Five Consecutive Years of More Than $1 Billion to Public Education

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1 An Agency of the State of California C O M P R E H E N S I V E A N N U A L F I N A N C I A L R E P O R T 2004/ $1.17 billion 2003/ $1.09 billion 2002/ $1.02 billion 2001/ $1.06 billion 2000/ $1.11 billion Five Consecutive Years of More Than $1 Billion to Public Education F O R T H E F I S C A L Y E A R E N D E D J U N E 3 0,

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3 California Lottery Comprehensive Annual Financial Report For the Fiscal Year Ended June 30, 2005 TABLE OF CONTENTS INTRODUCTORY SECTION Letter of Transmittal Certificate of Achievement for Excellence in Financial Reporting... Organization Chart with Principal Officials FINANCIAL SECTION Independent Auditors Report... 9 Management s Discussion and Analysis Financial Statements Statement of Net Assets Statement of Revenues, Expenses, and Changes in Net Assets Statement of Cash Flows Notes to Financial Statements STATISTICAL SECTION California Statistics Demographics for Population and Players Sales by Product and Other Revenues - Last Ten Fiscal Years Expenses by Type and Contributions - Last Ten Fiscal Years U.S. Lottery Statistics U.S. Lottery Data for Fiscal Years 2004 and

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5 I N T R O D U C T O R Y S E C T I O N C O M P R E H E N S I V E A N N U A L F I N A N C I A L R E P O R T

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7 California Lottery 600 North 10th Street Sacramento, California December 31, 2005 The California State Lottery (Lottery) is pleased to provide this Comprehensive Annual Financial Report (CAFR) for the fiscal year ended June 30, The Finance Department of the Lottery prepared this CAFR to present an overview of the California State Lottery. It includes the Lottery s annual financial statements presented in accordance with accounting principles generally accepted in the United States of America and audited in accordance with auditing standards generally accepted in the United States of America. The CAFR covers the financial activity of the Lottery, a single enterprise fund. The report follows formal standards of the Government Finance Officers Association of the United States and Canada (GFOA). Government organizations that publish this type of report can be compared to each other because similar kinds of information are included in the report. This letter of transmittal is designed to complement the Management s Discussion and Analysis that accompanies the financial statements and should be read in conjunction with it. Lottery management is responsible for the accuracy and completeness of the presentation, including all disclosures in this report. To the best of our knowledge, the enclosed information is accurate in all material respects and is reported in a manner designed to present fairly the financial position, results of operations, and the cash flows of the Lottery. All disclosures necessary to gain an understanding of the Lottery s financial activities have been included. California statutes require an annual financial audit by an independent Certified Public Accountant (CPA). The independent auditors report on the Lottery s financial statements is included in the financial section of this report. -1-

8 Profile of the Lottery The Lottery was created by a 1984 ballot initiative that was approved by 58% of the voters. The Lottery was established as an independent state agency to market and sell lottery products to the California public. By law, the Lottery is required to return 50% of revenues to prizes, at least 34% to public education and expend no more than 16% for administrative costs. The act specifies that the Lottery is operated and administered by a five member Commission appointed by the Governor. A Director, who is appointed by the Governor, serves as the chief administrator of the Lottery. The Legislature has the authority to amend the Lottery Act by a twothirds majority, if by doing so, it furthers the purposes of the measure. Lottery ticket sales began on October 3, 1985 with the sale of the first instant game ticket called California Jackpot. More than 21 million tickets were sold on the very first day and more than 1.7 billion tickets were sold in the first 9 months. Draw Game sales began on October 14, 1986 with Lotto 6/49. Daily draw games were introduced in March The Lottery currently offers six draw games. All draw game prizes are pari-mutuel and players have 180 days from the date of the drawing to claim prizes. Twenty years later, total Lottery sales have topped $46.3 billion and the Lottery offers a full range of products. Retailers pay prizes up to $599 and prizes for over $599 are paid directly by the Lottery. A brief description of each game is provided below. Scratchers Scratchers are instant games that are played by scratching the latex covering off a play area to reveal combinations and learning instantly whether the ticket is a winner. There are different ways to win a Scratchers game, such as matching two or three like symbols, your score beats their score, or your symbol matches a key symbol. The Lottery started Scratchers game sales in October 1985 with a $1 game. Multiple Scratchers games were initially offered in October The Lottery s first Scratchers game that retailed for more than $1 went on sale in October SuperLOTTO Plus Players select five lotto numbers from a field of 1 through 47 and one mega number from a field of 1 through 27. There are nine prize categories in this game. To win the jackpot, players must match all five lotto numbers plus the mega number. Jackpot prizes start at $7 million and have reached more than $190 million. The lowest prize is $1 for matching just the mega number. Winning numbers are drawn every Wednesday and Saturday at 7:57 p.m. In SuperLOTTO Plus, large jackpots fuel game sales and typically, more than 40% of the sales come from draws where the jackpot is $30 million or more. MEGA Millions Players select five lotto numbers from a field of 1 through 56 and one mega number from a field of 1 through 46. There are nine prize categories in this game. To win the jackpot, players must match all five lotto numbers plus the mega number. Jackpot prizes start at $12 million and have reached as much as $315 million. Winning numbers are drawn every Tuesday and Friday at 8:00 p.m. MEGA Millions is the largest multi-state lottery game in North America and with California sales, jackpots could reach record levels. -2-

9 Hot Spot This game was designed primarily for social trade styles like restaurants and bowling centers, but is available at all retailer locations. Players select numbers from a field of 1 through 80 and have a choice of playing five different spots. They can play two, three, four, five, or eight spots. A player who chooses to play a three spot would pick a set of three numbers. There are a total of 14 prize categories in this game. Draws are conducted daily every five minutes with the first draw at 6:05 a.m. and last draw at 2:00 a.m. Twenty winning numbers are selected for each draw. Draw results are broadcast by the gaming system to more than 5,000 television monitors located in retail locations statewide. Daily 3 This daily game was designed to provide very good odds of winning smaller prizes. Players select a set of three numbers from 0 through 9, as well as, a play style where players try to match the three numbers drawn in the exact order or in various combinations. There are seven prize categories in this game. The top prize averages between $400 and $600. Winning numbers are drawn twice a day. Fantasy 5 This daily lotto-style game was designed with better odds than Super LOTTO Plus. Players select a set of five numbers from 1 through 39. Winning tickets are those that match any two, three, four, or all five of the five numbers drawn. There are four prize categories in this game. Top prizes start at $50,000 and have reached more than $700,000 for matching all five numbers. Daily Derby This daily game was designed with a horse racing theme, but is not associated with the results of any actual horse race. Players select three horses from a field of twelve and a race time which is a set of three unique numbers (e.g., 0, 1, and 9) with each number selected from a field of 0 through 9. There are five prize categories in this game. Top prizes start at $50,000 and have reached more than $1 million for matching the race time and all three horses in exact order. The lowest prize is $2 for matching the 1 st place horse. From its inception in 1985 through June 30, 2005, the Lottery generated more than $46.3 billion in sales. The retailers who sell the lottery tickets received more than $3.0 billion in compensation. Approximately $23.7 billion was won by lucky Lottery winners. Additionally, the Lottery exceeded its mandate, which requires that 34 percent of all Lottery sales revenues, plus interest income, and unclaimed prizes be given to public education. Since October 1985, the Lottery has contributed an additional $486 million to education through operational savings. Prizes $23.7 Distribution of Revenues (in billions) October 3, June 30, 2005 Retailer Compensation $3.0 Direct Costs $1.2 Operating Expenses $2.3 Contributions to Education $

