STATE OF CALIFORNIA GRAY DAVIS, Governor
PUBLIC UTILITIES COMMISSION
505 VAN NESS AVENUE
SAN FRANCISCO, CA 94102-3298
August 29, 2003 Agenda ID# 2376
Alternate Agenda ID#2378
Agenda ID # 2636
Alternate Agenda ID# 2637
Ratesetting
TO: PARTIES OF RECORD IN RULEMAKING 01-09-001 and INVESTIGATION 01-09-002
RE: NOTICE OF AVAILABILITY OF DRAFT DECISIONS AND ALTERNATE DRAFT DECISIONS REGARDING PHASE 2A AND 2B AUDIT ISSUES
The following draft decisions and alternate draft decisions, which were issued on the above date, are available to the parties and the public:
· Administrative Law Judge (ALJ) Kenney's draft decision regarding Phase 2A audit issues. ALJ Kenney was previously designated as the principal hearing officer for Phase 2A of this proceeding.
· Commissioner Kennedy's alternate draft decision to ALJ Kenney's draft decision.
· ALJ Thomas's draft decision regarding Phase 2B audit issues. ALJ Thomas was previously designated as the principal hearing officer for Phase 2B of this proceeding.
· Commissioner Kennedy's alternate draft decision to ALJ Thomas's draft decision.
An Internet link to each of the previously identified documents was sent via e-mail to all the parties on the service list who provided an e-mail address to the Commission. An electronic copy of these documents can be viewed and downloaded at the Commission's web site ( www.cpuc.ca.gov). A hard copy of these documents can be obtained by contacting the Commission's Central Files Office [(415) 703-2045].
The previously identified draft decisions and alternate draft decisions were issued in a ratesetting proceeding that is subject to Pub. Util. Code § 1701.3(c). Pursuant to Resolution ALJ-180, a Ratesetting Deliberative Meeting to consider these drafts may be held upon the request of any Commissioner. If that occurs, the Commission will prepare and mail an agenda for the Ratesetting Deliberative Meeting 10 days before hand, and will advise the parties of this fact and of the related ex parte communications prohibition period.
The Commission may act on the previously identified draft decisions and alternate draft decisions at its first regular meeting occurring no earlier than 30 days after the date the drafts are issued. The Commission may also postpone action until later. If the Commission acts, it may adopt all or part of a draft as written, amend or modify it, or set it aside and prepare its own decision. Only when the Commission acts does the decision become binding on the parties.
Parties may file separate comments on each draft decision and alternate draft decision as provided in Article 19 of the Commission's "Rules of Practice and Procedure." These rules are accessible on the Commission's website ( http://www.cpuc.ca.gov). Pursuant to Rule 77.3 opening comments on each draft shall not exceed 25 pages. Comments must be served separately on the ALJ and the assigned Commissioner, and for that purpose I suggest hand delivery, overnight mail, or other expeditious method of service. In addition to service by mail, parties should send their comments in electronic form to ALJ Kenney at tim@cpuc.ca.gov, ALJ Thomas at srt@cpuc.ca.gov, Timothy Sullivan at tjs@cpuc.ca.gov, and to those listed in the appearance and state service portions of the service list who provided an electronic mail address to the Commission.
/s/ ANGELA K. MINKIN by PSW
Angela K. Minkin, Chief
Administrative Law Judge
ANG:hkr
ALJ/SRT/avs DRAFT Agenda ID #2636
Ratesetting
Decision PROPOSED DECISION OF ALJ THOMAS (Mailed 8/29/2003)
BEFORE THE PUBLIC UTILITIES COMMISSION OF THE STATE OF CALIFORNIA
Order Instituting Rulemaking on the Commission's Own Motion to Assess and Revise the New Regulatory Framework for Pacific Bell and Verizon California Incorporated. |
Rulemaking 01-09-001 (Filed September 6, 2001) |
|
Order Instituting Investigation on the Commission's Own Motion to Assess and Revise the New Regulatory Framework for Pacific Bell and Verizon California Incorporated. |
Investigation 01-09-002 (Filed September 6, 2001) |
INTERIM OPINION REGARDING PHASE 2B AUDIT ISSUES
TABLE OF CONTENTS
Title Page
INTERIM OPINION REGARDING PHASE 2B ISSUES 22
B. Involvement of Commission's Telecommunications Division
and Office of Ratepayer Advocates 55
E. Pacific's Books and Generally Accepted Accounting Principles 88
III. Undisputed Audit Adjustments 2323
IV. Disputed Audit Adjustments 2424
i. Was the Information "Privileged?" 2626
ii. Did Pacific Waive the Privilege? 2828
iii. Did the Limited Waiver Waive the
Privilege as to Claimants? 2929
Title Page
1. Local Number Portability Costs 3838
2. Local Competition Implementation Costs 4545
4. Software Buy-Out Agreement 4949
D. Depreciation Accounting-Intrabuilding Network Cable Amortization 5454
1. Accumulated Deferred Income Taxes 5555
2. Sales and Use Tax Accruals 5656
Title Page
ii. Compliance With Time Reporting Document Retention Requirements 9090
iii. 1998 Affiliate Oversight Group (AOG) Compliance Review of SBC Operations 9292
iii. Shared Services Affiliates 101101
iv. Services Provided by Pacific Bell to Affiliates 101101
v. Other Compliance with Affiliate Transaction Rules Issues - AMDOCS 105105
i. Pacific's Customer Database 105105
ii. Transfer of Pacific Bell Directory to Pacific Telesis Group 109109
i. Appropriateness of Considering ASI in this Proceeding 113113
i. Operating Revenue Adjustments - 1999 Employee Transfer Fee 117117
Title Page
1. Executive Compensation Allocated From Parent
and MSI-USA to Pacific 117117
2. Executive Award Payments Allocated to Pacific 120120
3. Executive Compensation Allocated From
Parent to Pacific Bell Directory 120120
4. Special Executive Compensation Allocated From
Parent to Pacific Bell Directory 121121
5. Executive Compensation Allocated
from SBC Operations 121121
6. Executive Compensation Allocated
from SBC Services 122122
1. Legal Expenses Allocated from Parent to Pacific 122122
2. Legal Expenses Allocated From Parent
to Pacific Bell Directory 123123
(c) Public Relations and Corporate Sponsorship
Allocated from Parent to Pacific and
Pacific Bell Directory 124124
V. Regulated and Nonregulated Cost Allocations 127127
A. Marketing Service - Affiliate Billings 127127
B. Other Regulated and Nonregulated Cost Allocation Issues 129129
1. National-Local Strategy Implementation Costs 129129
a. 1997 Corporate Sponsorship Costs - Pacific Bell Park 130130
b. Depreciation Expense Allocation 131131
c. Product Advertising Expense 132132
e. Customer Service Expense 134134
f. InterLATA Service Application Costs 135135
g. Fluctuation Analysis 136136
VI. Whether Pacific Impeded the Audit 140140
VII. Phase 2B Remedies (Audit - Pacific Bell) 148148
A. ORA's Proposed Remedies - Summary 148148
B. Correction of IEMR Reports for 1997-99 151151
Title Page
E. 18 Percent Interest on 1997-98 Shareable Earnings 153153
F. Suspension of Sharing in 1999 159159
G. 18 Percent Interest on All Underreported Earnings 161161
I. Completion of 1997-99 Audit - Affiliate Transactions 164164
J. Audit of Pacific's 2000-02 Reporting, Including Affiliate Transactions 166166
VIII. Recovery of Audit Costs 173173
IX. Comments on Proposed Decision 176176
X. Assignment of Proceeding 176176
APPENDIX A Summary of Adopted Adjustments to Net Operating Income and
Rate Base Pacific Bell Intrastate Regulated Operations, Phase 2B
1997, 1998, and 1999
APPENDIX B Joint Exhibit of Overland Consulting, Inc., ORA, TURN and Pacific Bell
Showing Impact of Audit Corrections on Pacific Bell's Reported
EIMR Results for 1997-1999
APPENDIX C Joint Schedule of Overland Consulting, Inc.'s, ORA's and TURN's
Position on Adjustments (as requested by ALJ Sarah Thomas)
INTERIM OPINION REGARDING PHASE 2B ISSUES
This decision acts on portions of an audit of Pacific Bell Telephone Company (Pacific)1 the Commission conducted as part of its oversight of the "New Regulatory Framework" (NRF). The NRF framework, implemented in 1990,2 relaxed regulation of certain large telephone companies in California in exchange for assurances regarding service quality, protection of ratepayer funds, and other measures. This phase of the proceeding (Phase 2B) examined all but the four largest issues presented in that audit; Phase 2A examined those four issues and will be the subject of a separate decision. We find that many of the audit findings are justified and that in many instances Pacific over-reported expenses with significant consequences for ratepayers.
