indicative price information from external sources, including broker quotes
and industry publications. If pricing information from external sources is
not available, Dominion must estimate prices based on available historical
and near-term future price information and use of statistical methods. For
options and contracts with option-like characteristics where pricing infor-
mation is not available from external sources, Dominion generally uses a
modified Black-Scholes Model that considers time value, the volatility of
the underlying commodities and other relevant assumptions. Dominion
uses other option models when contracts involve different commodities or
commodity locations and when contracts allow either the buyer or seller
the ability to exercise within a range of quantities. For contracts with
unique characteristics, Dominion estimates fair value using a discounted
cash flow approach. If pricing information is not available from external
sources, judgment is required to develop estimates of fair value. For indi-
vidual contracts, the use of different valuation models or assumptions
could have a material effect on the contract’s estimated fair value.
For cash flow hedges of forecasted transactions, Dominion must esti-
mate the future cash flows represented by the forecasted transactions, as
well as evaluate the probability of occurrence and timing of such transac-
tions. Changes in conditions or the occurrence of unforeseen events could
require discontinuance of hedge accounting or could affect the timing for
reclassification of gains or losses on cash flow hedges from accumulated
other comprehensive income (loss) (AOCI) into earnings.
Use of estimates in goodwill impairment testing
As of December 31, 2004, Dominion reported $4.3 billion of goodwill on its
Consolidated Balance Sheet, a significant portion of which resulted from
the acquisition of CNG in 2000. Substantially all of this goodwill is allo-
cated to Dominion’s Generation, Transmission, Delivery and Exploration &
Production reporting units. In April of each year, Dominion tests its good-
will for potential impairment, and performs additional tests more fre-
quently if impairment indicators are present. The 2004 annual test did not
result in the recognition of any impairment of goodwill, as the estimated
fair values of Dominion’s reporting units exceeded their respective carrying
amounts. During the fourth quarter of 2004, Dominion tested $72 million of
goodwill allocated to the Clearinghouse reporting unit after management
decided to exit certain energy trading activities and change the focus of the
business, which resulted in a reduction of the unit’s expected future cash
flows. This interim test indicated that no impairment existed and approxi-
mately $8 million of the unit’s goodwill was reallocated to other reporting
units as of December 31, 2004 in connection with management’s reorgani-
zation of that business. In 2003 and 2002, impairment charges of $78 mil-
lion and $13 million, respectively, were recognized as a result of interim
tests conducted for certain DCI subsidiaries and Dominion’s telecommuni-
cations business.
Dominion estimates the fair value of its reporting units by using a com-
bination of discounted cash flow analyses, based on its internal five-year
strategic plan, and other valuation techniques that use multiples of earn-
ings for peer group companies and analyses of recent business combina-
tions involving peer group companies. These calculations are dependent on
subjective factors such as management’s estimate of future cash flows, the
selection of appropriate discount and growth rates, and the selection of
peer group companies and recent transactions. These underlying assump-
tions and estimates are made as of a point in time; subsequent modifica-
tions, particularly changes in discount rates or growth rates inherent in
management’s estimates of future cash flows, could result in a future
impairment of goodwill. Although Dominion has consistently applied the
same methods in developing the assumptions and estimates that underlie
the fair value calculations, such as estimates of future cash flows, and
based those estimates on relevant information available at the time, such
cash flow estimates are highly uncertain by nature and may vary signifi-
cantly from actual results. If the estimates of future cash flows used in the
2004 annual test had been 10% lower, the resulting fair values would have
still been greater than the carrying values of each of those reporting units,
indicating no impairment was present.
Use of estimates in long-lived asset impairment testing
Impairment testing for an individual or group of long-lived assets or intan-
gible assets with definite lives is required when circumstances indicate
those assets may be impaired. When an asset’s carrying amount exceeds
the undiscounted estimated future cash flows associated with the asset,
the asset is considered impaired to the extent that the asset’s fair value is
less than its carrying amount. Performing an impairment test on long-lived
assets involves management’s judgment in areas such as identifying cir-
cumstances indicating an impairment may exist, identifying and grouping
affected assets and developing the undiscounted and discounted esti-
mated future cash flows (used to estimate fair value in the absence of mar-
ket-based value) associated with the asset, including the selection of an
appropriate discount rate. Although cash flow estimates used by Dominion