MANAGEMENT S DISCUSSION AND ANALYSIS December 31, 2011 and 2010

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1 Public Utility District No. 1 of Pend Oreille County, Washington MANAGEMENT S DISCUSSION AND ANALYSIS December 31, 2011 and 2010 The financial management of the Public Utility District No. 1 of Pend Oreille County (the District) offers readers of these financial statements this overview and summary analysis of the financial activities of the District for the years ended December 31, 2011 and This discussion and analysis is designed to be used in conjunction with the financial statements and notes, which follow this section. Overview of the Financial Statements The financial section of the Annual Report includes the Report of Independent Auditors, Management s Discussion and Analysis, Basic Financial Statements with accompanying notes, and Supplemental Information (unaudited). The financial statements of the District report the self-supporting, proprietary activities of the District funded primarily by the sale of power, water, and telecommunication services. The District reports the business-type activities in a manner similar to privatesector business enterprises, using the accrual basis of accounting, in accordance with accounting principles generally accepted in the United States of America. The District s reporting entity is comprised of four primary component units, or operating systems. The Electric System distributes electricity to residential and other consumers in Pend Oreille County. The Box Canyon Production System produces hydroelectric power from the Box Canyon Hydroelectric Project. The Water System consists of nine individual water distribution subdivisions. The Community Network System supplies wholesale broadband communication services. The financial statements are reported in a combined format, meaning each of the primary component units are reported in a columnar approach, which are combined to a District-wide total. The Combined Balance Sheets present information on the District s assets and liabilities and provide information regarding the nature and amount of resource investment (assets), and obligations incurred in the pursuit of such resources. This statement also provides a vehicle for evaluating the capital structure of the District and assessing liquidity and financial flexibility of the District. The Combined Statements of Revenues, Expenses, and Changes in Net Assets reports revenues and expenses as well as change in net assets (owners equity) for this period. This statement provides a measurement of the District s operations, helps to evaluate the level of cost recovery from charges for products and services, and can be used as a partial determinant of creditworthiness. The Combined Statements of Cash Flows provide information concerning cash receipts and disbursements during the reporting period resulting from operational, financing, and investing activities. This information provides insight into the District s ability to generate net cash flows and meet obligations, as they become due, and is an important indicator of the District s liquidity and financial strength. The Notes to Combined Financial Statements provide additional information that is essential to a full understanding of the financial statements, as described above, and are an integral part thereof. Summary of Financial Condition The District continues to maintain a solid financial position and is poised for continued cost effective service to its customers. To maintain desired operating cash flows, the District increased electric rates approximately 12% in July 2009 and 15% in July 2011, yet the District s electric rates continue to compare very favorably with other utilities in Washington State and across the nation. The District maintains significant cash reserve levels, which has been favorably commented on by the rating agencies, and resultantly continues to have the financial flexibility to react to unexpected adversity. District bonds are rated by Moody s Investors Service and Fitch Ratings. In 2009, Moody s Investors Service evaluated the District and confirmed the Electric System s previous A3 rating, but added a negative outlook, then assigned that same rating to Box Canyon Production System bonds. In 2009, Fitch Ratings evaluated the District s Electric System bonds as A- (stable), which is consistent with the rating they have given since they began analyzing the District in 2005, and assigned that same rating to the 2009 Box Canyon Production System bonds. There were no rating changes associated with the 2010 bond issuances. 1

2 Capital Projects Activities during 2011 and 2010 focused around major capital projects occurring at the District. Along with construction requirements and related changes in operations, the District has been involved with the related financing requirements for these capital projects. Box Canyon Hydroelectric Project FERC License The Box Canyon Hydroelectric Project license is discussed in Note 8 to the financial statements. Costs to complete capital projects required by the license are subject to several variables, including component price fluctuations and changes in engineering specifications. Current ongoing capital projects include turbine upgrades (estimated project cost of $110 million) and plant modernization (estimated project cost of $25 million), both of which are scheduled for completion by The District is financing these projects with periodic revenue bond issuances. The majority of the plant modernization work is complete. The first of the four turbine upgrades was completed in early The installation of the second is currently underway and the third unit is being manufactured. Each new turbine and associated generator output capacity is projected at 22.5 megawatts, an increase of 4.5 megawatts per turbine. Community Network System ARRA Project The District s Community Network System is engaged in a fiber optic project in south Pend Oreille County. The $34 million project, which provides fiber optic broadband service to the home and business premise, is 80% financed by an ARRA grant and scheduled for completion by March 31, The majority of the construction work is scheduled for Significant overruns or inability to complete the project could impact District broadband rates. An inability of the Community Network System to self-support its own activities could affect Electric System power rates. See Note 10 to the financial statements for further information. Electric System Transmission Line In 2010, the Electric System completed a $5.6 million transmission line project financed by a revenue bond issuance. The line is 115kv transmission capable from the Diamond Lake substation to a future Bare Mountain substation site, but is currently being used as distribution capacity to the southern part of the District s service territory until load growth dictates building the Bare Mountain substation, which is not forecasted in the next five years. Financial Analysis Combined Balance Sheet Information as of December 31, 2011, 2010, and Assets Current Assets $ 109,794,123 $ 108,552,814 $ 78,268,545 Other Assets 8,553,207 13,382,473 6,360,029 Net Utility Plant 170,134, ,699, ,793,551 Total Assets $ 288,481,923 $ 272,634,387 $ 218,422,125 Liabilities Current Liabilities $ 28,267,983 $ 19,363,407 $ 19,571,811 Other Liabilities 17,707,581 17,329,199 8,706,078 Long-Term Debt 133,314, ,594,944 95,919,815 Total Liabilities 179,289, ,287, ,197,704 Net Assets Invested in Capital Assets, Net of Related Debt 73,756,675 59,707,943 73,149,649 Restricted 16,867,675 15,803,224 9,367,515 Unrestricted 18,567,577 22,835,670 11,707,257 Total Net Assets 109,191,927 98,346,837 94,224,421 Total Liabilities and Net Assets $ 288,481,923 $ 272,634,387 $ 218,422,125 2