Phase 2B examined 68 accounting issues identified by Overland for scrutiny in this proceeding. As a result of Overland's review of these 68 issues, Overland proposed adjustments in Pacific's revenues of $625.3 million and adjustments in Pacific's ratebase of $2134.7 million. Of these adjustments, 17 totaling $118.4 million in revenue adjustments and no ratebase adjustments were uncontested. Of the 51 contested issues, we sustain Overland's analysis on 48 and reverse their recommendation on 3 based on the evidence submitted at hearing and our analysis of Commission policies. Concerning these contested issues, we order Pacific to make 35 adjustments in revenue, and 13 adjustments to its ratebase.
As a result of our decision today, we order Pacific to adjust its net operating income in 1997 by $293.5 million; in 1998 by $222.5 million; and in 1999 by $114.6 million. Thus, the adjustment to Pacific's net operating income total $630.6 million for the three years under review. In addition, we order ratebase adjustments of $787.0 million in 1997, $823.7 million in 1998, and $639.2 million in 1999. Thus, for these three years ratebase adjustments total $2250.0 million.
In 1997 and 1998, Pacific was under an obligation to share earnings above a certain threshold with ratepayers. However, its excessive reported expenses caused Pacific's reported earnings to be improperly depressed. In combination with the audit decision resulting from Phase 2A of this proceeding, the earnings rose to a level that requires Pacific to share earnings in 1998.
In 1999, Pacific also over-reported expenses, but was under no obligation in that year to share earnings with ratepayers. Certain parties participating in this case have asked that we reverse our decision to suspend sharing in 1999 on the ground that Pacific misled us into making it. We do not find sufficient evidence to support this allegation. Therefore, while we require Pacific to remedy its earnings reporting for 1999, the changes we order do not require ratepayer sharing in that year.
The audit adjustments that we adopt in this decision are combined with the Phase 2A adjustments and together reflected in Appendices A, D and E to our Phase 2A decision.3 The Phase 2B adjustments appear in Appendix A to this decision. In addition, we require Pacific to prepare schedules that identify each of this decision's adopted adjustments and demonstrate that it has properly reflected the ordered adjustments in its financial reporting. Pacific shall file the schedules, along with supporting documentation, as a compliance Advice Letter filing due no later than 60 days after the effective date of this decision.
When the Commission instituted NRF, it prescribed periodic audits of Pacific. The audits would serve to verify, among other things, that Pacific's financial reporting was accurate, that it was not subsidizing its non-regulated businesses with funds from the regulated local telephone company, and that to the extent ratepayers were to share in Pacific's earnings, Pacific was reporting those earnings correctly. The Order Instituting Rulemaking (OIR) commencing this proceeding stated that the audit should:
(1) analyze Pacific's NRF monitoring reports; (2) analyze Pacific's cost allocations and accounting practices and procedures that were established to protect against cross subsidization and anticompetitive behavior; (3) determine whether Pacific and its affiliates are following the Commission's rules for affiliate transactions; (4) determine whether Pacific is properly tracking and allocating costs related to non-regulated activities; and (5) determine whether non-structural safeguards adequately protect ratepayer and competitor interests with respect to non-regulated activities. (D.96-05-036, 66 CPUC 2d 274, 278, and OPs 3 and 4; and Executive Director letter dated September 18, 1998).4
B. Involvement of Commission's Telecommunications Division and Office of Ratepayer Advocates
The Pacific audit took an unusual turn from the outset. The Commission's Office of Ratepayer Advocates (ORA), which appears as an advocate in Commission proceedings on behalf of ratepayers, was originally assigned to conduct the audit. (ORA also carried out the Verizon audit addressed in Phase 1 of this proceeding. Pacific objected to ORA's involvement, and convinced the Commission to reassign the audit to its Telecommunications Division (TD), an industry division within the Commission that, among other things, advises the Commissioners on telecommunications issues.5 In discharging its obligation to oversee the Pacific Bell audit, the TD maintained the contract ORA had previously negotiated with an independent firm, Overland Consulting (Overland), to carry out the audit for the Commission.
Even though it sought TD's involvement in the audit, Pacific has frequently objected to the manner in which TD participated in the proceeding. TD has taken the position that it is not a "party" to the proceeding, but rather that it represents the Commission in an advisory capacity in carrying out the audit.
TD is an arm of the Commission. Therefore, it cannot be the subject of deposition or other routine discovery as would an ordinary party, may consult with Commission decision-makers including the Assigned Commissioner and Administrative Law Judges (ALJ) without being bound by the Commission's ex parte rules, and otherwise may act in its normal advisory role vis-à-vis the Commission.
ALJ Timothy Kenney, who handled Phases 1 and 2A of this proceeding, explained TD's role in a discovery ruling:
TD is not a party to this proceeding, but a division of the Commission that advises decision makers. TD's task in this proceeding has been to manage an audit that was ordered by the Commission. The auditors are not expert witnesses hired by a party to this proceeding, but consultants retained by the Commission to perform work that -- given more time and resources -- TD could have performed itself.6
During the audit, ORA also sought and was granted permission to conduct its own discovery examining Pacific's actions on issues covered by the audit. Ultimately, Overland presented its audit at hearing, TD managed Overland's contract and facilitated interactions between the auditors and Pacific, and ORA actively pursued various issues raised in the audit.