10 Relevant Financial Policies Accounting System and Policies The Lottery operates the California State Lottery Fund, an enterprise fund that, like a private business, utilizes the full accrual basis of accounting in accordance with accounting principles generally accepted in the United States of America. Budgetary Controls Budgetary control for the Lottery is addressed through its enabling legislation, which provides specific limitations on operating and administrative expenses. A comprehensive annual budget is prepared in conjunction with the Lottery s Annual Business Plan. The budget is prepared on both a cash basis and a full accrual basis of accounting. It is also prepared in distinct quarterly segments to facilitate comparison to the quarterly financial statements. The budget is based on sales forecasts, industry trends, program proposals, and approved action plans. While the Lottery does not have a legislatively approved budget, the operating budget is submitted to the Lottery Commission with the Annual Business Plan for approval. Actual costs are monitored throughout the year for compliance with the approved budget and appropriate adjustments are approved if necessary. Internal Controls An internal control structure has been designed to ensure that assets are protected from loss, theft, or misuse, and to ensure that the accounting system allows compilation of accurate and timely financial information. The internal controls are designed to provide reasonable assurance that these objectives are met. To enhance controls, Lottery management has separated responsibilities and provides approval and oversight for the following functions: personnel and payroll; purchasing and accounts payable; general ledger and accounts receivable; cash receipts and cash disbursements; retailer network management and retailer accounts receivable; and system data processing and system programming. Reviews of operations are achieved by the following procedures: Draw verification: An independent CPA witnesses the draws (except for computer automated drawings of Hot Spot ) of Lottery games, and inspects any equipment used in such draws, before and after each draw. An independent CPA and a Lottery Security employee attend and verify each Mega Millions draw, regardless of draw location. Security evaluation: An independent firm experienced in security procedures conducts a comprehensive study and evaluation of all aspects of security in the operation of the Lottery on a bi-annual basis. State Administrative Manual (SAM) audit: The State Controller s Office performs a study and evaluation of accounting and administrative controls every two years. The following measures have been implemented to ensure the integrity of the Lottery: Specialized security and law enforcement staff. Secured facilities and gaming equipment. Background checks on retailers, contractors and Lottery employees. Lottery tickets with special inks, dyes and security codes. Detailed and strict security procedures for game drawings. Lottery random number generators are in stand-alone systems and are certified by an independent audit firm prior to installation. Lottery draw balls are weighed and measured once a month to ensure standard compliance set by the Weights and Measures Division of the California Department of Agriculture. -4-

11 Employees The Lottery has 650 authorized employee positions at its headquarters located in Sacramento and at nine district offices located in Sacramento, San Francisco, Hayward, Fresno, Van Nuys, Santa Fe Springs, Santa Ana, Riverside and San Diego. Debt Administration The Lottery s long-term liabilities include payments owed to Lotto jackpot, Big Spin, Weekly Grand, and Decade of Dollars winners. The payments due winners are funded by amounts invested in zero coupon U. S. Treasury bonds. Cash Management Cash due from approximately 18,000 retailers is collected on a weekly basis through an electronic funds transfer system and deposited into an account within the California State Treasurer s Office. Idle cash is invested in the Surplus Money Investment Fund, and interest earnings are received semi-annually. The fund is administered by the Pooled Money Investment Board which is composed of the State Treasurer, the State Controller, and the Director of Finance. Risk Management The Lottery has elected, with a few exceptions, to be self-insured against loss or liability. Losses are accrued when the related liabilities occur. Except for workers compensation costs initially paid by State Compensation Insurance Fund for self-insured state agencies, the Lottery has purchased commercial insurance policies for protection from loss on certain assets. Additionally, major or critical contracts for the purchases of goods and services include requirements of vendors to maintain insurance coverage and/or financial security instruments, such as performance bonds or letters of credit. Major Initiatives Maximize Sales and Fund Scratchers Growth The Lottery has set a goal to produce record-breaking sales that would create a ten percent increase in profits in fiscal year 2005/06. If the sales goal of $3.65 billion is attained this would translate to more than $1.20 billion to public schools. The Lottery wants to ensure the combined sales from SuperLOTTO Plus and the new MEGA Millions game show a significant gain over last year s SuperLOTTO Plus sales. The Lottery plans to efficiently promote both Lotto games by directing most advertising towards these games, issuing jackpot alert messages, establishing brand identity and building regular playership for MEGA Millions, and implementing consumer promotions. With increased sales in lotto-type games, the Lottery is able to fund additional Scratchers growth. The Lottery is planning on introducing four $5 games (up from just two in the last fiscal year), continuing to feature the popular extended play games, Bingo and Crossword, promoting two new Scratchers games using licensed properties, and implementing up to five in-store point-of sale marketing campaigns. Additional Consumer Choices and Best Practices By exploring industry best practices, the Lottery plans to expand the number of product distribution points by investigating new retail outlets and also new business models and distribution methods to increase product availability. Another initiative is to develop a Lottery VIP club that will provide members a newsletter and information along with coupons and promotions. In addition, efforts to freshen product offerings and additional research and development to investigate potential new games and new promotions for existing products are planned. -5-

12 Improve Lottery s Infrastructure In the upcoming year, the Lottery will strengthen its infrastructure by continuing to review and improve processes, enhance technology to support efficient delivery of services, and address anticipated staff-related issues such as turnover, recruitment, and training. There are several projects planned for this year that will provide enhanced services to players and retail customers by adding functionality to the Lottery s player and retailer websites. Local Economy California s economy continued to generate new jobs in the first quarter of 2005, and the state s unemployment rate fell considerably. Total housing permits granted were down slightly from a year earlier. But existing home sales remained brisk, and the value of nonresidential permits increased. Personal income picked up solidly in the fourth quarter of Higher energy prices, somewhat higher interest rates, and a lack of fiscal stimulus are expected to slow economic growth in On an annual average basis, job growth will improve to 1.7 percent in California in 2005 and Unemployment rates are not expected to change much during the rest of 2005 and in Growth in total state personal income will dip slightly in 2005 before edging up in Housing permits are expected to trend downward. Awards and Acknowledgements The Government Finance Officers Association of the United States and Canada (GFOA) awarded a Certificate of Achievement for Excellence in Financial Reporting to the Lottery for its comprehensive annual financial report for the fiscal year ended June 30, This was the second consecutive year that the Lottery has achieved this prestigious award. In order to be awarded a Certificate of Achievement, a government must publish an easily readable and efficiently organized comprehensive annual financial report. This report must satisfy both generally accepted accounting principles and applicable legal requirements. A Certificate of Achievement is valid for a period of one year. We believe that our current comprehensive annual financial report continues to meet the Certificate of Achievement Program s requirements and we are submitting it to the GFOA to determine its eligibility for another certificate. This report demonstrates the professionalism and dedicated team effort of Lottery employees. We appreciate their contribution to the success of this report. Due credit should also be given to the Lottery Commissioners for their responsiveness and guidance in operating the Lottery. The Lottery is committed to providing thorough and relevant financial information to the public. This CAFR reflects our commitment to meet the highest standards of accountability and to maintain public trust through the highest ethics and integrity. Respectfully submitted, Patricia Eberhart, Director Finance and Administrative Division 1 Governor s Budget May Revision , page 6 2 Ibid, page 6 3 Ibid, page 6 4 Ibid, page 6-6-

