970514v2.docx

Q.Please state your name and business address?
A.My name is Robert E. Smith.  My business address is 472 West Washington Street, Boise, Idaho.
Q.By whom are you employed and in what capacity?
A.I am employed by the Idaho Public Utilities Commission.  My title is Senior Auditor.
Q.Please describe your educational background and professional experience.
A.I received my BBA degree majoring in Accounting from Boise State University in 1972.  Following graduation I was employed in the construction industry as Accountant/Office Manager until April 1975 when I accepted employment at the Idaho Public Utilities Commission.  During the course of my employment at the Public Utilities Commission, I have attended numerous training schools, programs and seminars in the field of regulation.
Q.Have you previously appeared as a witness in regulatory proceedings?
A.Yes, many times.
Q.What is the purpose of your testimony in this case?
A.I will present the Commission Staff’s position regarding the Capitol Water Corporation’s (Company) application to implement a temporary surcharge to recover the incremental cost of improvements to the system.  I will be presenting the Staff’s recommended surcharge amount and proposed accounting procedures should the Commission determine that the projects proposed by the Company are appropriate.
Q.Are you sponsoring any exhibits?
A.Yes.  I am sponsoring three exhibits identified as Staff Exhibit Nos. 101, 102 and 103.
Q.Are the improvements identified by the Company reasonable?
A.The lowering of the mains at the intersection of Ustick and Cole roads is required by the Ada County Highway District and is an unavoidable expense as discussed by Staff witness Oliason in his testimony. Staff believes the water quality improvements proposed by the Company are a reasonable approach to solving the problems associated with wells producing water high in iron and manganese.  According to the Idaho Division of Environmental Quality, these mineral deposits are secondary contaminants that pose no health hazards but are an esthetic and nuisance problem.  Affected customers may experience some economic disadvantages if clothing is discolored when washed in the colored water or if it becomes necessary to go to a laundromat to wash the clothing to avoid the discoloration.  Staff witness Oliason has reviewed each of the proposed improvements and discusses them in more detail in his testimony.
Q.Are all of the Company’s customers affected by the presence of these secondary contaminants?
A.No.  Staff Witness Oliason discusses this subject in more detail in his testimony.
Q.If the Commission determines that the proposed system improvements are in the best interest of the Company’s customers and directs the Company to proceed, should all of the customers be required to support the projects or only those customers who are experiencing problems?
A.All of the Company’s customers should financially support the projects.  All of the customers contribute to the demand on the system that requires the poor quality wells to be operated.  These wells are normally not operated except during the summer irrigation season when customer demands for water are at their peak.  A customer near one of the affected wells may experience poor quality water as a direct result of customers at the far end of the system sprinkling their lawns with the better quality water from a well near that end of the system.
Q.Has the Staff reviewed the projects, expenses and the means of financing proposed by the Company?
A.Yes.
Q.Have you reviewed the Company’s proposal for recovery of its costs?
A.Yes.
Q.Do you agree with the temporary surcharge method of recovery proposed by the Company?
A.The method the Company is proposing is not an unreasonable approach given the unusual nature of the expenditures.  However, the Staff is somewhat concerned about the portion of the Company’s request that represents continuing operating expenses.  Under normal circumstances such costs would be included in the Company’s base rates.  When the surcharge expires, the operating costs will continue.
Q.What is the amount of the continuing operating expenses you referred to?
A.Exhibit No. 103 enumerates each of the costs the Company is asking to recover through the requested surcharge.  This data was taken directly from the Company’s Exhibit No. 3.  Page 2 of the Company’s Exhibit No. 3 indicates that the Company is asking to recover $13,600 annually through the surcharge to pay for heating fuel, sequestering chemicals and incremental water testing.  These costs are normal operating expenses that would be recognized as known changes to the Company’s operating expenses in a general rate case and included in the Company’s base rate design.
Q.Are you taking exception to these items in this case?
A.No.  Staff recognizes the unusual circumstances the Company is confronted with at this time.  The majority of the Company’s request is associated with capital expenditures for system improvements.  These operating costs are directly related to the improvements the Company has made or proposes to make.  It is also important to note that these annual operating expenses are simply educated estimates at this time.