Overland prepared an audit report covering the years 1997-99 that was admitted into evidence during Phase 2A of this proceeding.7 In the report, Overland stated that it:
identified 67 corrections [increased by Overland's Supplemental Audit Report8 to 729] to Pacific Bell's regulated operating revenues, expenses and rate base. Audit corrections to bring financial results into compliance with CPUC requirements increased the regulated intrastate net operating income that Pacific Bell reported during the audit period by $1.94 billion. This translates into recommended customer refunds under NRF earnings sharing rules of $349 million for the years 1997 and 1998. NRF earnings sharing rules were suspended by the CPUC effective in 1999. Customer refunds would have totaled $457 million if the sharing rules had been effective.10
We address approximately two-thirds of the audit dollar results - attributable to four issues - in the Phase 2A decision. Therefore, whether the decisions we reach here on the remaining one-third will rise to a level requiring Pacific to share earnings with ratepayers depends on the results of Phase 2A. Because we expect the two decisions to issue at about the same time, this decision addresses each Phase 2B audit claim, but does not reach the ultimate issue of whether sharing is required or the amount of such sharing. The Phase 2A decision performs the calculations for both phases.
E. Pacific's Books and Generally Accepted Accounting Principles
Pacific contends that even if we agree with the audit on an adjustment - or Pacific concedes that the auditors' findings are correct - it does not automatically follow that Pacific's California books11 should be restated in the year in which the error occurred. Rather, Pacific claims that, in certain cases, Generally Accepted Accounting Principles (GAAP) allow adjustment only in the year in which the error was discovered. Because the audit did not take place until 2001, following Pacific's reasoning, the adjustments would occur after the audit period (and after the Commission suspended earnings sharing) and not result in ratepayer sharing. We disagree that this is the proper means of reflecting the audit changes, as we discuss below.
Pacific keeps several types of financial records. It uses one set for tax purposes, another for financial accounting and Securities and Exchange Commission (SEC) reporting purposes, and a third set to comply with regulatory accounting requirements the Commission imposes on the company under NRF. Only the third set of accounts is at issue in this decision.
Pacific explains that its so-called "FR" books (its witness could not explain the origin of this acronym) are the starting point to create the Intrastate Earnings Monitoring Reports (IEMRs). The IEMRs are the reports directly at issue in this proceeding, as they contain Pacific's California results in the format ordered by the Commission. Historically, the FR books were Pacific's externally reported results, used for SEC purposes, and thus were governed by GAAP. Even though Pacific started using another set of books - the "ER" books (again, the witness could not explain the acronym) - for external reporting purposes in 1995, it continued thereafter to maintain the FR books in order to produce the IEMR. At that time, Pacific simply "froze . . . the accounting requirements for the FR books, and . . . continue[d] to maintain the FR books on exactly the same basis that they were prior to that set of new external [books] being developed."12 Any GAAP changes instituted after 1995 are not reflected in the FR books. The only purpose of the FR books after 1995 was to create the IEMR.13
Pacific concedes that "[t]he Commission has the power to order Pacific to keep its regulatory books in any manner, limited only by the law." Nonetheless, it claims that anything that results in an adjustment to the FR must follow GAAP: "Because the FR books are kept pursuant to GAAP, where errors have occurred, the corrections to those errors must conform to GAAP."
Still, Pacific concedes that even under its reasoning, "material" errors might be recorded in the year they occurred: "the adjustments Pacific does not challenge would appropriately be included in the FR books, and should be reported in calendar year 2002 because they have no material effect on the previously reported FR financial results for years 1997, 1998, and 1999."14 And Pacific also admits that "where an error occurred outside of the FR books, but in the IEMR calculation process, [Accounting Practices Board Opinion] 2015 [setting forth the requirement under GAAP that a change in an estimate should not be accounted for by restating amounts reported in financial statements of prior periods] does not apply."16 Finally, Pacific concedes that the FR books do not even accommodate GAAP changes made after 1995, so it is unclear why changes to the books for 1997-99 would "violate GAAP."
If the FR books are not used for SEC reporting purposes, and "the Commission has the power to order Pacific to keep its regulatory books in any manner," and to make changes in the affected year for "material" errors, there is no reason the Commission cannot require Pacific to restate its IEMR for prior periods for California regulatory and ratemaking purposes. The FR books are in essence books the Commission requires Pacific to keep for ratemaking purposes since they have served no other purpose since 1995. Moreover, we find that D.96-05-036 put Pacific on notice that we intended to audit, analyze, and adjust these monitoring reports.
This Commission is not obligated to base its regulatory ratemaking accounting on GAAP or Financial Accounting Standards Board (FASB) pronouncements, and we have rejected the applicability of GAAP and FASB in the past. For example, the Commission contemplated adopting the FCC's Part 32 Uniform System of Accounts (USOA) for intrastate regulatory accounting in D.87-12-063. One of the perceived benefits of Part 32 was that it accommodated GAAP, while the FCC's previous USOA Part 32 did not. However, in D.87-12-063, the Commission declined to adopt the Part 32 and GAAP normalization policy, and maintained its own rules. As another example, in D.88-03-072, the Commission found that FASB Statement 87, regarding Employers' Accounting for Pensions, should not be used for intrastate ratemaking purposes and upheld a different methodology - the Aggregate Cost Method (ACM) - as the Commission's pension policy.
For the reasons set forth above, we order Pacific to make changes we require in this decision to its books for the year in which the error occurred and reflect the changes in the IEMRs for the applicable years. With the restated IEMRs, Pacific shall provide schedules that identify each of this decision's adopted adjustments and demonstrate that it has properly reflected the ordered adjustments in its financial reporting for ratemaking purposes.
Pacific claims that even if we find that Overland is correct on many of the disputed audit issues, ratepayers were nonetheless unharmed because NRF severs the link between costs and rates.
Under NRF, services were classified into three categories. Basic monopoly services were classified as Category I services. Discretionary or partially competitive services were classified as Category II services. Fully competitive services were classified as Category III services. The price for each Category I service was fixed except for an annual adjustment equal to the price-cap index. The price for each Category II service could vary within a price ceiling and price floor. The price floor was increased annually by inflation, and the price ceiling was revised annually by the price-cap index. Prices for Category III services were provided the maximum flexibility allowed by law.
One of the original elements of the Commission's NRF price cap form of regulation was a sharing mechanism. The sharing mechanism was intended to protect ratepayers from the utility earning excess profits. This was accomplished by establishing a market based rate of return that reflected what a reasonable level of earnings would be, and then adding an additional amount to reflect a "benchmark" rate of return that represented a threshold over which earnings would be shared with, or returned to, ratepayers. The benchmark during the audit period was 11.5 percent. Pacific was required to share profits in excess of its benchmark and up to 15 percent equally between ratepayers and shareholders, and split profits in excess of 15 percent 70-30 between shareholders and ratepayers.
It is true that NRF alters the direct link between a utility's costs and its prices. Under traditional cost-of-service regulation, the Commission calculated Pacific's cost of service, including its cost of capital, and based on that cost determined how much revenue Pacific needed to recover those costs. Costs therefore directly impacted how much revenue Pacific could recover.
However, we still rely on Pacific to maintain accurate expense, revenue and rate of return data and submit correct IEMR information so that we can make many important determinations:
· To ascertain whether exogenous or limited exogenous factor cost recovery treatment is appropriate and, if so, the amount by which rates should change.17
· To decide when individual service rate increases are justified.