3 2011 versus 2010 The December 31, 2011 increase in net utility plant reflects the District s ongoing work on capital projects previously discussed. Gross utility plant increased $23.0 million, approximately $11.1 million associated with the Box Canyon Project turbine upgrades and $7.4 million with the Community Network System ARRA project. No new debt was issued in 2011 to pay for these projects, yet current assets did not drop from the December 31, 2010 balance as might be expected from a spending of monies. This is due to several factors. The Community Network System ARRA project is largely funded by grant monies and District expenditures are reimbursed on a timely basis. The contractor for the Box Canyon turbine upgrade project delayed billings in the latter part of 2011, reflected in a $5.8 million increase in accounts payable at December 31, The billings are not in dispute. Also, spending of construction fund cash is partially masked by a $5,024,291 reclassification in a customer security deposit from long term to current asset status. Variations among years for Net Assets Invested in Capital Assets and Restricted Net Assets reflect the timing of debt issuance, deposits into restricted construction funds, and the ultimate expenditure of those monies for capital assets versus 2009 The increase in current assets of $30,284,269 relates to the increased long-term debt of $41,675,129. The District borrowed to finance its major capital projects and much of that borrowing remained unspent in construction fund reserves. As of December 31, 2010, the District increased construction and acquisition funds by $11,440,844, restricted debt service and debt reserve funds by $8,103,241, and unrestricted cash and cash equivalents by $10,631,756. The increase in both Other Assets and Other Liabilities reflects a security deposit held in a trust account on behalf of an industrial customer in lieu of a letter-of-credit provided by the customer in previous years. Gross utility plant increased $20,943,222 of which approximately $12.5 million was associated with the continuing upgrade work on the Box Canyon Project turbines and $4.3 million to complete the previously discussed $5.6 million transmission line project. Long-Term Debt at December 31, 2010 is 50% of total assets, up from 44% as of December 31, The District issued $70,310,000 of Box Canyon Production System revenue bonds in October 2009 and $34,110,000 of Box Canyon Production System revenue bonds and $20,745,000 of Electric System revenue bonds in November Year-end Net Assets is 36% of the total asset valuation of $272,634,387 compared to 43% as of December 31, The lower trend reflects the increase in assets and debt associated with the Box Canyon turbine upgrades and plant modernization. Electric System Operating Results Electric Operating Revenues Ponderay Newsprint Company $ 26,944,338 $ 28,166,921 $ 22,069,142 Other Retail Customers 12,190,672 10,359,671 11,327,321 Sales to Other Utilities 4,673,926 4,027,588 5,806,309 All Other 719,469 1,376,213 1,060,638 Total Operating Revenues 44,528,405 43,930,393 40,263,410 Electric Operating Expenses Power Costs 27,684,535 28,415,689 24,915,859 All Other 13,340,121 12,875,258 12,179,560 Total Operating Expenses 41,024,656 41,290,947 37,095,419 Net Operating Revenues 3,503,749 2,639,446 3,167,991 Non-Operating Expenses (1,161,658) (817,084) (890,271) Transfer of System Assets - (2,293,893) - Change in Net Assets $ 2,342,091 $ (471,531) $ 2,277,720 Debt Service Coverage 1.63x 1.86x 2.07x 3

