Memorandum #868

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Memorandum #868

     Memorandum #868

    June 16, 1998


TO: Officials of Municipalities with Electric Systems

     and Certified Public Accountants

FROM: T. Vance Holloman, Director

     Fiscal Management Section

SUBJECT: Statistical Information on Electric System Operations

    This publication has been prepared to enable local officials to compare their locality's electric system operations with the operations of other similar electric systems. Local officials are encouraged to compare their own performances to similar units and to statewide averages. Such comparisons may identify opportunities for improvement or may indicate improved performances from previous fiscal years. Key items are provided to indicate the comprehensive financial condition of each electric system. To facilitate the analysis of these key items, this report is segregated into the following four tables:

    Table A - “Financial Results and Key Ratios of Municipal Electric

    Systems”. This table summarizes the financial results of each

    municipal electric system for the last four fiscal years and

    includes key financial ratios.

    Table B - “Analysis of Transfers to the General Fund by Municipal

    Electric Systems and Effects on Property Taxes”. This table

    includes statistics for the last four fiscal years on the extent to

    which Electric Fund transfers have been used to subsidize the

    General Fund and the effects of transfers and the unit’s

    ownership of the electric system on the tax rate.

    Table C - “Ten Years of Comparative Data on Electric Fund Transfers as

    a Percentage of General Fund Revenues”. This table presents

    ten years of comparative data to highlight the extent to which

    Electric Fund transfers have been used to subsidize the

    General Fund.

    Table D - “Analysis of Capital Outlay Expenditures of Municipal Electric

    Systems”. This table includes an analysis of capital outlay

    expenditures of each municipal electric system for the last five

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    fiscal years, which should assist units in determining if they

    are adequately funding the maintenance and/or expansion of

    their electric systems.

    In each table, municipalities have been segregated into one of three groups: N.C. Eastern Municipal Power Agency, N.C. Municipal Power Agency No. 1, and all other units with electric systems. To facilitate the analysis of this information and to give an indication of how the statistics in this report are distributed, a statistical analysis is included, which shows the minimum, maximum, mean, median, and standard deviation of key items. For the statistical information in this report to be meaningful, financial reporting between local governments must be consistent. We are concerned that some local governments may not be using appropriate financial reporting practices in two areas: accrual of unbilled electric services, and accounting for reimbursements and quasi-external transactions.

Accrual of Unbilled Electric Services

    Since the Electric Fund operates in a manner similar to a commercial business, it should generally follow financial reporting standards similar to commercial organizations. These standards require that the full accrual basis of accounting be used and that revenues be recorded when they are measurable and earned. In the Electric Fund, revenues and receivables should be accrued at the end of each month for electric services provided to customers even if the customers have not yet been billed. If a municipality has provided services to its customers, it has “earned” the revenues for these services and should record a revenue and receivable. The failure to record such unbilled receivables results in a misstatement of the Electric Fund financial statements because expenses that have been incurred are recognized while the related revenues and receivables are not recognized.

Accounting for Reimbursements and Quasi-External Transactions

    If the General Fund provides administrative services for the Electric Fund, payments for these shared services should be allocated correctly between the two funds. These payments should not be accounted for as operating transfers. The appropriate accounting treatment involves recording expenditures or expenses in the reimbursing fund (e.g., Electric Fund) and reductions of expenditures or expenses in the fund that is reimbursed (e.g., General Fund). The failure to properly record reimbursements understates the costs of operations in the Electric Fund. In addition, it overstates expenditures in the General Fund, which causes fund balances available for appropriation as a percentage of expenditures to be understated. Furthermore, transactions that would be treated as revenues, expenditures, or expenses if they involved organizations external to the municipality, such as payments in lieu of taxes from the Electric Fund to the General Fund or sales of electricity to other funds of the municipality should be accounted for as revenues, expenditures, or expenses in the funds involved. For example, the municipal use of electricity for street lighting should be recorded as operating revenues in the Electric Fund and as expenditures in the General Fund. In addition, a similar entry should be made for the use of electricity by a Water and Sewer Fund. For further information on this subject, see Memorandum #814, “Issues of Concern for the Fiscal Year 1995-96 and Future Years”.