· To resolved whether recategorization requests (to move services among the three NRF service categories) should be approved.
· For purposes of universal service proceedings.
· For regulating rates for Category 1, such as unbundled network elements.18
Thus, we conclude that TURN is correct in stating that under NRF, "[d]uring a period when revenue sharing is in effect, a reduction in the amount of net revenues shared with ratepayers constitutes a form of economic harm to those ratepayers."19 The higher Pacific's costs as reported in the IEMR, the lower its revenues and ultimately its potentially shareable earnings.
Furthermore, we find that Pacific's accounting costs do have an effect on the price floors and ceilings the Commission sets for its services. These floors and ceilings are set based on studies of Pacific's forward-looking costs, which in turn are often derived, in part, from accounting costs. For example, in D.99-11-051,20 The Commission increased both price floors and price ceilings for directory assistance and a variety of other services based on studies of the forward-looking cost to provide such services. Thus, even apart from whether expenses are relevant to the issue of sharing, costs directly impact prices in this way.
Finally, it is essential to the regulatory process that we have accurate information regarding the earnings of companies we regulate. Regulated entities often contend that regulations are having an adverse effect on their earnings and their ability to attract capital. We cannot evaluate such claims properly if we lack reliable information regarding utilities' actual earnings, and the expense and revenue figures from which earnings are derived. In addition, regulated utilities may contend that a regulatory scheme is causing their earnings to be so low as to constitute an unconstitutional taking of property. Again, accurate earnings data is essential in order to evaluate such arguments. More generally, although NRF is a scheme in which rates do not necessarily change in response to changes in costs or earnings, accurate earnings reports are a critical tool in our ability to monitor the economic impact of our regulations on NRF carriers.
Pacific invokes a "materiality" threshold and claims that if a single audit correction is not "material," the Commission essentially should ignore it. However, the only reference to materiality for this audit that we have been able to find appears in the original decision ordering the audit:
The auditor should adhere to generally accepted auditing standards with the exception that the materiality threshold should be reduced to a scope determined by DRA; the Commission is interested in full compliance with its rules and regulations.21
The Commission made clear that it was imposing a low threshold of materiality in order to insure "full compliance with its rules and regulations." Thus, to the extent ORA found an item to be material, Pacific's concession allowing "material" restatements to prior years' financial results22 undermines its argument. Moreover, as TURN points out, even if a single item of adjustment is immaterial, "materiality needs to be considered in context. If the Commission were only considering the impact of a single [small dollar] issue . . . it may not be material. But where, as here, the Commission's review is likely to result in a cumulative adjustment in an amount that meets anyone's definition of material, then every issue should be considered, no matter how small in isolation."23 We agree.
Overland also discussed the concept of materiality. With regard to affiliate transactions, the audit report stated that it "did not conclude that internal control weaknesses affecting affiliate service transactions had a material impact on Pacific Bell's Commission-basis financial results during the years 1997 through 1999."24 By the same token, however, Mr. Welchlin clarified at hearing that an amount not in itself material might rise to the level of materiality if combined with other amounts:
Q. And do you believe - and just again focusing on the question of materiality from the standpoint of sharable evenings [sic - should be "earnings"] - . . . that even a $10 million figure is material if it were to be found?
A. In conjunction with other related issues, a $10 million or a $5 million issue, that obviously has to be considered.
Q. How about a $450,000 issue, would that meet your test of materiality for sharable earnings issues?
A. If it was the only issue in the case, it would not.
Q. 237,000?
A. If it was the only issue in the case, it would not by itself rise to a level of materiality.25
Thus, the auditors recognized that materiality depended on whether one examined an item in isolation or in the context of many other audit adjustments.
Thus, we find that, in combination, the audit corrections Overland identified were sufficiently material to require the changes in Pacific's reporting that we order in this decision. A correction is material not only because of its impact on shareable earnings. First, as noted above, we use the IEMR and the data upon which it is based for many reasons, rather than only to determine whether ratepayers will share in Pacific's earnings. Second, even if the issue does not affect the IEMR at a "material" financial level under Pacific's definition, there may be reasons related to Commission authority and conformity with applicable law and regulation that would lead us to conclude that Pacific committed error. It is too limiting to claim that our rules are designed solely to prevent financial harm to ratepayers. Third, an error with a current small dollar impact during the audit period could cause a large financial impact in subsequent years if not corrected.
Therefore, we reject Pacific's claim that we cannot act on an audit recommendation unless it "materially" (using a definition of materiality without record support) affects shareable earnings.
H. Overland's Qualifications to Perform the Audit
Pacific contended during Phase 2A and 2B of this proceeding that Overland was not qualified to perform the audit because the firm is not registered by the state board of accountancy in California or in any other state and thus is not a certified public accounting firm. We address the contentions in both phases here.
We find no merit in Pacific's allegation that Overland did not meet the criteria established by D.96-05-036. In D.00-02-047, the Commission had before it Overland's proposal to perform the audit,26 which included full disclosure of Overland's qualifications to conduct the audit.27 Indeed, the Commission explicitly recognized in D.00-02-047 that Overland is not a CPA firm, but a consulting firm that employs and subcontracts with CPAs.28 With this knowledge in mind, the Commission explicitly authorized TD to hire Overland.29 Thus, the Commission itself determined that Overland met the criteria established by D.96-05-036.
The record in this proceeding supports the Commission's decision in D.00-02-047 that Overland was well qualified to conduct the audit of Pacific. Overland's clients are primarily state public service commissions, other state agencies, and regulated utilities. In addition to the California Public Utilities Commission, Overland's previous clients included the Alaska Public Utility Commission, the Arizona Corporation Commission, the Kansas Corporation Commission, the Kentucky Public Service Commission, the New York Public Service Commission, the Oklahoma Corporation Commission and the Wyoming Public Service Commission. Utility clients included Kansas Pipeline Company, Middle South Utilities, and Tele-Communications, Inc. (TCI).30
Overland has extensive experience in auditing regulated telecommunications utilities. For example, Overland has previously conducted audits of (1) US West Communications, Inc., of Minnesota, (2) GTE Southwest Incorporated, (3) New York Telephone, (4) AT&T Communications, and (5) Roseville Telephone Company.31
With respect to California utilities, Overland has performed several significant regulatory audits on behalf of the Commission during the past eight years. In 1994, Overland conducted an audit of the operating expenses associated with Pacific Gas and Electric's (PG&E's) pipeline expansion project. In 1996, Overland performed a regulatory audit of Southern California Gas (SoCalGas) in connection with the company's performance-based ratemaking case. In 1997 and 1998, Overland performed a regulatory audit of PG&E's holding company and affiliate relationships, and in 1998 and 1999 they audited administrative and general expenses in connection with PG&E's general rate case. In 1999, Overland performed an audit of Roseville Telephone Company's affiliate transactions and non-regulated activities, and in 2000 submitted testimony concerning Roseville's IEMR earnings calculations. Since 2000, Overland has performed the regulatory audit of Pacific Bell.32
We find no merit in Pacific's allegation that none of the Overland personnel who were primarily responsible for the audit were qualified to conduct the audit. Mr. Lubow, who signed the audit report and thereby took ultimate responsibility for the audit, has participated in over 75 audits and testified as an expert witness in over 100 regulatory proceedings.33
Mr. Welchlin, who was one of Overland's two lead auditors, has more than 20 years of experience as a utility industry auditor and regulatory consultant. His career includes experience as an internal auditor with Illinois Power Company, as a supervising auditor with the Texas Public Utilities Commission, and as a consultant for a variety of regulatory audits involving companies such as AT&T, New York Telephone, Western Resources, Southern Union Company, SoCalGas, PG&E, and Roseville Telephone Company.34
Mr. Harpster, the other lead auditor, is a CPA with 22 years of regulatory and consulting experience. He has participated in more than 35 proceedings before the Federal Energy Regulatory Commission, courts in Arizona and Louisiana, and numerous state commissions, including four separate proceedings before this Commission involving SoCalGas and PG&E.35
Mr. Oetting, who replaced Overland's Mr. Klote in analyzing data request responses and testifying at hearing, has 14 years of experience as an accountant in public and private industry.