Q.Do you agree with the Company’s proposed surcharge amounts of $4.06 per month for residential customers and 25% for commercial customers?
A.No.  I have completed an analysis of the cash flow requirements needed to balance the receipt of revenue with the demands for cash expenditures.  Staff’s analysis indicates that a temporary residential surcharge of $3.27 per month is adequate.  The 25% temporary increase to commercial customers does appear reasonable. Mr. Oliason discusses the development of these rates in more detail in his testimony.
Q.How did the Staff arrive at these surcharge levels?
A.My analysis is shown on Exhibit Nos. 101 through 103.  Exhibit No. 102 is an annual amortization schedule for the $402,624.71, seven-year loan the Company proposes to acquire from the Bank of America.  As shown on that exhibit, the Company will need to generate cash flow of $80,834.04 annually to service this loan.
Q.Will the Company need annual cash flow in excess of this $80,834.04?
A.Yes.  The Company estimates that incremental annual operating expenses of $13,600 will also be incurred to support the system improvements.
Q.The annual loan payments of $80,834.04 plus the incremental expenses of $13,600 equal $94,434.04.  Is that the total annual cash that the Company needs to collect from its customers?
A.No.  Income tax regulations complicate the calculation of the revenues required to produce sufficient cash to service the loan and pay operating expenses.
Q.How have you made the required adjustments to recognize the income tax complications?
A.First, on Exhibit No. 103, I have analyzed each of the investments or expenses and categorized them as shown in Columns (B), (E) and (F) as:  subject to tax depreciation/amortization; not subject to tax depreciation/amortization; or operating expense.  I have also calculated the amount of annual tax amortization/depreciation expense for the appropriate items as shown in Column (D) using the tax lives shown in Column (C).
Exhibit No. 101 completes the calculation.   In Columns (A) through (F) of this exhibit, the total annual cash requirement is calculated for twenty years.  Columns (G) through (J) distribute the annual cash required between customer classes and calculate the respective monthly surcharges for each year.  Mr. Oliason in his testimony uses this exhibit to levelize the surcharge amount for the duration of the surcharge period.
Q.How did you allocate the annual cash requirement between the residential and commercial customers?
A.I used the ratio of total revenues collected from the two classes in 1996.  The 1996 billed revenues are shown on Exhibit No. 101 in the note just above Columns (A) through (E) on the exhibit.  Approximately 86.1% of the cash requirement was allocated to residential customers in Column (G) and the remaining 13.9% was allocated to commercial customers in Column (I).
Q.The Company has requested that it be allowed to collect a surcharge for a period of seven years.  Why have you carried your calculation out for a period of twenty years?
A.As the following discussion will show, Federal and State income tax requirements will produce financial ramifications well beyond the seven-year life of the bank loan.  These tax ramifications will carry forward for a period of twenty years.
Q.How is the annual cash requirement shown in Column (F) developed?
A.The cash required is composed of the annual loan payment, Columns (A) and (B), plus the $13,600 of annual operating expenses, Column (E), plus the income tax expense, Column (D), associated with revenues collected from customers to recover the required cash flow.
Q.How is the income tax expense shown in Column (D) calculated?
A.The note in the top right corner of this exhibit is a calculation to develop the Company’s composite income tax rate and the gross-up factor used to insure that revenues collected will produce the required cash flow after income taxes are paid.  These factors are applied to the annual payment of loan principal, Column (A), less the annual tax depreciation and amortization, Column (C).  The annual interest, Column (B), and annual operating expenses, Column (E), do not have any tax consequences associated with them.
Q.You have not indicated that the Company would recover the depreciation and amortization expenses shown in Column (C) through the monthly surcharge.  Are you proposing that these expenses be borne by the Company?
A.No.  The Depreciation and Amortization expenses shown here are for tax purposes only.  These costs would be funded up front with the proceeds of the bank loan and are embedded in the loan amortization payments.  The Company is not proposing to include the assets in its rate base for normal ratemaking purposes.  It is necessary to treat these expenses in this manner in order to recognize the tax timing differences that complicate the surcharge calculation and to insure adequate cash flows.
Q.Why, in years eight through twenty on your exhibit, are the income taxes shown in Column (C) negative numbers?