4 Operating Revenues The District s largest customer, Ponderay Newsprint Company, represented 76% of the District s retail energy usage in 2011 compared to 78% and 74% in 2010 and 2009, respectively. Ponderay Newsprint Company s billing is based on contractually agreed actual cost of service methodology rather than under a rate schedule. Accordingly, their billings increase or decrease in direct relation to the District s power supply costs. Further, they receive credit for the majority of the District s wholesale power sales to other utilities; therefore, their billings decrease when Sales to Other Utilities increase, and vice versa. Other Retail Customers revenues, which represent all retail energy customers other than Ponderay Newsprint Company, increased in 2011 largely due to a mid-year rate increase of approximately 15% for all customer classes. The District had a similar increase of 12% in mid Despite a full year at the higher rate level, 2010 retail customer revenues dropped from 2009 due to an unseasonably warm winter in the first part of 2010 and resultantly low power sales. The number of District residential energy customers remained approximately level in 2011, and grew at less than 1% in 2010 and 2009, reflective of the state of the regional and national housing market and economic downturn. In February 2009, the District s then second largest customer, Teck, shut down its zinc mining operations due to low commodity prices. The mine continues to operate essential systems and perform certain exploratory surveys and consumes approximately a third as much power as under historical full operation. The District is unaware of any Teck plans to resume full operations or alternatively move to complete plant closure. The following chart reflects the District s comparatively low rate structure. Cents per Kilowatt National Residential WA State Residential District Residential District Commercial District Industrial Ponderay Newsprint Sales to Other Utilities are primarily associated with the Bonneville Power Administration Block and Slice of the System products as discussed in Note 5 to the financial statements. The Slice of the System product generation quantity varies with Columbia River water flows and its resale value moves with power market prices and regional economic conditions. Additionally, the quantity of power excess to customer load requirements and therefore sold into the wholesale market varies. Resultantly, wholesale sales to other utilities will vary from year to year. The District considers variations from 2009 to 2011 to be normal. Energy Resources and Power Costs Percent Annual Resource Quantity 50% 40% 30% 20% 10% 0% Box Canyon Boundary Bonneville Other Millions of Dollars Annual Resource Cost $18.0 $15.0 $12.0 $9.0 $6.0 $3.0 $ Box Canyon Boundary Bonneville Other The cost of power from the District s third primary source, the Box Canyon Hydroelectric Project, increased in recent years as a result of debt service associated with turbine upgrades and plant modernization efforts as well as FERC license compliance obligations. Additionally, power generation varies with water flows and capacity increases as the turbine upgrade work continues. The cost of generating Box Canyon power averaged $32 per MWh in 2011, $34 in 2010 and $23 in The District has a right to 48 megawatts of power capacity from the City of Seattle s Boundary Hydroelectric Project for the term of their existing and pending FERC licenses. At less than $5 per megawatt hour in 2011, power received from Boundary Hydroelectric Project is the District s most inexpensive power source and a key component of the District s low customer rates. 4

5 Power obtained from the Bonneville Power Administration (Bonneville or BPA) cost $25 per megawatt hour in 2011, $31 in 2010, and $28 in The District s entitlement quantity and cost of Bonneville power is variable depending on water flows. The District entered into a new 20-year contract, effective October 1, 2011, which contractually reduced the District s entitlement quantity to approximately 3/4 of the prior entitlement level. Other Energy Resources include costs to operate the Calispell Powerhouse, which produces less than 1 megawatt per hour, market power purchases necessary to balance resources to customer load, power marketed under contract for the Kalispel Tribe, and transmission related expenditures. Other Costs All Other Operating Expenses include operations and maintenance, administrative and general, taxes, and depreciation, the balances of which increase slightly, reflecting normal fluctuations and higher depreciation expense. The 2010 Transfer of System Assets relates to expansion of the District s fiber optic infrastructure. To better track revenues and expenses associated with fiber services, during 2010 the District segregated the Community Network System as a separate operating system. The infrastructure assets were previously held in the Electric System, and were transferred to the Community Network System effective January 1, Debt Service Coverage The Debt Service Coverage Ratio measures cash flow from operations in comparison to annual debt service. As a result of the Electric System bonds issued late 2010, the measurement declined as debt service increased. The 15% rate increase, effective seven months later, restored the ratio to the District s desired level. The District planned the seven month delay to deliberately reduce cash reserves understanding there would be a one year decline in the 2011 ratio as a result of the timing difference. Box Canyon Production System Operating Results Production Operating Revenues Sales to the Electric System $ 14,847,710 $ 15,890,603 $ 10,736,050 All Other 1,448,319 1,600 1,725 Total Operating Revenues 16,296,029 15,892,203 10,737,775 Production Operating Expenses 11,032,364 12,579,639 9,828,345 Net Operating Revenues 5,263,665 3,312, ,430 Non-Operating Revenues (Expenses) (3,840,751) (1,708,546) (460,009) Change in Net Assets $ 1,422,914 $ 1,604,018 $ 449,421 Debt Service Coverage 1.17x 1.08x 2.34x The Box Canyon Production System encompasses costs related to the generation of hydroelectric power at Box Canyon Dam. The Production System sells power it produces to the District s Electric System, priced at generation cost, including the cost to build or acquire capital assets. The revenue requirement for asset acquisition is related to deposits into capital acquisition reserves or payment of debt service on related borrowings. In 2011, other operating revenue reflects a contractor settlement associated with the turbine upgrade work, which was negotiated to make the District whole for lost generation and additional costs associated with the unit being out of service past contractually agreed on dates. Changes in Operating Expenses are largely attributable to power purchases made to firm up to contractually required levels of production. Under the Ponderay Newsprint Contracts, if Box Canyon generation is less than 453,330 megawatts during the annual water year, the District will purchase wholesale power to firm generation up to this contractual level. Firm-up power purchases therefore vary with annual Pend Oreille River flows, do not occur in all years, and totaled $896,159, $2,462,721and $741,802 in 2011, 2010 and 2009, respectively. A secondary reason for variation in operating expenses for the Production System is environmental work being performed as required by FERC license conditions. The type and expense of environmental work will vary from year to year. Stream 5