Thus, we are satisfied that Overland and its personnel had the necessary expertise to conduct this audit.
We also find no merit in Pacific's allegation that Overland failed to conduct the audit in accordance with Generally Accepted Auditing Standards (GAAS) because (1) Overland's auditors lacked adequate technical training and proficiency as auditors, (2) Overland failed to exercise due professional care, and (3) Overland conducted its audit in a biased manner. Overland and its personnel were well qualified to conduct the audit for the previously stated reasons. The one area in which Overland was unable to meet GAAS was where Pacific failed to give it adequate information to allow the auditors to perform their auditing function and form a professional opinion based on verifiable data. We discuss instances where this occurred - and related remedies - in the body of this decision. This was not the fault of Overland, but rather a problem of Pacific's own creation.
Furthermore, the record shows that Overland went to extraordinary efforts to exercise due professional care. The sufficiency of Overland's efforts is demonstrated by the extensive analysis of issues contained in its audit report and the 1,297 detailed data requests included in the appendices to the audit report. Indeed, while Pacific accuses Overland of not exercising due professional care, Pacific complains about the large number of questions asked and the volumes of data that Pacific was required to produce to satisfy the auditors.36
Finally, we find no credible evidence that Overland is biased against Pacific. The fact that most of Overland's audit findings are adverse to Pacific is not an indication of bias, but that they created a report based on extensive analysis.
Pacific also claims that Overland represented to the Commission that it would perform its audit in conformity with certain standards of NARUC, the National Association of Regulatory Utility Commissioners. However, at hearing, Overland's witness testified that the reference to NARUC standards in its proposal letter was a word processing error that resulted when Overland reused an earlier proposal draft.37 Since the Commission did not require that the audit be carried out consistently with any NARUC standards, Overland's claim is credible.
The one NARUC standard Pacific claims Overland violated states that "[t]he consulting firm should present draft reports, consistent with the client's requirements, in order to afford the client and the auditee the opportunity to make pertinent comments and factual corrections wherever necessary, and to allow for the discussion of conclusions and recommendations before a final report is prepared." Because the Commission did not require the auditors to follow the NARUC standard, even if it were true that the "client's requirements" would have allowed such sharing of drafts, the NARUC standard has no relevance here. In any event, Pacific had ample opportunity to dispute the audit findings, both at hearing and in subsequent briefing.
Pacific also claims that the auditors engaged in detailed policy discussions, allegedly in violation of the audit standards. It is indeed true that D.96-05-036 states that the "work product [of the audit] should not include lengthy policy discussions . . . ."38 However, the Commission said in the same decision that, "The [audit report] should include an analysis of all issues uncovered, including any relevant documentation . . . . Recommendations as to specific accounting measures would also be welcome." We also asked for "a thorough, aggressive audit."39 We therefore interpret our instructions to include more than simply pointing out errors; rather, we expected the auditors to suggest means of resolving problems.
Furthermore, many of the items Pacific identifies as "lengthy policy discussions" relate directly to accounting measures and therefore are entirely within the letter of the Commission's order. One Overland recommendation relates to the Commission's "authority to set accounting . . . standards," another relates to "remov[ing] parent billings . . . from regulated expenses," a third relates to whether affiliates should collect sales referral fees when they provide referral services to Pacific's customers, a fourth relates to "treatment of costs associated with . . . services marketed to customers outside . . . Pacific's local exchange territory," and a fifth relates to "treatment of costs incurred to enter the long distance market."40 The points Overland makes are entirely consistent with the requirement of "an analysis of all issues uncovered," and "[r]ecommendations as to specific accounting measures."
Finally, Pacific criticizes errors in Overland's audit. While there may have been a few errors, they are inconsequential in an audit of this size. As the body of this decision establishes, we have resolved against Pacific many of the claims with which Pacific takes issue.
III. Undisputed Audit Adjustments
Several of the audit findings are undisputed. The undisputed issues relate to expenses Pacific incurred in shutting down its Advanced Communications Network; its sale of Bellcore; and parent SBC's political and legislative influence expenditures, its charitable contributions, memberships and foundation expense, to name but a few examples.
A chart listing the undisputed items appears as Appendix D to this decision. Pacific shall make all IEMR changes reflected in that Appendix and reflected more fully in the audit report. Pacific shall include in its compliance Advice Letter filing, due within 60 days of the effective date of this decision, schedules that identify each of the undisputed audit adjustments and demonstrate that Pacific has properly reflected the ordered adjustments in its financial reporting.
IV. Disputed Audit Adjustments
We discuss the disputed audit adjustments in the same order as Overland discussed them in the audit report, as follows:
· Issues affecting Pacific's Revenues and Other Operating Income
· Issues affecting Operating Expense
· Employee Benefits
· Depreciation Accounting
· Income Taxes
· Net Plant
· Other Rate Base Items
· Affiliate Transactions
· Regulated and Nonregulated Allocation
While the parties did not all agree that this was the appropriate order in which to discuss the issues, or even that any particular issue "belonged" under a particular category, they all agreed on a joint outline arranged in this order. Thus, for ease of understanding, we use the outline as well.
After discussing the foregoing specific audit adjustments, we discuss the following four issues:
· NRF Monitoring (items for consideration in Phase 3 of the proceeding)
· Whether Pacific Impeded the Audit
· Phase 2 Remedies
· Recovery of Audit Costs
A. Revenue and Other Operating Income
a. Withholding of "Privileged" Information
Overland found that Pacific understated revenue and overstated expenses "as a result of unsupported and unauditable contingent liability accruals . . . ."41 According to Overland, it was unable to substantiate Pacific's accruals for contingent litigation and regulatory liabilities. Such accruals, in which Pacific estimates future anticipated expenses related to lawsuits and regulatory proceedings, increase Pacific's reported expenses and therefore decrease earnings. Because the accruals were not properly documented, Overland states, earnings subject to sharing should have been higher in 1997 and 1998, as well as in 1999 had there been sharing in that year.42
Pacific states that it was not required to furnish information documenting its decisions on how and why to post accruals for these liabilities, on the grounds such information was covered by the attorney-client privilege. While Pacific gave Overland documents from the underlying proceedings (complaints, answers and other major pleadings), it refused to disclose its reasoning behind the accruals, claiming disclosure would waive the privilege. Overland therefore disallowed all such accruals as unauditable, replacing the accrued amounts with actual payouts where available and with nothing where no such payouts had occurred.