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15 ORGANIZATION CHART WITH PRINCIPAL OFFICIALS FI N A N C E A N D A D M I N I ST R A T I O N D I V I SI O N Patricia E berhart FI N A N C E D E PA R T M E N T H U M A N R E SO U R C E S D E PA R T M E N T B U SI N E SS/FA C I L I T I E S SE R V I C E S D E PA R T M E N T C L A I M S A N D PL A Y E R SE R V I C E S D E PA R T M E N T L E G A L /C O N T R A C T SE R V I C E S O FFI C E M elissa M eith SE C U R I T Y /L A W E N FO R C E M E N T D I V I SI O N W illiam H er to g h e FI E L D O PE R A T I O N S H E A D Q U A R T E R S O PE R A T I O N S G A M I N G A PPL I C A T I O N M A N A G E M E N T O FFI C E CALIFORNIA STATE LO TTER Y C O M M IS S IO N John M a ss, C ha ir Loretta Doon R a c he l M onte s M a nue l O rte ga D IR EC TO R M e lissa M e ith (A c ting) CHIEF DEPUTY DIRECTOR M e lissa M e ith I N T E R N A L A U D I T S O FFI C E PU B L I C R E L A T I O N S/ C O M M U N I C A T I O N S O FFI C E C ath leen D in u b ilo M ich ael D o y le ( A ctin g ) I N FO R M A T I O N T E C H N O L O G Y SE R V I C E S D I V I SI O N Ellen Ishimoto A PPL I C A T I O N SE R V I C E S D E PA R T M E N T I T I N FR A ST R U C T U R E D E PA R T M E N T C L I E N T SE R V I C E S D E PA R T M E N T I T A D M I N I ST R A T I V E SE R V I C E S O FFI C E I T PL A N N I N G O FFI C E PR O G R A M M A N A G E M E N T O FFI C E L E G I SL A T I V E O FFI C E V acan t M A R K E T I N G D I V I SI O N Jim H aseg aw a R E SE A R C H A N D FO R E C A ST I N G D E PA R T M E N T G A M E O PE R A T I O N S D E PA R T M E N T C O N SU M E R M A R K E T I N G A N D A D V E R T I SI N G D E PA R T M E N T SA L E D I V I SI O N T r icia M etzg er K E Y A C C O U N T S D E PA R T M E N T N O R T H E R N FI E L D O PE R A T I O N S SO U T H E R N FI E L D O PE R A T I O N S R E T A I L E R N E T W O R K M A N A G E M E N T D E PA R T M E N T -8-

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17 F I N A N C I A L S E C T I O N C O M P R E H E N S I V E A N N U A L F I N A N C I A L R E P O R T

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19 -9-

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21 MANAGEMENT S DISCUSSION AND ANALYSIS The following discussion and analysis of the California State Lottery s financial performance provides an overview of financial activities for the fiscal year ended June 30, Please read it in conjunction with the California State Lottery Financial Statements that follow this section. FINANCIAL HIGHLIGHTS The assets of the Lottery exceeded its liabilities at the close of the most recent fiscal year by $275.9 million, which is attributable to unrealized gains on investments the Lottery holds to fund future payments due on annuitized lottery prizes. The California State Lottery had the best year ever since the Lottery s launch in 1985, with sales approximating $3.33 billion. With these unprecedented sales, approximately $1.176 billion will be transferred to California s public schools, making this the fifth consecutive year to transfer more than $1 billion to education. Operating revenues increased by 12.1% from the previous year. The Scratchers games brought in more than half of all ticket revenues and the new MEGA Millions game, introduced during the last two weeks of the fiscal year, brought in $2.4 million on the first day of sales alone. OVERVIEW OF THE FINANCIAL STATEMENTS These required statements offer short- and long-term financial information about the California State Lottery. The Statement of Net Assets provides information about the nature and amounts of investments in resources (assets) and obligations (liabilities) at the close of the fiscal year. All of the current year s revenues and expenses are accounted for in the Statement of Revenues, Expenses, and Changes in Net Assets. This statement measures the success of the Lottery s operations over the past year. The final required financial statement is the Statement of Cash Flows. The primary purpose of this statement is to provide information about the Lottery s cash receipts and cash payments during the reporting period. The statement reports cash receipts, cash payments, and net changes in cash resulting from operations, investing, and financing activities, and provides answers to such questions as where did cash come from, and what was cash used for. The financial statements are prepared on the accrual basis in accordance with accounting principles generally accepted in the United States of America. The California State Lottery is structured as a single enterprise fund with revenues recognized when earned, not when received. -10-

22 FINANCIAL ANALYSIS NET ASSETS A summary of the California State Lottery s net assets is presented below: Dollar Percent June 30, 2004 June 30, 2005 Change Change Current and other assets $2,951,147,741 $2,907,354,323 $ (43,793,418) (1.5%) Capital assets 38,071,794 40,968,035 2,896, % Total assets 2,989,219,535 2,948,322,358 (40,897,177) (1.4%) Current liabilities 847,603, ,247,083 60,643, % Long-term prize liability 1,883,850,751 1,764,168,645 (119,682,106) (6.4%) Total liabilities 2,731,454,470 2,672,415,728 (59,038,742) (2.2%) Invested in capital assets 38,071,794 40,968,035 2,896, % Restricted for unrealized gains on Investments 257,765, ,906,630 18,141, % Unrestricted (deficit) (38,071,794) (40,968,035) (2,896,241) 7.6% Total net assets $ 257,765,065 $ 275,906,630 $ 18,141, % A summary of the California State Lottery s change in net assets is presented below: Dollar Percent June 30, 2004 June 30, 2005 Change Change Operating revenues - Lottery sales $2,973,975,717 $3,333,620,669 $ 359,644, % Prizes 1,566,027,494 1,795,254, ,226, % Sales after prizes 1,407,948,223 1,538,366, ,418, % Game costs 264,055, ,192,965 26,137, % Income before operating expenses 1,143,893,007 1,248,173, ,280, % Operating expenses 106,766, ,246,898 3,480, % Operating income 1,037,126,877 1,137,926, ,799, % Non-operating (expenses) revenues (1,241,362,901) (1,119,784,802) 121,578,099 (9.8%) Change in net assets (204,236,024) 18,141, ,377,589 (108.9%) Total net assets - beginning of year 462,001, ,765,065 (204,236,024) (44.2%) Total net assets - end of year $ 257,765,065 $ 275,906,630 $ 18,141, % -11-

