Dominion Power 2004 Annual Report Download - page 66

Notes to Consolidated Financial Statements, Continued
common stock on the date of grant. Stock option awards generally do not
result in compensation expense since their exercise price is typically equal
to the market price of Dominion’s common stock on the date of grant.
Compensation expense, if any, for both types of awards is recognized on a
straight-line basis over the stated vesting period of the award.
The following table illustrates the pro forma effect on net income and
earnings per share (EPS) if Dominion had applied the fair value recognition
provisions of SFAS No. 123,
Accounting for Stock-Based Compensation , to
stock-based employee compensation:
Year Ended December 31, 2004 2003 2002
(millions)
Net income — as reported $1,249 $ 318 $1,362
Add: actual stock-based compensation expense,
net of tax(1) 10 10 5
Deduct: pro forma stock-based compensation expense,
net of tax (20) (36) (52)
Net income — pro forma $1,239 $ 292 $1,315
Basic EPS — as reported $ 3.80 $1.00 $ 4.85
Basic EPS — pro forma 3.77 0.92 4.68
Diluted EPS — as reported 3.78 1.00 4.82
Diluted EPS — pro forma 3.75 0.92 4.65
(1) Actual stock-based compensation expense reflects primarily the issuance of restricted stock.
Cash and Cash Equivalents
Current banking arrangements generally do not require checks to be funded
until actually presented for payment. At December 31, 2004 and 2003,
accounts payable includes $158 million and $123 million, respectively of
checks outstanding but not yet presented for payment. For purposes of the
Consolidated Statements of Cash Flows, Dominion considers cash and
cash equivalents to include cash on hand, cash in banks and temporary
investments purchased with a remaining maturity of three months or less.
Inventories
Materials and supplies and fossil fuel inventories are valued primarily
using the weighted-average cost method. Stored gas inventory used in
local gas distribution operations is valued using the last-in-first-out (LIFO)
method. Under the LIFO method, those inventories were valued at $59 mil-
lion at both December 31, 2004 and 2003. Based on the average price of
gas purchased during 2004, the cost of replacing the current portion of
stored gas inventory exceeded the amount stated on a LIFO basis by
approximately $302 million. Stored gas inventory held by certain nonregu-
lated gas operations is valued using the weighted-average cost method.
Derivative Instruments
Dominion uses derivative instruments such as futures, swaps, forwards
and options to manage the commodity, currency exchange and financial
market risks of its business operations. Dominion also manages a portfolio
of commodity contracts held for trading purposes as part of its strategy to
market energy and to manage related risks.
All derivatives, except those for which an exception applies, are
reported on the Consolidated Balance Sheets at fair value. One of the
exceptions
— 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. Derivative contracts that are subject to fair value accounting,
including unrealized gain positions and purchased options, are reported as
derivative assets. Derivative contracts representing unrealized losses and
options sold are reported as derivative liabilities. For derivatives that are
not designated as hedging instruments, any changes in fair value are
recorded in earnings.
Valuation Methods
Fair value 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 certain statistical methods, including
regression analysis.
For options and contracts with option-like characteristics where pricing
information 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 when estimat-
ing fair value. Other option models are used by Dominion under special cir-
cumstances, including a Spread Approximation Model, when contracts
include different commodities or commodity locations and a Swing Option
Model, when contracts allow either the buyer or seller the ability to exer-
cise within a range of quantities. For contracts with unique characteristics,
Dominion estimates fair value using a discounted cash flow approach
deemed appropriate in the circumstances and applied consistently from
period to period. If pricing information is not available from external
sources, judgment is required to develop the estimates of fair value. For
individual contracts, the use of different valuation models or assumptions
could have a material effect on the contract’s estimated fair value.
Derivative Instruments Designated as Hedging Instruments
Dominion designates a substantial portion of derivative instruments, held
for purposes other than trading, as fair value or cash flow hedges for
accounting purposes. For all derivatives designated as hedges, the relation-
ship between the hedging instrument and the hedged item is formally docu-
mented, as well as the risk management objective and strategy for using
the hedging instrument. Dominion assesses whether the hedge relationship
between the derivative and the hedged item is highly effective in offsetting
changes in fair value or cash flows both at the inception of the hedge and on
an ongoing basis. Any change in fair value of the derivative that is not effec-
tive in offsetting changes in the fair value or cash flows of the hedged item
is recognized currently in earnings. Also, management 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. Dominion discontinues hedge accounting prospectively for deriva-
tives that have ceased to be highly effective hedges.
Cash Flow Hedges — A significant portion of Dominion’s hedge strate-
gies represents cash flow hedges of the variable price risk associated with
the purchase and sale of electricity, natural gas and oil. Dominion also uses
foreign currency forward contracts to hedge the variability in foreign
exchange rates and interest rate swaps to hedge its exposure to variable
interest rates on long-term debt. For cash flow hedge transactions in which
D 2004/Page 64