We recognize that the California Supreme Court has limited our access to attorney-client privileged information in furtherance of our regulatory duties.43 However, Overland explains and the parties make several arguments claiming that in this case Pacific should have furnished Overland the allegedly privileged information. TURN and ORA argue alternatively that the relevant information is not actually privileged, that Pacific waived the privilege, and that even if the information was privileged, release of it to Overland would not waive the privilege as to the claimants in the relevant legal and regulatory proceedings. We address each of these arguments below.
i. Was the Information "Privileged?"
TURN claims that the information was not privileged at all. Pacific withheld information explaining how Pacific allocated the contingent liabilities among above-the-line and below-the-line accounts and between the intra- (state) and interstate (federal) jurisdictions. These regulatory decisions could not have involved communications between lawyer and client, TURN claims, because they deal with NRF accounting treatment and jurisdictional separations, rather than with legal analysis of the viability of a particular litigation or regulatory claim. Since decisions about such allocations are not "confidential communication[s] between client and lawyer,"44 TURN claims, Pacific should have turned over the materials related to these allocations.45
Pacific claims the information is privileged, and that any requirement that it release the information to Overland would waive the privilege. Pacific does not separately address TURN's argument that the information is not privileged because it relates to regulatory accounting rather than legal analysis of the merits of claims against Pacific.
We agree with TURN that this allocation information was not privileged and that Pacific should have turned it over to Overland. Pacific did not allege that lawyers were involved in deciding whether to account for a particular matter above- or below-the-line, or in the state or federal jurisdiction. The audit report makes clear that Pacific failed to produce this allocation information along with the legal analyses.46
ii. Did Pacific Waive the Privilege?
TURN and ORA argue that Pacific waived the attorney-client privilege. They claim that Pacific put the reasonableness of its lawyers' advice at issue in this proceeding, thereby waiving the privilege and requiring production of the relevant advice for the sake of fairness: "The person or entity seeking to discover privileged information can show waiver by demonstrating that the client has put the otherwise privileged communication directly at issue and that disclosure is essential for a fair adjudication of the action."47 As ORA put the matter, "the information regarding liability estimates that Pacific has refused to provide is not protected by the attorney-client privilege because the privilege can not be used both as a sword and a shield."48
Where, as here, a party claims its regulatory position is reasonable based on the advice of counsel, but seeks to preclude discovery about that advice, waiver may be implied.49 Here, there is no dispute that Pacific claims its contingent liability accruals are reasonable based on the competence of the management team - including the lawyers - making the decisions about such accruals. As Pacific's Mr. Wells testified, "The support for such an assessment [of Pacific's accruals for contingent liabilities] is management's professional judgment, nothing more, nothing less."50 When asked to explain who "management" was in this instance, Mr. Wells explained that, "The primary people making those judgments at Pacific would be the controller and one or two other members of the senior finance staff in conjunction with our legal counsel . . . ."51 It is not reasonable for Pacific to claim the Commission should accept "management's professional judgment, nothing more, nothing less," without allowing examination of the basis for that judgment. Thus, we agree with TURN and ORA that a limited waiver of the attorney-client privilege occurred here.
iii. Did the Limited Waiver Waive the Privilege as to Claimants?
Pacific claims it would have waived the attorney-client privilege for all purposes had it given its own analyses to Overland. That is, it claims that the parties suing it or pressing regulatory claims against it would be able to obtain the same contingent liability analyses in discovery if Pacific gave them to Overland.
Pacific cites no authority for the proposition that disclosure to auditors for the express purpose of auditing accruals waives the privilege as to all claimants. Indeed, as TURN and ORA point out, waiver under these circumstances need not be presumed. While the general rule is that disclosure of protected information to any third party constitutes waiver, some courts have created a "selective waiver" exception under which corporate disclosure of privileged materials to a government agency waives the privilege only as to that agency.52
Thus, we find that Pacific should have turned information about its contingent liability accruals over to Overland. Some information - relating to allocation of dollars above- and below-the-line and across jurisdictions - was not privileged at all. Pacific waived the privilege as to the remaining information by asking the Commission simply to accept the judgment of its management, "nothing more, nothing less," in making contingent liability accruals. Finally, it is far from clear that disclosure of the information to independent auditors, particularly those auditing on behalf of the Commission, waives the privilege as to claimants. Indeed, as we show next, disclosure to auditors is a standard practice.
b. Standard Practice in Accounting Industry
The evidence at hearing established that auditors normally receive such privileged information as a matter of course. This is standard practice in the accounting industry. During the hearing, a representative of Pacific's own auditor witness, Deloitte & Touche (Deloitte), made clear that Deloitte generally has access to the client's privileged information when evaluating contingent liability accruals:
Q. If Deloitte & Touche is auditing a client's books and is presented with contingent liability, is it Deloitte & Touche's practice to ask for the underlying documentation supporting the accrual of those contingent liabilities?
A. If . . . that's necessary to support the accrual, they would ask from the company's attorneys to be able to look at that type of information.
Q. And would, under certain circumstances, . . . your firm obtain such information under a confidentiality agreement if there is an issue about attorney-client privilege?
A. Well, we are independent accountants, and . . . we . . . have that confidentiality agreement with . . . the client.
Q. And so in reviewing these accruals, you, in at least certain cases, obtain attorney-client privileged information in order to verify the appropriateness of the accruals.
A. Yes.53
Here, by contrast, Pacific concedes it did not give Overland access to such information. Rather, it claims that it was adequate to give Overland publicly available case information (e.g., complaints, answers and other pleadings) and for Overland to do its own independent legal analysis of whether Pacific properly set its accrual amounts.54 Pacific claims it made its Controller, Dennis Wells, available for an interview, but Overland states that during that interview, Mr. Wells indicated he had been instructed not to answer questions concerning the substance of the accruals.55 Pacific's conduct made it impossible for Overland to carry out the audit in accordance with GAAS.
c. Protecting the Confidential Information
There are adequate means of protecting the confidentiality of the information at this Commission. We routinely hold confidential documents under seal, even if they are admitted at hearing. Pub. Util. Code § 583 makes it a misdemeanor for Commission staff to release information held under seal to third parties. Thus, this is not a case such as Westinghouse Elec. Corp. v. Republic of the Philippines, 951 F.2d 1414 (3d Cir. 1991), which Pacific relies on for the proposition that disclosure of privileged information to a government agency waives the privilege. In that case, the information would have been part of the public record, whereas here, it clearly would have been held under seal.
d. Remedy - Contingent Liabilities
Without the privileged information, Overland was unable to verify the correctness of the contingent liability accruals. Indeed, Overland contends it would have violated GAAS for it simply to accept Pacific's claimed accruals without adequate documentation. Nor is there other information in the record justifying those accruals. Indeed, as Mr. Harpster testified, the accruals appeared to be unjustified in the few cases in which he had details.56
Thus, we agree with Overland that Pacific's contingent liability accruals were improper for purposes of this proceeding and should be reduced in accordance with the audit recommendation. The unauditable accruals improperly increased intrastate regulated operating expenses by almost $103 million on an intrastate pre-tax basis during the audit period, with the majority of the accruals occurring in 1997, when sharing was in place.57
We note that Pacific did not recognize contingent liabilities for FCC accounting purposes during the audit period because carriers must petition the FCC for permission to record such liabilities and Pacific did not do so.58 Thus, our refusal to recognize such liabilities does not place Pacific on a different footing with this Commission from the one it was on with the FCC during the audit period.