23 REVENUES The following chart shows the major sources and the percentages of operating revenues for the fiscal year ended June 30, 2005: Operating Revenues Hot Spot 5.2% Daily games 9.4% Lotto games 33.3% Off-line 52.1% A summary of total revenues for the fiscal years ended June 30, 2004 and 2005, and the amount and percentage of change in relation to prior year amounts is as follows: Dollar Percent June 30, 2004 June 30, 2005 Change Change Operating revenues: Lotto games $1,166,953,613 $1,109,931,087 $(57,022,526) (4.9%) Off-line 1,338,975,654 1,736,788, ,812, % Hot Spot 167,989, ,296,572 6,306, % Daily games 300,056, ,604,900 12,548, % Total operating revenues 2,973,975,717 3,333,620, ,644, % Non-operating revenues: Unrealized gains (losses) on investments (204,236,024) 18,141, ,377, % Interest on funds held by State Treasurer 6,688,602 9,877,245 3,188, % Other income 246, , , % Total non-operating revenues (197,301,198) 28,990, ,291, % Total revenues $2,776,674,519 $3,362,610,954 $ 585,936, % The increase in sales was mostly attributable to Scratchers sales. The very popular crossword and bingo games continued to be very successful and contributed to the best sales year ever. Also in May, the California State Lottery was the first in the nation to release collectible Star Wars Scratchers, in conjunction with the premiere of the new Star Wars movie. In addition, $5 Scratchers tickets continued to be highly requested by our players. -12-

24 EXPENSES The following chart shows prizes, game costs and operating expenses as a percentage of operating revenues for the fiscal year ended June 30, Prizes, Games Costs and Operating Expenses as a Percent of Operating Revenues Retailer costs 7.0% On-line/Off-line Game costs 1.7% Operating expenses 3.3% Allocation to Education Fund 34.1% Prizes 53.9% A summary of expenses for the fiscal years ended June 30, 2004 and 2005, and the amount and percentage change in relation to prior year amounts is as follows: Dollar Percent June 30, 2004 June 30, 2005 Change Change Prizes: On-line prizes $ 793,824,249 $ 774,688,702 $(19,135,547) (2.4%) Off-line prizes 772,203,245 1,020,565, ,362, % Total prizes 1,566,027,494 1,795,254, ,226, % Game costs: Retailer costs 205,744, ,447,844 27,702, % On-line/off-line game costs 58,310,241 56,745,121 (1,565,120) (2.7%) Total game costs 264,055, ,192,965 26,137, % Operating expenses: Salaries, wages, and benefits 40,759,704 41,913,096 1,153, % Advertising 30,972,632 36,797,516 5,824, % Promotion, public relations, and point of sale 9,066,450 10,406,811 1,340, % Other professional services 7,568,645 5,380,499 (2,188,146) (28.9%) Depreciation and amortization 8,396,577 7,202,654 (1,193,923) (14.2%) Other general and administrative expenses 10,002,122 8,546,322 (1,455,800) (14.6%) Total operating expenses 106,766, ,246,898 3,480, % -13-

25 Dollar Percent June 30, 2004 June 30, 2005 Change Change Non-operating expenses: Allocations to Education Fund 1,044,061,703 1,148,775, ,713, % Total expenses $2,980,910,543 $3,344,469,389 $363,558, % Off-line prize expense increased by approximately $248 million or 32.2% primarily as a result of an increase in sales and higher prize payouts. On-line/off-line game costs decreased as the new gaming contract with GTECH went into effect in October 2003 at a reduced percentage of sales rate. Advertising and promotion, public relations and point of sale increased because of the introduction of the new MEGA Millions game. Other professional services decreased because there were additional expenses for the year ended June 30, 2004 related to the new gaming system transition and the redesigned Lottery website that went on-line to the public in March Depreciation expense decreased because gaming system equipment was fully depreciated and under the new GTECH contract the California State Lottery does not own the majority of the gaming equipment. Other general and administrative expenses decreased primarily as a legal contingency recorded in the 2003/2004 fiscal year did not materialize and the expense was reversed in the current year. Allocations to the Education Fund increased as a result of increased lottery sales. CAPITAL ASSETS A summary of capital assets as of June 30, 2004 and 2005, and the amount and percentage of change in relation to prior year amounts is as follows: Dollar Percent June 30, 2004 June 30, 2005 Change Change Non-depreciable capital assets: Land $ 4,922,805 $ 4,922,805 $ - - Depreciable capital assets: Gaming terminals 947, ,443 (670,427) (70.7%) Vending machines 34,461,991 28,846,588 (5,615,403) (16.3%) Buildings 23,727,459 25,591,768 1,864, % Data processing equipment 16,995,329 7,457,143 (9,538,186) (56.1%) Office furniture and equipment 8,348,037 5,131,780 (3,216,257) (38.5%) Leasehold improvements 564, ,262 (48,815) (8.7%) Other 5,955,936 5,805,628 (150,308) (2.5%) Subtotal 91,000,699 73,625,612 (17,375,087) (19.1%) Less accumulated depreciation (57,851,710) (37,580,382) 20,271,328 (35.0%) Total depreciable capital assets 33,148,989 36,045,230 2,896, % Capital assets, net $ 38,071,794 $ 40,968,035 $ 2,896, % During the 2005 fiscal year, net capital assets increased by approximately $2.9 million or 7.6%. The majority of this increase was due to the purchase of new heating and air conditioning units and vending machines. Aggregate additions to capital assets approximated $11 million. It should be noted that the Lottery conducted a thorough inventory of all assets and wrote off many older items that were determined to be obsolete. Assets with an initial cost of approximately $28 million dollars were written off; however, the majority of this equipment was fully depreciated and this accounts for the change in accumulated depreciation as well. Depreciation expense for the year ended June 30, 2005 approximated $7.1 million. Additional detailed information on capital assets may be found in the accompanying notes to the financial statements. -14-

26 LONG - TERM DEBT At June 30, 2005, the California State Lottery had $1.76 billion in outstanding long-term prize liability versus $1.88 billion last year, a change of 6.4%. The majority of the change is attributable to on-line prize liability as most SuperLOTTO Plus jackpot winners now choose the cash option rather than annuitized payments and more annuities have matured this year than were purchased. Additional detailed information on long-term prize liability may be found in the accompanying notes to the financial statements. CONTACTING THE LOTTERY S FINANCIAL MANAGER This financial report is designed to provide a general overview of the California State Lottery s finances and to demonstrate the accountability for the money the Lottery earns. If you have questions about this report or need additional financial information, contact the California State Lottery, Finance Department, 600 N. 10th Street, Sacramento, CA

27 CALIFORNIA STATE LOTTERY FUND STATEMENT OF NET ASSETS JUNE 30, 2005 ASSETS Current assets: Cash and cash equivalents (Note 2) $ 326,644,719 Investments, current portion (Note 2) 354,997,601 Accounts receivable, net of allowances (Note 3) 152,718,336 Due from state funds (Note 4) 3,902,708 Ticket inventories 8,198,637 Other 6,790,155 Total current assets 853,252,156 Non-current assets: Investments, less current portion (Note 2) 2,032,157,631 Capital assets, net (Note 5) 40,968,035 Deferred charges, net 21,944,536 Total non-current assets 2,095,070,202 TOTAL ASSETS $2,948,322,358 LIABILITIES Current liabilities: Accounts payable $ 36,421,147 Current prize liability (Note 6) 582,495,927 Due to state funds (Note 7) 279,759,412 Accrued liabilities 6,688,191 Unearned revenue 2,882,406 Total current liabilities 908,247,083 Non-current liabilities: Prize liability, less current portion (Note 6) 1,764,168,645 TOTAL LIABILITIES 2,672,415,728 Commitments and contingencies (Notes 8 and 12) NET ASSETS Invested in capital assets 40,968,035 Restricted for unrealized gains on investments (Note 2) 275,906,630 Unrestricted (deficit) (40,968,035) TOTAL NET ASSETS $ 275,906,630 See accompanying notes to the financial statements. -16-