6 rehabilitation work and fish studies done in the Pend Oreille River resulted in a 35% increase in costs in 2010 versus Other costs, such as operations, maintenance, and administrative costs have been relatively consistent from 2009 to The increase in Non-Operating Expenses relate to increased interest expense, net of allowance for funds used during construction (AFUDC) capitalized interest, associated with financing the Box Canyon capital project work. As the Box Canyon Hydroelectric System receives revenue from the Electric System sufficient to cover operating costs, including debt service and a component for capital spending, the normal senior lien debt service ratio will be slightly over 1.0x. The ratio will only be significantly above 1.0 during years the District elects to finance significant capital project work through current rates as opposed to debt financing. Water System Operating Results Water Operating Revenues Sales to Retail Customers $ 398,397 $ 387,194 $ 381,244 All Other 11,614 7,376 20,850 Total Operating Revenues 410, , ,094 Water Operating Expenses 537, , ,358 Net Operating Expenses (127,555) (134,805) (90,264) Non-Operating Revenues 1,031, , ,592 Change in Net Assets $ 903,573 $ 177,570 $ 595,328 The District operates nine separate water systems throughout Pend Oreille County. The District is contractually obligated to maintain separate and distinct rates for each water system which reflect the individual system s costs. The majority of the variations in the preceding table are normal variations. Grant revenues of $1,041,145, $323,372, and $697,958 are included in Non-Operating Revenue for 2011, 2010, and 2009, respectively, which funds were used to improve infrastructure. Community Network System Operating Results Community Network Operating Revenue Sales to Retail Customers $ 444,460 $ 439,659 $ 416,357 Inter-System Sales 218, ,664 66,000 All Other 42,728 1,400 28,985 Total Operating Revenues 705, , ,342 Operating Expenses 754, , ,933 Net Operating Revenues (Expenses) (49,388) (150,501) 24,409 Non-Operating Revenues 6,225, ,967 - Transfer of System Assets - 2,293,893 - Change in Net Assets $ 6,176,512 $ 2,812,359 $ 24,409 Due to the receipt of an American Recovery and Reinvestment Act (ARRA) grant, the District is broadening the scope of its broadband utility services. The $34 million project, previously discussed in the previous capital narrative, is scheduled for completion in March, New revenues are expected to begin in the second half of Sales to Retail Customers are made through third party service providers under applicable wholesale laws, are currently to businesses rather than residential in nature, and have increased in recent years with customer business requirements. Inter-system sales are services provided for the internal benefit of the District itself. The increase in 2010 Inter-System revenue is largely due to the District using dedicated fiber lines for system control and security purposes. Other revenue includes contributed capital, grant 6

7 proceeds that reimburse operating expenses, and miscellaneous revenues, which can vary based on new customer service requirements. Operating expenses include operations and maintenance to maintain the fiber optic line and related equipment, labor, and contracts for control and intertie services. The 2010 Operating Expense increase largely reflects increased depreciation on fiber optic infrastructure assets transferred from the Electric System. Prior to 2010, the Community Network System was reported as part of the Electric System. Effective January 1, 2010, the District spun the assets off into a separate operating system. The 2009 information reported in the chart above was originally disclosed in the notes to the 2009 financial statements. Other Significant Matters A description of currently known facts, decisions, and conditions that are expected to have a significant affect on future financial position or results of operations follows. Ponderay Newsprint Company District contracts with Ponderay Newsprint Company expire in The District is unaware of any plans for ceasing of their operations; however, the condition exists that District has additional business risk from an unusually high concentration of sales to a single entity. The rate impact from a loss of Ponderay Newsprint Company sales could be significant to the District, cannot be accurately forecasted, and depends upon the interaction of many factors, including but not limited to, then existing cost of production of Box Canyon Project power, cost of acquisition of Bonneville power, and market or resale value of this power. Contacting the District s Financial Management The financial report is designed to provide interested parties with a general overview of the District s finances and to demonstrate District accountability for the money it receives. If you have questions about this report, or require additional or clarifying financial information, contact the District s financial department as set forth on the last page of this Annual Report under Organizational Information Corporate Office. John D. Jordan, CPA Director of Finance 7

8 Public Utility District No. 1 of Pend Oreille County, Washington COMBINED BALANCE SHEETS ASSETS Box Canyon Community Combined Total Electric Production Water Network As of December 31, System System System System Current Assets Cash and cash equivalents (Note 2) $ 15,903,490 $ 13,832,408 $ - $ 3,913,849 $ 33,649,747 $ 34,588,746 Restricted cash and cash equivalents (Note 2) 12,611,790 50,601, ,212,846 65,315,455 Restricted short-term investment (Note 2) 5,052, ,052,619 4,814,779 Receivables- Accounts and contracts, net 1,086,694-26,900 16,672 1,130, ,289 Other 349,739 3, ,606 1,583,139 2,307, ,931 Unbilled revenue (Note 1) 873, , , ,667 Materials and supplies 1,310, , ,166 1,514,429 1,265,302 Prepaid expenses and other 331,353 1,839, ,018, ,645 Due from other systems 590,993 2,250, Total Current Assets 38,111,275 68,526, ,568 5,710, ,794, ,552,814 Non-Current Assets Restricted long-term investment (Note 2) ,024,291 Contracts and notes receivable (Note 10) 3,961,093 2,118, ,118,106 1,724,936 Non-utility plant (Note 8) 228, , ,572 Deferred licensing costs (Note 1) - 4,611, ,611,274 4,741,233 Unamortized debt issue costs 257,076 1,332,016 6,520-1,595,612 1,735,441 Total Non-Current Assets 4,446,384 8,061,396 6,520-8,553,207 13,382,473 Utility Plant (Note 3) Land and land rights 2,745, ,295 77,305 61,721 3,668,756 3,668,756 Hydroelectric plant and equipment 1,257,364 62,718, ,976,001 39,665,305 Structures, building and equipment 100,542,274-7,730,901 5,737, ,011, ,652,576 Intangible assets 226,203 12,463, ,690,588 12,707,247 Construction work in progress 1,344,854 29,544,189-8,098,827 38,987,870 43,639, ,116, ,510,764 7,808,948 13,898, ,334, ,333,786 Less accumulated depreciation and amortization 43,557,877 14,413,472 2,335,387 2,893,008 63,199,744 59,634,686 Net Utility Plant 62,558,253 91,097,292 5,473,561 11,005, ,134, ,699,100 Total Assets $ 105,115,912 $ 167,685,623 $ 5,918,649 $ 16,716,405 $ 288,481,923 $ 272,634,387 The accompanying notes are an integral part of these combined financial statements. 8