In its Supplemental Report, Overland also identified revenue overstatements of $14.7 million and $23.1 million for two liability accruals (the percentage of interstate use, or PIU accrual, and the Uniform System of Accounts Rewrite, or USOAR) in 1997 on an intrastate pre-tax basis.59 Overland also states that "[i]ntrastate regulated operating revenues are understated by $40.5 million in 1997 as a result of unsupported and unauditable accruals for regulatory contingent liabilities.").60 We also adopt these adjustments for the reasons stated above.
Because FCC rules did not allow contingent liability accruals (absent petition and pre-approval) during the audit period, Pacific's FCC books contain only claims actually paid. Thus, as ORA points out, the audit adjustment disallowances still allow substantial costs to remain in Pacific's IEMR reports, on the same cash basis the FCC allows.
As shown in Appendix A, we adopt the intrastate regulatory after-tax adjustments of $52.8 million in 1997, $1.1 million in 1998, and $7.0 million in 1999 for Contingent Liabilities-Operating Expense. We also adopt the audit adjustments of $8.7 million for PIU Accrual, $13.7 million for USOAR Rewrite, and $24.0 million for Contingent Liabilities - Revenues for 1997 on an intrastate regulatory after-tax basis as shown in Appendix A.
In 1996, Pacific implemented a new automated bill collection system called the Revenue Collection Risk Management System (RCRMS). Overland states that as a result of problems that Pacific agrees occurred with RCRMS, Pacific's uncollectible revenues and settlements with contract billing customers61 were overstated during the audit period. Pacific incurred additional uncollectibles in 1996 principally because RCRMS had an error that prevented nonpaying customers from having their telephone service disconnected. Thus, Pacific incurred significant bad debt and related write-offs because nonpaying customers continued to have service.
Had the accounting for uncollectible revenues and expenses related to RCRMS been correctly posted in 1996, when Pacific recognized and corrected the problem, rather than in subsequent years, Pacific would have had higher potentially shareable earnings in 1997, 1998 and 1999. Overland states that intrastate uncollectible revenues were overstated by $53.5 million in 1997.62
In addition, because Pacific Bell failed to accrue additional uncollectibles for AT&T, MCI, Sprint and other contract billing customers in the year it recognized the RCRMS problems, intrastate uncollectible settlement expenses were overstated by $42.1 million in 1997, 1998 and 1999.63 In total, according to Overland, audit period net operating income was overstated by $78.5 million as a result of Pacific's failure to properly account for uncollectibles caused by problems with RCRMS.64
The dispute is over when Pacific should have accrued the additional uncollectible revenue and settlement expenses - in 1996, when the RCMRS problem was discovered and corrected, or in subsequent years. ORA contends Pacific was well aware of the problems in 1996 and should have accrued the expense in that year. Pacific agrees that it was aware of problems with RCRMS in 1996,65 but contends it did not realize the magnitude of the problem from an expense perspective until 1997, and therefore appropriately booked the expenses in 1997.
While Pacific's bad debt write-offs rose significantly in November and December 1996 - a fact ORA's witness Michael Brosch found to be evidence that Pacific should have accrued an amount for estimated bad debts that year - Pacific claims there were also significant decreases in the July-September 1996 period. The numbers effectively offset each other, masking the problem, Pacific contends.
We find Pacific's claim unpersuasive. It assumes that Pacific only paid attention to its uncollectibles figure annually rather than focusing on month-by-month performance. We cannot believe that Pacific took such a casual approach to its uncollectibles, which are bad debts that it will never recover. Were it to only examine these figures annually, we would have real concerns about the extent to which Pacific is monitoring its bad debts.
Moreover, evidence in the record contradicts Pacific's claim and shows that other than in the period in 1996 at issue, Pacific's bad debt did not fluctuate drastically as it did during that period. The fluctuation put Pacific on notice of a serious problem in 1996, and Pacific should have taken action to accrue an amount for estimated bad debts in that year.
Pacific's collections history shows a fairly even ebb and flow of net bad debt from January 1995 through August 1996, when the percentage of accounts showing net bad debt ranged from a high of approximately three percent to a low of approximately one percent. The trend never lasted more than two months in any one direction - up or down - during that period.66
In contrast, the rate of bad debt increased steadily from August 1996 to the end of the year. The graphic depiction of this debt showed a line headed steadily upward from a low of one percent in August 1996 to a high of five percent in December 1996. Never again through December 1997 was the volatility nearly as great. Moreover, Pacific's own internal document dated July 23, 1996 showed Pacific was well aware of a number of financial problems stemming from the RCRMS system as of that date.67
The evidence was plain that Pacific had a significant problem in 1996, and it should have recorded the expense that year. Had it done so, rather than carrying the 1996 expense forward to 1997, it would have reported lower expense, and higher potentially shareable earnings, in 1997. We therefore agree with the audit that Pacific should have recorded RCRMS-related expenses in 1996 rather than 1997. Pacific should make the recommended audit adjustment and restate its 1996 books as well. The adopted intrastate regulatory after-tax amounts are $16.6 million in 1997, $7.8 million in 1998 and $512,000 in 1999. We also adopt the audit adjustment of $53.5 million in 1997 for uncollectible revenues on an intrastate regulatory after-tax basis.
3. Other Revenue/Operating Income Issues - Directory Publishing
The remaining issue with revenue impact relates to how Pacific Bell Directory accounted for its revenues (and expenses) during the audit period. Prior to the fourth quarter of 1996, Pacific accounted for revenues and expenses over the life of the directory. In 1996, it changed its policy to "conform to the policies of SBC,"68 and began recognizing revenue and expense when the directory is issued. Overland stated it could not determine whether the change had an impact on 1997 revenues and expenses, and we do not find that there is any need to pursue the item further. Pacific correctly recognized a one-time pre-tax gain of $143 million in 1996, but we do not find that the audit establishes there were effects in 1997 for which Pacific did not properly account.
1. Local Number Portability Costs
a. Introduction
Overland found that Pacific did not properly account for its local number portability (LNP) costs, citing two separate reasons. First, it claimed Pacific should have deferred these costs - required by the Telecommunications Act of 1996 (1996 Act) and the FCC - as a regulatory asset, rather than charging such costs to expense.69 Deferral would have reduced operating expenses - and increased earnings potentially shareable with ratepayers - by $171 million on an intrastate pre-tax basis during the audit period.70
Overland also stated that LNP expenses were not even relevant to Pacific's California expense reporting. Overland noted that "[t]he FCC has affirmatively and directly asserted jurisdiction over the LNP costs recovered through the FCC tariff," and concluded that "the costs . . . should be assigned directly to the interstate jurisdiction."71 Overland cited a May 1998 FCC order in support of its conclusion.72 Using a jurisdictional separations approach, Overland found that Pacific never should have reported LNP costs as intrastate expenses on its IEMR.