28 CALIFORNIA STATE LOTTERY FUND STATEMENT OF REVENUES, EXPENSES, AND CHANGES IN NET ASSETS JUNE 30, 2005 Operating revenues: Lottery sales $3,333,620,669 Prizes 1,795,254,439 Sales after prizes 1,538,366,230 Less game costs: Retailer costs 233,447,844 On-line game costs 35,702,574 Off-line game costs 21,042,547 Total game costs 290,192,965 Income before operating expenses 1,248,173,265 Operating expenses: Salaries, wages, and benefits 41,913,096 Advertising 36,797,516 Promotion, public relations, and point of sale 10,406,811 Other professional services 5,380,499 Depreciation and amortization 7,202,654 Other general and administrative expenses 8,546,322 Total operating expenses 110,246,898 Operating income 1,137,926,367 Non-operating (expenses) revenues: Investment earnings (Note 9) 28,018,810 Other income 971,475 Allocation to Education Fund (Note 7) (1,148,775,087) Total non-operating (expenses) revenues (1,119,784,802) Change in net assets 18,141,565 Total net assets - beginning balance 257,765,065 Total net assets - ending balance $ 275,906,630 See accompanying notes to the financial statements. -17-

29 CALIFORNIA STATE LOTTERY FUND STATEMENT OF CASH FLOWS JUNE 30, 2005 Cash flows from operating activities: Receipts from customers $3,332,789,066 Payments for prizes (2,031,748,217) Payments to retailers (233,496,249) Payments to suppliers for goods and services (94,641,410) Payments to employees (36,286,701) Internal activity-payments to state (8,542,650) Other receipts 929,530 Net cash flows provided by operating activities 929,003,369 Cash flows from non-capital financing activities: Distributions to Education Fund (1,134,756,612) Net cash flows used in non-capital financing activities (1,134,756,612) Cash flows from capital and related financing activities: Proceeds from disposal of capital assets 39,024 Payments for capital assets (10,974,253) Net cash flows used in capital and related financing activities (10,935,229) Cash flows from investing activities: Purchase of securities (92,847,021) Proceeds from matured securities 360,862,000 Surplus Money Investment Fund interest 7,927,317 Net cash flows provided by investing activities 275,942,296 Increase in cash and cash equivalents 59,253,824 Cash and cash equivalents at June 30, ,390,895 Cash and cash equivalents at June 30, 2005 $ 326,644,719 See accompanying notes to the financial statements. -18-

30 CALIFORNIA STATE LOTTERY FUND STATEMENT OF CASH FLOWS JUNE 30, 2005 Cash flows from operating activities: Operating income $1,137,926,367 Adjustments to reconcile operating income to net cash provided by operating activities: Depreciation and amortization 7,202,654 Provision for doubtful accounts (570,051) Provision for returned tickets (1,338,570) Provision for free ticket redemptions 3,799,163 Net loss on retirement or disposal of capital assets 934,424 Other income 971,475 Changes in assets and liabilities: Increase in accounts receivable (3,499,053) Decrease in due from state funds 397,233 Decrease in ticket inventories 57,659 Increase in other assets (217,538) Decrease in deferred charges 5,911,560 Increase in accounts payable 13,337,354 Decrease in prize liability (236,493,777) Increase in due to state funds 145,000 Decrease in accrued liabilities (333,837) Increase in deferred revenues 776,906 Decrease in retailer deposits (3,600) (208,922,998) Net cash flows provided by operating activities $ 929,003,369 Supplemental disclosure of non-cash activities: Interest accreted on annuitized prizes $ 149,514,739 Unclaimed prizes directly allocated to the Education Fund $ 27,019,168 Unrealized gain on investments $ 18,141,565 See accompanying notes to the financial statements. -19-

31 CALIFORNIA STATE LOTTERY FUND NOTES TO FINANCIAL STATEMENTS JUNE 30, SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Organization The California State Lottery (Lottery) was created with the passage of the California State Lottery Act of 1984 (Act). The Lottery is a part of the primary government of the State of California and is reported as a proprietary fund and business-type activity within the State of California's financial statements. The purpose of the Act is to support the preservation of the rights, liberties, and welfare of the people by providing additional monies to benefit education without the imposition of additional or increased taxes. The operations of the Lottery are separate and distinct from other operations of the State of California. The Act mandates that, as nearly as practical, 50 percent of the total annual revenues from Lottery sales be returned to the public in the form of prizes and that at least 34 percent be allocated to benefit public education. No more than 16 percent of the total annual revenues from sales of tickets or shares shall be allocated for payment of operating expenses of the Lottery (Note 11). Basis of Presentation The Lottery is accounted for as an enterprise fund. The financial statements are prepared on the accrual basis of accounting and the economic resources measurement focus in accordance with accounting principles generally accepted in the United States of America. Operating revenue and expenses are those that result from providing services and producing and delivering goods and/or services. Revenue Recognition - Off-Line Games Sales of lottery tickets are made to the public through contracted retailers. Revenue is recognized upon the sale of tickets to the retailers. An allowance is recognized for the retailers' right to return unsold tickets after each game end. Operating revenue is reduced for free tickets. Retailers receive a commission of six percent which is recognized when tickets are sold to the retailers. Revenue Recognition - On-Line Games Lottery sales are made to the public through gaming terminals at contracted retailers. Revenue is recognized upon the sale to the public. With the exception of MEGA Millions, the public has the right to cancel a sale on the same day before pool closure. All MEGA Millions sales are final. The applicable retailers' commission of four and one-half to six percent is recognized when sales are made to the public. Recognition of the revenue from sales for future draws is deferred until those draws become current. The retailers' commission related to the deferred revenue is reflected as a prepaid expense until the related deferred revenue is recognized. Prizes - Off-Line Games Prize expense for off-line games is recognized based on the predetermined prize structure for each game in the period ticket revenue is recognized. Prizes that are not claimed are recognized as unclaimed prizes 180 days after the end of each game. Unclaimed prizes not directly payable by the Lottery Commission are recognized as a reduction of prize expense and included in the Lottery's operating income that is -20-

