Dominion Power 2004 Annual Report Download - page 32

D 2004/Page 30
Management’s Discussion and Analysis of Financial Condition and Results of Operations, Continued
Discount rates are determined from analyses performed by a third
party actuarial firm of AA/Aa rated bonds with cash flows matching the
expected payments to be made under Dominion’s plans. Due to declines in
bond yields and interest rates, Dominion reduced the discount rate used to
calculate 2004 pension and other postretirement benefit cost to 6.25%
compared to the 6.75% and 7.25% discount rates that it used to calculate
2003 and 2002 pension and other postretirement benefit cost, respectively.
The medical cost trend rate assumption is established based on analy-
ses performed by a third party actuarial firm of various factors including the
specific provisions of Dominion’s medical plans, actual cost trends experi-
enced and projected, and demographics of plan participants. Dominion’s
medical cost trend rate assumption as of December 31, 2004 is 9% and is
expected to gradually decrease to 5% in later years.
The following table illustrates the effect on cost of changing the critical
actuarial assumptions discussed above, while holding all other assump-
tions constant:
Increase in
Net Periodic Cost
Other
Actuarial Change in Pension Postretirement
Assumption Assumption Benefits Benefits
(millions)
Discount rate (0.25%) $13 $ 6
Rate of return on plan assets (0.25%) 10 2
Healthcare cost trend rate 1% N/A 22
In addition to the effects on cost, a 0.25% decrease in the discount rate
would increase the projected pension benefit obligation by $122 million
and would increase the accumulated postretirement benefit obligation by
$45 million.
Accounting for regulated operations
Dominion’s accounting for its regulated electric and gas operations differs
from the accounting for nonregulated operations in that Dominion is
required to reflect the effect of rate regulation in its Consolidated Financial
Statements. Specifically, Dominion’s regulated businesses record assets
and liabilities that nonregulated companies would not report under
accounting principles generally accepted in the United States of America.
When it is probable that regulators will allow for the recovery of current
costs through future rates charged to customers, Dominion defers these
costs that otherwise would be expensed by nonregulated companies and
recognizes regulatory assets in its financial statements. Likewise,
Dominion recognizes regulatory liabilities in its financial statements when
it is probable that regulators will require reductions in revenue associated
with customer credits through future rates and when revenue is collected
from customers for expenditures that are not yet incurred.
Management evaluates whether or not recovery of its regulatory
assets through future regulated rates is probable and makes various
assumptions in its analyses. The expectations of future recovery are gener-
ally based on orders issued by regulatory commissions or historical experi-
ence, as well as discussions with applicable regulatory authorities. If
recovery of regulatory assets is determined to be less than probable, the
regulatory asset will be written off and an expense will be recorded in the
period such assessment is made. Management currently believes the
recovery of its regulatory assets is probable. See Notes 2 and 14 to the
Consolidated Financial Statements.
Accounting for gas and oil operations
Dominion follows the full cost method of accounting for gas and oil explo-
ration and production activities prescribed by the SEC. Under the full cost
method, all direct costs of property acquisition, exploration and develop-
ment activities are capitalized and subsequently depreciated using the
units-of-production method. The depreciable base of costs includes esti-
mated future costs to be incurred in developing proved gas and oil
reserves, as well as capitalized asset retirement costs, net of projected
salvage values. Capitalized costs in the depreciable base are subject to a
ceiling test prescribed by the SEC. The test limits capitalized amounts to a
ceiling
— the present value of estimated future net revenues to be derived
from the production of proved gas and oil reserves assuming period-end
pricing adjusted for cash flow hedges in place. Dominion performs the ceil-
ing test quarterly, on a country-by-country basis, and would recognize asset
impairments to the extent that total capitalized costs exceed the ceiling. In
addition, gains or losses on the sale or other disposition of gas and oil
properties are not recognized, unless the gain or loss would significantly
alter the relationship between capitalized costs and proved reserves of
natural gas and oil attributable to a country.
Dominion’s estimate of proved reserves requires a large degree of judg-
ment and is dependent on factors such as historical data, engineering esti-
mates of proved reserve quantities, estimates of the amount and timing of
future expenditures to develop the proved reserves, and estimates of
future production from the proved reserves. Given the volatility of natural
gas and oil prices, it is possible that Dominion’s estimate of discounted
future net cash flows from proved natural gas and oil reserves that is used
to calculate the ceiling could change in the near term.
The process to estimate reserves is imprecise, and estimates are sub-
ject to revision. In the last five years, revisions to Dominion’s estimates of
proved developed and undeveloped reserves have averaged approximately
3% of the previous year’s estimate. If there is a significant variance in any
of its estimates or assumptions in the future and revisions to the value of
its proved reserves are necessary, related depletion expense and the calcu-
lation of the ceiling test would be affected and recognition of natural gas
and oil property impairments could occur. See Notes 2 and 28 to the Con-
solidated Financial Statements.
Income Taxes
Judgment is required in developing Dominion’s provision for income taxes,
including the determination of deferred tax assets and any related valua-
tion allowance. Dominion evaluates the probability of realizing its deferred
tax assets on a quarterly basis by reviewing its forecast of future taxable
income and the availability of tax planning strategies that can be imple-
mented, if necessary, to realize deferred tax assets. Failure to achieve fore-
casted taxable income or successfully implement tax planning strategies
might affect the ultimate realization of deferred tax assets.
Newly Adopted Accounting Standards
During 2004 and 2003, Dominion was required to adopt several new
accounting standards, the requirements of which are discussed in Notes 2
and 3 to the Consolidated Financial Statements. The accounting standards
adopted during 2003 affect the comparability of Dominion’s Consolidated
Statements of Income. The following discussion is presented to provide an
understanding of the impacts of those standards on that comparability.