Pacific contends the issue only involves state-federal jurisdictional separations: "the dispute regarding the assignment of LNP costs boils down to a dispute regarding the timing of the [jurisdictional] separation of the costs [between the federal, or interstate, and California, or intrastate, jurisdictions]."73 Once the FCC decided that LNP costs should be characterized as 100% interstate, Pacific contends, the costs should have moved off the IEMR books and onto the federal books. Pacific agrees that the FCC's May 1998 order should have triggered this change.74
We find that both arguments have merit, and adopt a hybrid approach. Consistent with Statement of Financial Accounting Standards (FAS) No. 71,75 which relates to deferral of costs as a regulatory asset, we find that Pacific should have deferred the LNP costs as a regulatory asset as of April 1996. In that month, the Commission issued D.96-04-052, promising Pacific a true-up for recovery of past costs related to interim number portability (INP). We find that this decision gave Pacific adequate certainty of future cost recovery to trigger an obligation to defer LNP expenses as a regulatory asset at that time.
Moreover, Pacific never should have reported any LNP expenses in the intrastate portion of its IEMR, because as of May 1998, the FCC provided that carriers could recover such costs entirely from interstate (non-California) rates. Any later expense recovery should have happened exclusively at the federal level, and never should have affected Pacific's California expenses.
b. Criteria for Deferral as a Regulatory Asset - FAS 71
Costs that are deferred as a regulatory asset do not appear on the IEMR as an expense. Because lower expenses increase earnings - and, potentially, sharing - while regulatory assets have no impact on earnings, the difference between an expense and a regulatory asset is significant in terms of Pacific's IEMR.
Pacific contends that Overland and TURN are incorrect that the criteria for deferring the costs as a regulatory asset were met at any time before a July 16, 1999 FCC order76 concluding its investigation of the long-term number portability tariff transmittals.
Pacific also claims that to defer LNP costs would have violated FAS 71's two-part requirements for deferring costs as a regulatory asset. Paragraph 9 of the FAS 71 requirements provides that a regulated enterprise shall capitalize (defer as a regulatory asset) all or part of an incurred cost that would otherwise be charged to expense if both of the following criteria are met:
a. It is probable that future revenue in an amount at least equal to the capitalized cost will result from inclusion of that cost in allowable costs for rate-making purposes.
b. Based on available evidence, the future revenue will be provided to permit recovery of the previously incurred cost rather than to provide for expected levels of similar future costs.
Pacific appears to contend that FAS 71 requires not only that the costs being deferred be "probable" of recovery, but also that the precise amount of recovery be known at the time of deferral. TURN contends that FAS 71 does not require that a utility know the amount of probable recovery when it makes the decision to defer a regulatory asset.
After FAS 71's issuance, FAS 90 refined the definition of "probable" by making it consistent with FAS 5. FAS 5 defines something as "probable" if it meets the first of two conditions:
a. Information available prior to issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements. [footnote omitted]. It is implicit in this condition that it must be probable that one or more future events will occur confirming the fact of the loss.
b. The amount of loss can be reasonably estimated.
TURN contends that since the term "probable" only appears in paragraph (a) of FAS 5, only paragraph (a) should be read into FAS 71. Since paragraph (a) of FAS 5 only requires that it be probable that an asset has been impaired or a liability incurred, it follows that FAS 71 only requires that it be probable that all or part of the cost recovery will be allowed. FAS 71 does not require that it be probable that the full amount of costs incurred will be recoverable. Rather, TURN contends, "if any amount is probable of recovery, [FAS] 71 mandates creation of a regulatory asset."77
Pacific, on the other hand, contends that FAS 71 also requires that management be able reasonably to estimate the amount of loss. If it was never probable from the FCC decisions or other regulatory action that Pacific would recover all of its costs, Pacific claims, it was never appropriate to defer a regulatory asset of any amount. Indeed, Pacific claimed it could only make such deferral once it had a "rate order" specifying precisely the amount it would recover.
TURN contends that a rate order is not the only assurance of recovery, and that Pacific's own cited reference provides four types of evidence - and not just a rate order - that could support future recovery and thus establishment of a regulatory asset.78 It also asserts that Pacific's approach would effectively write the "all or part" language out of FAS 71, which provides that, "a regulated enterprise shall capitalize all or part of an incurred cost . . . ." Thus, even if only "part" of the cost was probable of recovery, that "part" should be capitalized.
We agree with TURN's analysis. It was not necessary under FAS 71 that every single dollar of cost, and every single cost category, be probable of recovery. Rather, the more sensible interpretation of FAS 71, and the related pronouncements in FAS 90 and FAS 5, is that once it became probable that Pacific would be able to recover a category of LNP costs, it should have deferred those costs as a regulatory asset. Pacific's approach - that it should assume it would recover zero costs and record no asset as long as it was not guaranteed recovery of 100% of the costs - is unreasonable.
As for timing, we agree with TURN that "as of early 1996, the Commission made it clear that at least some portion of costs incurred to implement local number portability was probable of recovery as an allowable cost for ratemaking purposes."79 In April 1996, our D.96-04-05280 ordered Pacific to file tariffs for the wholesale provision of "interim number portability" (INP), set wholesale rates for INP and promised a true-up of past billings - including a surcharge benefiting Pacific - if, once rates were set, revenues did not match the associated costs. We directed Pacific to establish a memorandum account to facilitate the future true-up. While we changed the method for calculating such costs over time,81 our 1996 decision set up a framework making clear that Pacific would recover its costs of number portability.
We find that all the prerequisites for Pacific to defer the LNP costs as a regulatory asset were in place no later than April 1996.
c. Jurisdictional Separations
Because we adopt a hybrid approach, the foregoing conclusion does not conclude the inquiry. We also find that as of May 1998, when the FCC issued its Third Report and Order, Pacific should have recovered all of the expense related to LNP exclusively in the federal jurisdiction.
As noted previously, Pacific agrees that the May 1998 FCC order triggered an allocation of 100% of the costs to the interstate jurisdiction: "By May 1998, it was determinable that the FCC intended LNP costs to be fully allocated to the interstate jurisdiction. . . ."82 Thus, Pacific should not have reported any intrastate LNP costs on its IEMR after issuance of the May 1998 FCC order.
d. Conclusion - LNP Costs
In summary, Pacific should have: 1) deferred LNP costs as a regulatory asset as of April 1996, when this Commission issued D.96-04-052, and 2) charged all LNP expense to the federal jurisdiction as of the FCC's May 1998 order on LNP cost recovery. Pacific should modify its IEMR to remove all LNP costs, including plant and depreciation, from its 1997, 1998 and 1999 reported intrastate results of operations. The intrastate regulatory after-tax adjustment for the LNP costs is $51.3 million in 1997, $27.9 million in 1998, and $22.3 million in 1999 as shown in Appendix A. The plant adjustment is $14.5 million in 1997, $32.8 million in 1998 and $43.5 million in 1999. The adjustment for LNP Dep