32 CALIFORNIA STATE LOTTERY FUND NOTES TO FINANCIAL STATEMENTS JUNE 30, SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) Prizes - Off-Line Games (continued) allocated to the Education Fund. Unclaimed prizes directly payable by the commission are allocated directly to the Education Fund. Prize expense relative to the Lottery's weekly off-line grand prize drawing is recorded based on the estimated prize structure for each game as revenue is recognized. Periodically, prize expense is adjusted to reflect amounts actually won. Prizes of $1 million or more are generally paid in twenty equal annual installments. The Weekly Grand, the Extravaganza 2000, the Twice as Grand, and the Weekly $2,000 Payday top prizes are paid in weekly installments for twenty years. The Decade of Dollars top prizes are paid in annual installments for ten years. Prize expense for these prizes is based on the present value of the annuity using an interest rate equal to the interest yield on the zero coupon U.S. Treasury bonds which the Lottery acquires to fund the annuity payments. Interest earned is imputed on the annuity using the same interest rate. Prizes - On-Line Games SuperLOTTO Plus and MEGA Millions - Prize expense for the twice-weekly, on-line games are recognized on the basis of the predetermined prize structure when the revenue is recognized. Nine distinct prize categories are established which are dependent upon the amount of money wagered and the quantity of numbers to be matched. In the event that no winning share for a specific prize category in SuperLOTTO Plus is selected, all monies allocated for that prize are carried forward to the following drawing and added to the Five of Five plus MEGA number category (grand prize). In the event that no winning share for a specific prize category in MEGA Millions is selected, all monies allocated for that prize are carried forward to the following drawing and remain in the pool for that same prize category. All SuperLOTTO Plus prizes won but not claimed within the specified period are allocated directly to the Education Fund. In the event that a MEGA Millions grand/jackpot prize won in California is unclaimed, the prize monies will be returned to the Party Lotteries in the same ratio that each Party Lottery contributed to such prize and the amount contributed for the grand/jackpot prize by the California Lottery will be allocated directly to the Education Fund. The unclaimed prize monies for all other MEGA Millions prizes categories won in California but not claimed within the specified period are allocated directly to the Education Fund. Super LOTTO grand/jackpot prizes of $1 million or more that were won prior to April 1, 1998 are paid in twenty equal annual installments. Effective April 1, 1998 grand/jackpot prizes of $1 million or more are paid either in twenty-six graduated annual payments or in a single payment equal to the cash value of the twenty-six-payment annuity, in accordance with the rules and regulations of the Lottery. Payments for all other prize categories are made in a single payment. MEGA Millions grand/jackpot prizes won in California are paid in 26 equal annual installments, however, claimants will have up to 60 days after the date they became entitled to the prize to irrevocably elect to receive the cash value of the prize instead of 26 annual payments. Fantasy 5 - Prize expense for the seven-draws-per-week, on-line game is recognized on the basis of the predetermined prize structure when the revenue is recognized. Distinct prize categories are established dependent upon the amount of money wagered and the quantity of numbers to be matched. In the event that no winning share for a specific prize category is selected, all monies allocated for that prize category are carried forward to the following drawing and added to the 5 of 5 prize category. All Fantasy 5 prizes won but not claimed within the specified period are allocated directly to the Education Fund. -21-

33 CALIFORNIA STATE LOTTERY FUND NOTES TO FINANCIAL STATEMENTS JUNE 30, SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) Prizes - On-Line Games (continued) Daily 3 - Prize expense for the two-draws-per-day, on-line game is recognized on the basis of the predetermined prize structure when the revenue is recognized. Distinct prize categories are established which are dependent upon the amount of money wagered, the quantity of numbers to be matched, and the order of numbers chosen. All Daily 3 prizes won but not claimed within the specified period are allocated directly to the Education Fund. Daily Derby - Prize expense for the seven-draws-per-week, on-line game is recognized on the basis of the predetermined prize structure when the revenue is recognized. Distinct prize categories are established which are dependent upon the amount of money wagered, the quantity of numbers to be matched, and the order of numbers chosen. In the event that no winning share for a specific prize category is selected, all monies allocated for that prize category are carried forward to the following drawing and added to the Grand Prize category. All Daily Derby prizes won but not claimed within the specified period are allocated directly to the Education Fund. Hot Spot - Prize expense for the multiple-draws-per-day, on-line game is recognized on the basis of the predetermined prize structure when the revenue is recognized. Distinct prize categories are established which are dependent upon the amount of money wagered and the quantity of numbers to be matched. In the event that no winning share for a specific Hot Spot prize category is selected, all monies allocated for that prize category are carried forward to the following drawing and added to its respective prize category. All Hot Spot prizes won but not claimed within the specified period are allocated directly to the Education Fund. Cash Equivalents Cash equivalents represent cash deposited in the Surplus Money Investment Fund. Investments The Lottery applies Statement No. 31 of the Governmental Accounting Standards Board (GASB 31), Accounting and Financial Reporting for Certain Investments and for External Investment Pools. This statement establishes accounting and financial reporting standards for all investments held by governmental external investment pools and establishes fair value standards for other governmental entities. In accordance with GASB 31, the Lottery has stated investments, which consist of zero coupon U.S. Treasury bonds, at fair value. The difference between the carrying value and the fair value of the investment is reported as a component of total net assets on the Statement of Net Assets. Allowances for Doubtful Accounts, Ticket Returns, and Free Ticket Redemptions The allowance for doubtful accounts is based on an analysis of collectibility of accounts receivable which considers the age of the accounts and current economic conditions. An allowance for ticket returns for off-line games is estimated using sales revenue and historical return data for the games in progress at the end of the reporting period. An allowance for free ticket redemptions for off-line games is estimated using sales revenue and free ticket redemption data for games in progress at the end of the reporting period. -22-

34 CALIFORNIA STATE LOTTERY FUND NOTES TO FINANCIAL STATEMENTS JUNE 30, SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) Ticket Inventories Inventories are carried at cost and consist of tickets for games in progress not yet sold to retailers and tickets for future games. The cost of tickets is charged to operations when the tickets are sold to retailers. The cost of unissued and returned tickets is written off at the end of each game. Capital Assets The Lottery has adopted a policy of capitalizing assets with an acquisition cost or established value of $5,000 or greater. Capital assets are carried at cost. Depreciation on property and equipment is computed using the straight-line method over estimated lives ranging from three to seven years. Depreciation on buildings, improvements, and land improvements is computed using the straight-line method over estimated lives of five to forty years. When assets are retired or otherwise disposed of, the costs and related accumulated depreciation are removed from the accounts and any resulting gain or loss is reflected in operations in the period of disposal. Amortization of leasehold improvements is computed using the straight-line method over the remaining lease terms. Deferred Charges The Lottery incurs costs in connection with certain contracts which extend beyond a one-year period. These costs are deferred and amortized over the life of the contracts. As more fully disclosed in Note 12, a prepayment of $35 million was made on the GTECH contract in the 2003/2004 fiscal year. Advertising Advertising costs are expensed when the related liability is incurred. Advertising expense totaled $36,797,516 for the year ended June 30, Investment Earnings Investment earnings are composed of both unrealized gains or losses associated with the change in fair value of investments and interest income. Unrealized gains and losses are generally not realized as the investments are held to maturity; however, the investments must be stated at fair value thus creating investment earnings in the interim. Generally, all cash is held on deposit with the California State Treasurer and is invested by that office in the Surplus Money Investment Fund. Interest on funds held by the State Treasurer is distributed quarterly. Compensated Absences Payable Vested vacation balances are accrued as a liability and adjusted quarterly. Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the -23-