9 Public Utility District No. 1 of Pend Oreille County, Washington COMBINED BALANCE SHEETS LIABILITIES AND NET ASSETS Box Canyon Community Combined Total Electric Production Water Network As of December 31, System System System System Current Liabilities Accounts payable $ 4,670,341 $ 8,481,338 $ - $ 417,874 $ 13,569,553 $ 7,779,587 Accrued compensation and benefits 1,897, ,897,979 1,775,239 Accrued taxes 670,985 98,063 1, , ,470 Customer prepayments and deposits 2,098,944-4,369 2,500 2,105,813 1,052,973 Accrued bond interest 756,848 3,158,177 1,981-3,917,006 2,936,259 Current portion of long-term debt 2,733,333 1,235,714 37,591-4,006,638 2,938,999 Current portion of deferred revenue ,168 49,588 49,588 Current portion of deferred licensing costs - 1,950, ,950,354 2,105,292 Due to other systems ,660 2,263, Total Current Liabilities 12,828,430 14,923, ,232 2,886,248 28,267,983 19,363,407 Other Liabilities Deferred revenue (Notes 1 and 10) ,667, , ,781 Deferred licensing costs (Note 1) - 4,611, ,611,274 4,741,233 Contract security liability (Note 5) 10,089,100 2,127, ,216,114 11,658,185 Total Other Liabilities 10,089,100 6,738,288-4,667,953 17,707,581 17,329,199 Long-Term Debt Revenue bonds (Note 4) 29,198, ,619, ,817, ,047,543 Other long-term debt (Note 4) 173, , , ,401 Due to other systems , Total Long-Term Debt 29,371, ,619, , , ,314, ,594,944 Total Liabilities 52,289, ,281, ,375 7,727, ,289, ,287,550 Commitments and Contingencies (Note 8) Net Assets Invested in capital assets, net of related debt 30,811,275 26,993,899 5,119,347 10,832,154 73,756,675 59,707,943 Restricted for: Economic Development 20, , ,601 Debt service 6,705,619 10,141, ,846,716 15,694,623 Total Restricted 6,726,578 10,141, ,867,675 15,803,224 Unrestricted 15,288,823 5,269,110 (147,073) (1,843,283) 18,567,577 22,835,670 Total Net Assets 52,826,676 42,404,106 4,972,274 8,988, ,191,927 98,346,837 Total Liabilities and Net Assets $ 105,115,912 $ 167,685,623 $ 5,918,649 $ 16,716,405 $ 288,481,923 $ 272,634,387 The accompanying notes are an integral part of these combined financial statements. 9

10 Public Utility District No. 1 of Pend Oreille County, Washington COMBINED STATEMENTS OF REVENUES, EXPENSES, AND CHANGES IN NET ASSETS Box Canyon Community Combined Total Electric Production Water Network As of December 31, System System System System Operating Revenues Sales to retail customers- Ponderay Newsprint Company $ 26,944,338 $ - $ - $ - $ 26,944,338 $ 28,166,921 Other retail customers 12,190, , ,460 13,033,529 11,186,524 Sales to other utilities 4,673, ,673,926 4,027,588 Inter-system sales 161,373 14,847, , Contributed capital (Note1) 274,296-6, , ,324 Grant revenues (Note 9) - 3,033-42,055 45,088 - Other 283,800 1,445,286 5, ,544, ,302 Total Operating Revenues 44,528,405 16,296, , ,452 46,521,365 43,866,659 Operating Expenses Power costs 27,684, , ,720,890 14,370,876 Operations and maintenance 4,547,727 5,599, , ,695 10,574,672 11,392,492 Administrative and general 3,484,006 2,191,919 49,692 50,999 5,487,631 5,100,857 Taxes 2,016, ,425 20,272 2,608 2,142,446 2,032,840 Depreciation and amortization 3,292,247 2,241, , ,538 6,005,255 5,302,890 Total Operating Expenses 41,024,656 11,032, , ,840 37,930,894 38,199,955 Net Operating Revenues (Expenses) 3,503,749 5,263,665 (127,555) (49,388) 8,590,471 5,666,704 Non-Operating Revenues (Expenses) Interest income 122, , , , ,472 Interest on debt (1,506,642) (6,201,781) (8,587) - (7,717,010) (5,871,641) AFUDC interest (Note 1) - 1,001, ,001,199 1,488,944 Grant revenues (Note 9) - - 1,041,145 6,229,669 7,270, ,357 Sullivan net revenue (Note 8) 38, ,376 83,857 Other, net 184,364 1,218,385 (1,556) (7,498) 1,408,352 1,555,723 Total Non-Operating Revenues (Expenses) (1,161,658) (3,840,751) 1,031,128 6,225,900 2,254,619 (1,544,288) Change in Net Assets 2,342,091 1,422, ,573 6,176,512 10,845,090 4,122,416 Accumulated Net Assets Beginning of year 50,484,585 40,981,192 4,068,701 2,812,359 98,346,837 94,224,421 End of year $ 52,826,676 $ 42,404,106 $ 4,972,274 $ 8,988,871 $ 109,191,927 $ 98,346,837 The accompanying notes are an integral part of these combined financial statements. 10