A.As I indicated earlier, because of tax timing differences, depreciation and amortization expenses for tax purposes will continue well beyond the seven-year surcharge period proposed by the Company.  These tax deductible expenses will produce a tax savings that would not otherwise exist in the amount of $4,677.35 per year.
Q.Do the tax savings in those years help to offset the continuing cost of the operating expenses discussed earlier in the amount of $13,600 per year?
A.Yes.  As shown in Column (F) for years eight through twenty, the cash requirement to fund expenses is $8,922.65.  This amount is the net cost of the $13,600 annual operating expenses less the tax savings of $4,677.35.
Q.If all else remained equal would the Company need to increase rates in the eighth year?
A.Assuming the Company is earning exactly its required rate of return, it would need to increase rates by 2.15% in year eight coincident with the expiration of its surcharge.
Q.Does the Staff agree with the Company’s proposed changes to its tariff schedules?
A.No.  Staff witness Oliason discusses the tariffs in more detail in his testimony.
Q.Would customer bills be affected in any way other than the addition of a surcharge?
A.Yes.  The Company’s franchise from the City of Boise requires the imposition of a 3% Franchise tax on all water revenues.  The surcharge revenues would not be exempt from this tax.  Columns (K) and (L) on Exhibit No. 101 show the incremental taxes associated with the surcharges.
Q.Has the Company indicated how it proposes to account for the funds invested in physical improvements to the water system?
A.No.  The Company has indicated that it would not seek to include the investments in its future rate base for ratemaking purposes but has not indicated how it would record these investments in its financial records.
Q.Has the Company indicated how it would account for the incremental operating expenses or revenues collected from the surcharge?
A.No.
Q.Do you have any specific recommendations regarding accounting procedures?
A.Yes.  These investments, expenses, and revenues collected through the surcharge and the associated loan need to be separately identified in the Company’s records.
Q.How do you suggest that the Company isolate these activities?
A.I recommend that a separatebalancing account be created on the Company’s books with all transactions related to this application flowed through that account on a monthly basis as transactions occur. Initially, the Company should accrue a receivable from customers in the balancing account for expenditures associated with this application that have already been incurred.  Expenditures associated with the installation of physical plant should be recorded in the Contributions in Aid of Construction account to offset the accrued receivable.  The offset for accrued receivables associated with expense items should be recognized in the owners’ capital accounts.
Q.Are the Company’s accounting and billing systems sophisticated enough to accommodate this balancing account approach?
A.Yes, I believe they are.  I visited with the Company about this approach and am confident that the General Ledger accounting system will accommodate such an account.  The Company’s billing program will need to be modified slightly to identify the billing surcharge separately but I understand that this too can be accomplished.  I would suggest that the Company discuss this approach with its outside accounting firm (Presnell Gage) to establish the specific procedures the Company would follow.  The Commission Staff is willing to work with the Company and its accountants to develop satisfactory accounting procedures and file an audit memo outlining the procedures.
Q.Why do you believe it is necessary to create this balancing account procedure?
A.This approach is necessary in order to track the recovery of the Company’s costs from customers.  The Company has proposed that it be allowed to collect the surcharge to pay these costs and that it would neither suffer nor benefit from the proposed changes in the system.  The balancing account procedure provides the vehicle that will make it possible to track the cash flows to insure that the Company does not over collect its costs from the customers.  The surcharge should expire at the time all approved costs are recovered.  At the end of each year any excess revenue accumulated (if any) should be used to prepay the outstanding loan balance.
Q.You just indicated that the surcharge should terminate at the time all of the Company’s costs are recovered.  Do you believe there is a possibility the surcharge could terminate in less than seven years?
A.Yes.  Neither the Company nor the Staff has factored customer growth into the calculation of the surcharge amount.  Customer growth will occur but to what extent is unknown.  New customers will provide additional surcharge revenue that will help shorten the lifetime of the surcharge.
Q.Staff witness Oliason discusses some of the items that the Commission could possibly decide are not necessary at this time.  Have you calculated the effect elimination of these items would have on the amount of the surcharge?
A.No, I have not.  The Commission could accept or reject one or several of the proposed projects. Recalculating the amount of the surcharge can be accomplished easily once a decision on the proposed projects is made.
Q.Does that complete your testimony?
A.Yes.