35 CALIFORNIA STATE LOTTERY FUND NOTES TO FINANCIAL STATEMENTS JUNE 30, SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) Use of Estimates (continued) financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Government Accounting Standards Board Statement No. 20 (GASB 20) As required under GASB 20, Accounting and Financial Reporting for Proprietary Funds and Other Governmental Entities That Use Proprietary Fund Accounting, the Lottery will continue to apply all applicable GASB pronouncements as well as Financial Accounting Standards Board (FASB) Statements and Interpretations, Accounting Principles Board (APB) Opinions, and Accounting Research Bulletins (ARBS) of the Committee on Accounting Procedure issued on or before November 30, 1989, unless those pronouncements conflict or contradict GASB pronouncements. The Lottery has elected under GASB 20 to not apply all FASB Statements and Interpretations issued after November 30, 1989, due to the governmental nature of the Lottery operations. 2. DEPOSITS AND INVESTMENTS Investments consist of zero coupon U.S. Treasury bonds with yields ranging from 1.40 percent to percent as follows: Face Amount Cost Fair Value Current portion: For off-line games $ 21,883,000 $ 8,728,840 $ 21,527,786 For on-line games 338,751, ,176, ,469,815 Total current portion 360,634, ,904, ,997,601 Long-term portion: For off-line games 113,836,000 50,016,102 90,656,545 For on-line games 2,529,374, ,149,942 1,941,501,086 Total long-term portion 2,643,210, ,166,044 2,032,157,631 Total investments $3,003,844,000 $1,133,071,037 $2,387,155,232 As disclosed in Note 1, the Lottery applies the provisions of GASB 31. In accordance with GASB 31, the Lottery carries its investments at fair value. The fair value of investments is based on published market prices and quotations from a major investment firm. The following represents the changes in fair value of investments for the year ended June 30, 2005, in accordance with the requirements of GASB 31. Changes in fair value of investments: Unrealized investment gains at July 1, 2004 $ 257,765,065 Unrealized investment gains, current period 18,141,565 Total unrealized investment gains $ 275,906,

36 CALIFORNIA STATE LOTTERY FUND NOTES TO FINANCIAL STATEMENTS JUNE 30, DEPOSITS AND INVESTMENTS (continued) Unrealized investment gains represent the excess of fair value over the original purchase cost plus interest accreted on investments at June 30, The prize investments are uninsured and unregistered investments held in book-entry form at the Federal Reserve Bank of New York. The U.S. Treasury bonds are backed by the full faith and credit of the United States government. All of the Lottery s investments are included in category 1, the lowest risk as defined by the Governmental Accounting Standards Board. The deposit and investment policies of the Lottery are determined by the Lottery Commission and state statute. Prize investments consist of zero coupon U.S. Treasury bonds, which are carried at fair value and are adjusted for the accretion of interest based on the purchased yield and maturity date. Deposits are held in insured depositories, or by the State Treasury, or in the Surplus Money Investment Fund. As of June 30, 2005, deposits in financial institutions were covered by federal depository insurance or were collateralized by the financial institution through a pool of securities held to collateralize all public deposits the institution holds and are included in category 1, the lowest risk as defined by the Governmental Accounting Standards Board. The following deposits, included in cash and cash equivalents, are in pools managed by other State of California government units and are not evidenced by securities. Interest income earned on outstanding cash balances is allocated among pool participants based on average daily cash balances. As of June 30, 2005, the carrying value of deposits in the Surplus Money Investment Fund approximated fair value. State Treasury $ 5,598,823 Surplus Money Investment Fund 321,040, ACCOUNTS RECEIVABLE Accounts receivable consist of the following: $326,638,823 Amounts due, primarily from retailers $191,568,757 Less: Allowance for free ticket redemption (30,925,015) Allowance for doubtful accounts (3,639,882) Allowance for ticket returns (4,285,524) Accounts receivable, net $152,718, DUE FROM STATE FUNDS Due from state funds consists primarily of interest income due on cash deposited with the State Treasurer in the Surplus Money Investment Fund. -25-

37 CALIFORNIA STATE LOTTERY FUND NOTES TO FINANCIAL STATEMENTS JUNE 30, CAPITAL ASSETS Capital assets consist of the following: Beginning Balance Increase Decrease Ending Balance Non-depreciable capital assets: Land $ 4,922, $ 4,922,805 Depreciable capital assets: Gaming terminals 947, ,760 (821,187) 277,443 Vending machines 34,461,991 7,071,075 (12,686,477) 28,846,589 Buildings 23,727,459 2,015,307 (150,998) 25,591,768 Data processing equipment 16,995,329 1,190,519 (10,728,706) 7,457,142 Office furniture and equipment 8,348, ,207 (3,504,464) 5,131,780 Leasehold improvements 564,077 4,900 (53,715) 515,262 Other 5,955, ,485 (403,793) 5,805,628 Less accumulated depreciation and amortization: 95,923,504 10,974,253 (28,349,340) 78,548,417 Gaming terminals (925,230) (11,494) 813,932 (122,792) Vending machines (23,071,685) (3,601,225) 12,686,477 (13,986,433) Buildings (9,026,646) (768,889) 63,084 (9,732,451) Data processing equipment (13,267,859) (1,535,177) 10,098,608 (4,704,428) Office furniture and equipment (7,383,963) (344,783) 3,311,236 (4,417,510) Leasehold improvements (431,361) (27,542) 42,255 (416,648) Other (3,744,966) (817,711) 362,557 (4,200,120) (57,851,710) (7,106,821) 27,378,149 (37,580,382) Capital assets, net $ 38,071,794 $ 3,867,432 $ (971,191) $ 40,968,035 Depreciation and amortization charged to income on capital assets was $7,106,821 for the year ended June 30,

38 CALIFORNIA STATE LOTTERY FUND NOTES TO FINANCIAL STATEMENTS JUNE 30, PRIZE LIABILITY Prize liability consists of the following: Off-Line On-Line Total Current: Annuitized prizes $ 25,527,959 $ 387,601,633 $ 413,129,592 Other prizes 145,342,842 24,023, ,366,335 Total current prize liability 170,870, ,625, ,495,927 Long-term annuitized prizes 114,736,000 2,529,374,000 2,644,110,000 Less imputed interest (33,429,327) (846,512,028) (879,941,355) Net present value of long-term prizes 81,306,673 1,682,861,972 1,764,168,645 Total prize liability $252,177,474 $2,094,487,098 $2,346,664,572 The amount of prizes due within one year is $582,495,927. Long-term prize liability as of June 30, 2005 for each of the next five years and for subsequent years is as follows: Principal Interest Total For the year ending June 30, 2007 $135,848,925 $175,940,223 $ 311,789, ,368, ,883, ,251, ,259, ,553, ,813, ,324,381 85,078, ,402, ,489,860 64,997, ,487, ,738, ,454, ,193, ,110,650 23,123, ,234, ,862,211 12,993,414 78,855, ,745,076 1,395,920 21,140,996 Total long-term prize liability $985,748,252 $778,420,393 $1,764,168,645 Activity in the prize liability accounts consists of: Balance, July 1, 2004 $2,460,662,779 Prize expense 1,795,254,439 Prize payments (2,031,748,217) Interest imputed on annuities 149,514,739 Unclaimed prizes (27,019,168) Balance, June 30, 2005 $2,346,664,