11 Public Utility District No. 1 of Pend Oreille County, Washington COMBINED STATEMENTS OF CASH FLOWS OPERATING AND FINANCING ACTIVITIES Box Canyon Community Combined Total Electric Production Water Network As of December 31, System System System System Cash Flows from Operating Activities Receipts from customers $ 44,950,579 $ - $ 368,504 $ 435,137 $ 45,754,220 $ 54,812,516 Receipts from other operating revenues 48,069 1,507,013-42,055 1,597,137 49,669 Payments to suppliers for goods and services (15,023,937) (10,681,162) (147,670) (110,668) (25,963,437) (32,162,931) Payments to employees for services (5,049,860) (3,887,310) (161,299) (201,715) (9,300,184) (9,089,859) Payments to (from) other systems (14,927,657) 14,503, , , Net cash from operating activities 9,997,194 1,442, , ,063 12,087,736 13,609,395 Cash Flows from Noncapital Financing Activities Non-operating asset Acquisition and construction of long-term asset (71,643) (71,643) (99,783) Receipts from revenues 139, ,989 7,675 Payments for goods and services (137,745) (137,745) (381,738) Change in license surrender liability (Note 8) ,938 Economic Development Fund Transfers and other receipts (25,000) (25,000) 25,000 Awarded to grant applicants (9,773) (9,773) (16,654) Intersystem financing 126, ,917 (767) (373,412) - - Net change in noncapital financing activities 22, ,917 (767) (373,412) (104,172) (4,562) Cash Flows from Capital and Related Financing Activities Acquisition and construction of capital assets (2,639,310) (4,774,746) (1,011,995) (7,417,583) (15,843,634) (15,172,320) Proceeds from grants ,531 4,859,169 5,638,700 1,380,519 Change of deferred revenue (Note 1) (49,588) (49,588) (49,589) Proceeds from issuance of revenue bonds ,687,573 Payments on revenue bonds (1,700,000) (1,180,714) - - (2,880,714) (7,620,714) Interest paid on revenue bonds (1,182,682) (5,679,452) - - (6,862,134) (4,110,709) Scheduled payments on notes payable (13,333) - (44,953) - (58,286) (44,954) Interest paid on notes payable - - (8,819) - (8,819) (125,745) Payment on notes payable (5,000,000) Net change in capital and related financing activities (5,535,325) (11,634,912) (286,236) (2,608,002) (20,064,475) 23,944,061 The accompanying notes are an integral part of these combined financial statements. 11

12 Public Utility District No. 1 of Pend Oreille County, Washington COMBINED STATEMENTS OF CASH FLOWS INVESTING ACTIVITIES AND RECONCILIATIONS Net change in investing activities 4,898, ,245-3,711 5,039,303 (9,585,574) Net Change in Cash and Cash Equivalents 9,382,306 (9,807,274) - (2,616,640) (3,041,608) 27,963,320 Cash and Cash Equivalents (Note 2) Beginning of year 19,132,974 74,240,738-6,530,489 99,904,201 71,940,881 End of year $ 28,515,280 $ 64,433,464 $ - $ 3,913,849 $ 96,862,593 $ 99,904,201 Reconciliation of Net Operating Revenues (Expenses) to Cash Flows from Operating Activities Net operating revenues (expenses) $ 3,503,749 $ 5,263,665 $ (127,555) $ (49,388) $ 8,590,471 $ 5,666,704 Adjustments to reconcile net operating revenues (expenses) to net cash from operating activities Depreciation and amortization 3,292,247 2,241, , ,538 6,005,255 5,302,890 Changes in operating assets and liabilties: Receivables (250,215) 58,694 (38,257) (639) (230,417) 55,427 Unbilled revenue (Note 1) (95,023) - - (9,357) (104,380) 403,351 Due to other systems (245,741) - 245, Materials and supplies (235,350) (559) 1,518 (14,736) (249,127) 146,981 Prepaid expenses and other current assets 64,400 (1,029,671) - - (965,271) 948,658 Deferred charges (Note 1) - (154,938) - - (154,938) (821,653) Accounts payable, customer deposits and prepayments 3,793,582 (4,934,728) ,616 (972,180) 1,789,507 Accrued compensation, benefits, and taxes 169,545 (1,320) , ,530 Net cash from operating activities $ 9,997,194 $ 1,442,476 $ 287,003 $ 361,063 $ 12,087,736 $ 13,609,395 Supplemental Disclosure of Noncash Financing Activities Accrued capital construction costs $ - $ 3,093,808 $ - $ - $ 3,093,808 $ (2,825,893) The accompanying notes are an integral part of these combined financial statements. 12