39 CALIFORNIA STATE LOTTERY FUND NOTES TO FINANCIAL STATEMENTS JUNE 30, DUE TO STATE FUNDS Due to state funds consists of the following: Due to Education Fund $ 279,531,079 Due to other state funds 228,333 Total due to state funds $ 279,759,412 Activity in the Due to Education Fund account consists of: 8. LEASES Balance, July 1, 2004 $ 238,493,436 Allocations, due to Education Fund, earned by the California State Lottery Fund $1,148,775,087 Unclaimed prizes directly allocated to the Education Fund 27,019,168 1,175,794,255 Allocations to the Education Fund (1,134,756,612) Balance, June 30, 2005 $ 279,531,079 The Lottery leases office, warehouse, and parking lot facilities under operating leases. These leases expire in various years through July 31, Most operating leases have a provision for early termination. These leases could be terminated between September 2005 and October The future minimum lease payments under operating leases as of June 30, 2005, are as follows: Operating Leases For the year ending June 30, 2006 $ 734, , , , ,960 Thereafter 91,012 Total minimum payments $2,509,288 Rental expense for all operating leases totaled $1,336,965 for the year ended June 30,

40 CALIFORNIA STATE LOTTERY FUND NOTES TO FINANCIAL STATEMENTS JUNE 30, INVESTMENT EARNINGS Investment earnings consist of: Interest on funds held by State Treasurer $ 9,877,245 Unrealized gain on investments 18,141,565 Interest accreted on investments 149,514, ,533,549 Less interest expense imputed on annuity liability (149,514,739) Investment earnings, net $ 28,018, RETIREMENT PLAN The Lottery contributes to the Public Employees Retirement Fund administered by the Public Employees' Retirement System of the State of California (PERS), an agent multiple-employer public employee defined benefit pension plan. PERS provides retirement benefits to plan members and beneficiaries. In addition, post-retirement health care benefits are provided by the primary government. PERS acts as a common investment and administrative agent for participating public entities within the State of California and uses the accrual basis of accounting. Benefit provisions and all other requirements are established by state statute. Since all state agencies are considered collectively to be a single employer, the actuarial present value of vested and nonvested accumulated plan benefits attributable to the Lottery's employees cannot be determined. Similarly, the net assets available for benefits of Lottery employees cannot be determined. PERS issues a separate comprehensive annual financial report that includes financial statements and required supplementary information. The PERS annual financial report may be obtained from their executive office: 400 P Street, Sacramento, CA Generally, full-time employees are eligible to participate as members of PERS and are eligible to retire at age 50 with at least five years of service or age 55 with at least ten years of service depending on the plan selected by the employee. Annual retirement benefits are determined based on age at retirement, the length of membership service, and the amount of earnings based on the highest or last 12 consecutive months' average. Active plan members are required to contribute a percentage of their salary depending on their plan selection and employment classification. Employees required contributions vary from 0.0% to 8.0%. The Lottery is required to contribute at an actuarially determined rate. The Lottery's contributions are based on a percentage of annual covered payroll depending on the plan selected and member status. For the year ended June 30, 2005, the Lottery's payroll for employees covered by PERS was approximately $28.0 million and the total payroll for the period was approximately $28.7 million. The contribution requirements of plan members and the Lottery are established and may be amended by PERS. Required employer contribution rates (expressed as a percentage of compensation) for the 2004/2005 fiscal year are as follows: -29-

41 CALIFORNIA STATE LOTTERY FUND NOTES TO FINANCIAL STATEMENTS JUNE 30, RETIREMENT PLAN (continued) State Miscellaneous Member First Tier % State Miscellaneous Member Second Tier % Peace Officer % The Lottery s pension cost for the year ended June 30, 2005, for PERS was equal to the Lottery s required contributions which was determined as part of the most recent actuarial valuation of PERS dated June 30, Three year trend information for the Lottery: Fiscal Year Ending Annual Pension Cost (APC) Percentage Of APC Contributed Net Pension Obligation 11. STATUTORY COMPLIANCE 6/30/03 $3,049, % $0 6/30/04 $4,038, % $0 6/30/05 $4,719, % $0 Lottery prize payments and other operating expenses are shown below as a percentage of operating revenue for the year ended June 30, The Act mandates that, as nearly as practical, 50 percent of the total annual revenues from Lottery sales be returned to the public in the form of prizes and that at least 34 percent be allocated to benefit public education. No more than 16 percent of the total annual revenues from Lottery sales shall be allocated for payment of expenses of the Lottery. In addition, unclaimed prizes not directly payable by the commission, which amounted to $12,277,318 for the year ending June 30, 2005, are recognized as a reduction of prize expense and included in the Lottery's operating income that is allocated to the Education Fund. Unclaimed prizes directly payable by the commission are allocated directly to the Education Fund. Finally, all of the interest earned on funds held in the State Lottery Fund shall be allocated for the benefit of public education. This interest is not to be considered part of the 34 percent of the total annual revenues from sales that is otherwise required to be allocated for public education. -30-

42 CALIFORNIA STATE LOTTERY FUND NOTES TO FINANCIAL STATEMENTS JUNE 30, STATUTORY COMPLIANCE (continued) Lottery sales $3,333,620, % Prizes 1,795,254, % Expenses of the Lottery Retailer costs 233,447, % Game costs 56,745, % Operating expenses 110,246, % Less bartered operating expenses (41,945) 0.00% Total expenses of the Lottery $ 400,397, % Revenues to Education Allocation of sales $1,137,968, % Unclaimed prizes directly allocated to the Education Fund 27,019,168 Interest income 9,877,245 Other income 971,475 Less bartered income (41,945) Total declared for allocation to Education Fund $1,175,794, COMMITMENTS AND CONTINGENCIES A contract has been awarded to GTECH and includes both gaming and telecommunication systems and services. The Lottery pays a fee of 1.36 percent of sales during the contract term ending on October 13, The total estimated amount of the contract is $300 million. Approximately $82.6 million in fees have been incurred under the new contract as of June 30, In addition to the fees incurred, a prepayment of $35 million was made to GTECH by the Lottery. GTECH will repay the full amount plus interest via weekly payments equal to 0.2% of sales. The weekly payments will be effected through the reduction of GTECH s weekly fee billings to the Lottery. The prepayment bears interest at a rate equal to the Surplus Money Investment Fund rate plus one-half of one percent. GTECH may repay the outstanding amount after one year of full system operations and any remaining balance must be paid in full at the end of the contract term. The balance outstanding at June 30, 2005 approximated $27.7 million. Approximately $5.8 million has been recorded as an other current asset as it is expected to be settled within one year. The Lottery has been named as a defendant in a number of lawsuits and claims. While the ultimate monetary outcome of these claims cannot be estimated at this time, it is the opinion of management, after consulting with legal counsel, that the disposition of any litigation in which the Lottery is involved will not have a material adverse effect on the financial condition or on the operations of the Lottery. -31-

43 CALIFORNIA STATE LOTTERY FUND NOTES TO FINANCIAL STATEMENTS JUNE 30, RISK MANAGEMENT Since its inception, the Lottery has been primarily self-insured for risks such as flood, business interruption, theft, employee errors and omissions, and other potential liabilities. Losses are recognized when conditions for accrual are met. Liabilities for workers' compensation costs are accrued based on estimates derived from the State Compensation Insurance Fund. This estimate is based on actuarial reviews of the employee workers compensation program and includes indemnity payments, compensation benefits, and leave benefits. -32-

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45 S T A T I S T I C A L S E C T I O N C O M P R E H E N S I V E A N N U A L F I N A N C I A L R E P O R T