13 Public Utility District No. 1 of Pend Oreille County, Washington NOTES TO COMBINED FINANCIAL STATEMENTS December 31, 2011 and 2010 NOTE 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES Organization Public Utility District No. 1 of Pend Oreille County, Washington (the District) is a municipal corporation governed by an elected three-person Board of Commissioners. The District s reporting entity is comprised of four primary component units, or operating systems. The Electric System distributes electricity to residential and other consumers in Pend Oreille County. The Box Canyon Production System produces hydroelectric power from the Box Canyon Hydroelectric Project (the Box Canyon Project). The Water System consists of nine individual water distribution subdivisions. The Community Network System supplies wholesale broadband communication services; previously an endeavor of the Electric System, the Community Network System became a separate operating system effective January 1, The District is required by various financing and contractual arrangements to report separately on each system and maintain each system as a separate entity with separate obligations. Basis of Accounting and Presentation The accounting policies of the District conform to generally accepted accounting principles (GAAP) as applicable to proprietary funds of governments. The Governmental Accounting Standards Board (GASB) is the accepted standard setting body for establishing governmental accounting and financial reporting principles. The District applies all GASB pronouncements, and as provided for in GASB Statement No. 20, the District has elected not to implement pre-codified FASB Statements and Interpretations issued after November 30, Accounting records are maintained in accordance with methods prescribed by the State Auditor under the authority of Revised Code of Washington Chapter 43.09, the Uniform System of Accounts prescribed by the Federal Energy Regulatory Commission (FERC) for the Electric System, Box Canyon Production System, and Community Network System, and the Uniform System of Accounts for Class C Water Utilities prescribed by the National Association of Regulatory Utility Commissioners for the Water System. System columns presented in the financial statements do not sum to the combined totals due to the elimination of certain intersystem transactions. These transactions relate to inter-system power sales and purchases, loan balances and interest on inter-system loans, and inter-system administrative charges. A summary of other significant accounting policies utilized in the preparation of the combined financial statements follows. New Accounting Standards In March of 2009, the GASB issued Statement No. 54, Fund Balance Reporting and Governmental Fund Type Definitions. The objective of this Statement is to enhance how fund balance information is reported and improve its usefulness in decision making. Governments are required to implement GASB Statement No. 54 for fiscal years beginning after June 15, This Statement does not apply to proprietary funds; therefore, it is not applicable for the District. In June 2010, the GASB issued Statement No. 59, Financial Instruments Omnibus, updating and improving existing standards regarding financial reporting and disclosure requirements of certain financial instruments. GASB Statement No. 59 is effective for financial statements for periods beginning after June 15, The District evaluated the changes to financial instrument reporting and disclosures outlined in the Statement, and concluded that this Statement does not have any reporting impact for the District. In November 2010, the GASB issued Statement No. 61, The Financial Reporting Entity: Omnibus an amendment of GASB Statements No. 14 and No. 34. This Statement modifies certain requirements and criteria for inclusion of component units in the financial reporting entity. GASB Statement No. 61 is effective for financial statements for periods beginning after June 15, The District is evaluating the impact on its financial statements. In December 2010, the GASB issued Statement No. 62, Codification of Accounting and Financial Reporting Guidance Contained in Pre-November 30, 1989 FASB and AICPA Pronouncements. This statement incorporated into GASB s authoritative literature FASB and AICPA pronouncements issued on or before November 30, 1989 that do not conflict with GASB pronouncements and classified post-november 30, 1989 non-gasb standards as other accounting literature. GASB Statement No. 62 is effective for financial statements for periods beginning after December 15, The District is evaluating the impact on its financial statements. In June 2011, the GASB issued Statement No. 63, Financial Reporting of Deferred Outflows of Resources, Deferred Inflows of Resources and Net Position. This Statement specifies where deferred outflows of resources and deferred inflows of resources, as well as assets and liabilities, should be displayed. The Statement also discusses how net assets, now retitled net position, should be 13

14 Note 1 Organization and Significant Accounting Policies (continued) displayed. GASB Statement No. 63 is effective for financial statements for periods beginning after December 15, The District is evaluating the impact on its financial statements. In June 2011, the GASB issued Statement No. 64, Derivative Instruments: Application of Hedge Accounting Termination Provision. This Statement, an amendment of GASB Statement No. 53, clarifies the circumstances in which hedge accounting should not be terminated. GASB Statement No. 64 is effective for financial statements for periods beginning after June 15, The District had no derivative instruments in 2010 or 2011 and accordingly, no hedge accounting. ACCOUNTING POLICIES Revenue Recognition and Unbilled Revenue The Electric System, Water System, and Community Network System recognize revenue as earned on a monthly basis based on rates established by the District s Board of Commissioners and, for the Electric System, in accordance with power sales contracts with Ponderay Newsprint Company (Note 5). The District estimates unbilled revenues for energy delivered to customers between their last respective meter reading date and December 31, and records that amount as unbilled revenue for the current year. The Box Canyon Production System recognizes revenue on a cost-of-service basis from sales to the Electric System. Allowance for Uncollectible Accounts Management reviews accounts receivable on a regular basis to determine if any receivables will potentially be uncollectible. The allowance for uncollectible accounts includes amounts estimated through an evaluation of specific accounts, based on the best available facts and circumstances, of customers that may be unable to meet their financial obligations, and a reserve based on historical experience. Cash and Cash Equivalents For purposes of the statement of cash flows, the District considers all highly liquid investments (including restricted assets) with a maturity of three months or less when purchased to be cash equivalents. Investments Short-term investments with a maturity of between three and twelve months, at date of purchase, are recorded at amortized cost with discount or premium amortized on a straight-line basis over the life of the investments. The District records all other investments at fair value based on quoted market rates, with changes in unrealized gains and losses reported as investment income. Materials and Supplies Materials and supplies are recorded at average cost. Utility Plant Utility plant assets are stated at cost, including an allowance for funds used during construction (AFUDC). Betterments and major renewals over $2,000 are capitalized, while maintenance and repairs are charged to operations as incurred. Depreciation is determined by the straight-line method over the estimated useful lives of the related assets, which ranges from 7 to 50 years. Composite rates are used for asset groups and, accordingly, no gain or loss is recorded on the disposition of an asset unless it represents a large and unusual retirement. Contributed Capital Contributions in Aid of Construction are District-mandated customer connection charges used to fund construction of system properties necessary to extend service to a new customer. The payments are initially recorded as liabilities, then reclassified to operating revenue (contributed capital) when the associated facilities are constructed or acquired. Deferred Licensing Costs The FERC issued the District a 50-year operating license for the Box Canyon Project in July Certain FERC license conditions require payments to various outside entities for projects and operating costs which will not be directed by, or controlled by, the District. The District has estimated and present valued these payments over the 50-year license and recorded a deferred asset and licensing costs liability. The District has not recorded the future costs of the remaining expenses related to license implementation which will be capitalized or expensed, as may be appropriate, when incurred. Deferred Financing Costs Bond issue costs, discounts, and premiums are amortized to interest expense, using the effective interest method, over the term of the bonds. The excess of costs incurred over the carrying value of bonds refunded on early extinguishment of debt is amortized to expense over the shorter of the remaining life of the old bonds or the life of the new issue (Note 4). Deferred Revenue In August 2000, the District entered into an agreement with Seattle City Light concerning a cost sharing arrangement for building of fiber optic communications capability in Pend Oreille County. Among other terms and conditions, the District retained ownership of all constructed network assets with a commitment to grant Seattle City Light a 30-year right-of-use for 8 to 12 dark fiber strands along the District s network backbone. Seattle City Light made a one-time, lump sum payment of $1,487,650 under the agreement. The District recorded the payment as deferred revenue and is amortizing the balance to Community Network System revenue on a straight-line basis over the 30-year life of the agreement. The unamortized balance 14

15 Note 1 Organization and Significant Accounting Policies (continued) was $929,781 and $979,369 as of December 31, 2011 and 2010, respectively. Also, the Community Network System deferred revenue includes an Electric System $4.5 million prepayment for future services as discussed in Note 10. The unamortized balance associated with this payment was $3,940,340 and $4,092,920 as of December 31, 2011 and 2010, respectively. Net Assets Invested in Capital Assets, Net of Related Debt This component of net assets consists of capital assets, net of accumulated depreciation, borrowed monies not yet spent, as held in restricted construction and acquisition funds, and outstanding debt balances related to the purchase or construction of capital assets. Restricted Net Assets Amounts presented as restricted net assets are constrained by provisions imposed by external parties and cannot be used for normal operations. Balances currently classified as restricted include funds held by the Economic Development Revolving Fund (Note 2); bond principal and interest due for the upcoming year, less unfunded accrued interest; construction and acquisition funds net of the unspent portion of debt proceeds; and bond reserve funds. Unrestricted Net Assets Amounts included as unrestricted net assets do not meet the definition of either Net Assets Invested in Capital Assets, Net of Related Debt or Restricted Net Assets and are used for normal operations. Compensated Absences Employees accrue personal leave to be used for vacation, sick, and family leave purposes. Annual leave granted each employee varies in accordance with years of service and may be carried forward from year-to-year, capped at a maximum bank of 1,200 hours for employees hired before April 2011 or 700 hours for employees hired after March The District records the cost of personal leave as earned, not as taken. Derivative Instruments Derivatives instruments are recorded on the balance sheet as an asset or liability measured at fair value. Changes in fair value are recognized currently as revenue or expense unless the derivatives meets specific hedge accounting criteria to be determined as effective. Changes in fair value for effective hedges are deferred. For power contracts requiring physical delivery, the District applies the normal purchase and normal sales exception under GASB Statement No. 53. District policy is to avoid derivative instruments excepting special situations as may be approved by the Board. Accordingly, the District had no derivative instruments in either 2010 or Accounting Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Significant Risks and Uncertainties The District is subject to certain business risks that could have a material impact on future operations and financial performance. These risks include weather and natural-disaster-related disruptions; collective bargaining labor disputes; changing local and national economic conditions; fish and other Endangered Species Act issues; Environmental Protection Agency regulations; federal government regulations or orders concerning the operation, maintenance, licensing and license surrender of hydroelectric facilities; the financing and completion of significant capital projects including the Box Canyon Project turbine upgrade and the Community Network System fiber optic deployment project; changing federal and state laws, regulation and requirements; concentration risk in the form of sales to a major customer, Ponderay Newsprint Company and related potential impact on District power contracts (Note 5); and market and credit risks inherent in buying and selling of power, a commodity with inelastic demand characteristics and minimal storage capability. Reclassifications - Certain reclassifications may be made to prior year financial statements presentation to conform to the current year presentation. NOTE 2. CASH AND INVESTMENTS Cash and investments are recorded in accounts as required by the District s bond indentures. Restricted assets represent accounts that are restricted by bond covenants or third party contractual agreements. Accounts that are allocated solely by direction of the District s Board of Commissioners are considered to be board designated accounts. Board designated accounts are reported as unrestricted assets as their use may be redirected at any time by approval of the Commissioners. 15