How to Interpret Figures in this Report

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    In analyzing the statistics in this memorandum, the amounts for a particular unit should be compared to similar units, to statewide averages, and to national performance indicators published by organizations such as the credit rating agencies. In addition, the mean and standard deviation statistics should be analyzed to determine if the amounts for a unit are significantly above or below the amounts reported by other units. The amounts reported for a unit may be significantly out of line if they are more than one standard deviation above or below the mean. If an amount is determined to be significantly out of line, the reasons for the variance should be investigated. However a significant deviation from the mean is not necessarily an indication of a financial weakness, but instead may be an indication of a significant event having taken place, such as an expansion of the electric system or the occurrence of abnormal weather. It should be noted that even though there may be variations from one unit to another in some of the accounting policies used to arrive at the figures presented in this report, the effects of such variations should not materially affect the overall comparability of these statistics. In analyzing the attached tables, the following items should be considered:

    Table A - Financial Results and Key Ratios of Municipal Electric Systems (Note: See “Key to Financial Statistics and Ratios” at the end of this table.)

Financial Results

a. Electric power purchases and Other operating expenses. Units should be

    working to control expenses in the Electric Fund, particularly within the category “Other Operating Expenses”, which is the major expense area within a unit’s control. Although the largest operating expense item is "Electric Power Purchases", this amount is not entirely within a unit's control since the wholesale rates are set by the power agency. If the percentage of electric power purchases is significantly above other units, it may be that cost increases imposed by the power agency have not been passed on to customers but instead have been absorbed by the Electric Fund, or possibly that an effective load management system has not been implemented. Because of the changes in the utility industry, units may be forced to absorb future cost increases to remain competitive with investor-owned utilities.

    b. Operating margin. This ratio is an indicator of the profitability of the electric operating activities. If a unit’s operating margin is significantly below the amounts for

    other similar units, it may be an indication that user fees are too low or that operating expenses are too high. According to the report, "Selected Indicators of Municipal Performance" published by Moody's Investors Service, the median operating margin for electric distribution systems that was derived from its national databases was 11.1 in 1995.

c. Operating transfers out (in). This ratio shows the net operating transfers made

    to (from) all other funds of the municipality. A positive ratio gives an indication of the extent to which the Electric Fund is being used to subsidize other funds. A negative ratio gives an indication of the extent to which the Electric Fund is being subsidized by other funds. As a goal, units should only make transfers to other funds if they have met their working capital needs and if they have sufficient reserves for rate stabilization purposes and capital outlays.

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    d. Net income. This ratio is an indicator of the overall profitability of the electric system after payments are made for interest on long-term debt and miscellaneous expenses.

Key Ratios

    e. Quick ratio. This ratio gives an indication of the Electric Fund’s ability to pay its current bills, thereby providing a measure of short-term liquidity. Because the quick ratio is snapshot of a utility’s liquidity at a point in time, it may vary considerably throughout the year. A widely accepted minimum benchmark for the ratio of quick assets to current liabilities is 2 to 1; in other words, an electric system should have at least $2 in quick assets for each $1 of current liabilities. A quick ratio that is significantly below this level may be explained in part by excessive transfers being made from the Electric Fund.

    f. Coverage ratio. This ratio is a measure of the degree of protection creditors have from a default on debt obligations. As the ratio approaches 1 to 1, there is a greater risk that the Electric Fund will not be able to make its debt service payments and electric power purchases from its current year’s cash flows.

    g. Days sales in receivables. This ratio gives an indication of how quickly payments are being collected. Each unit should have procedures in place to ensure that electric customers are making payments within the prescribed due date. If this ratio is much greater than the maximum number of days allowed before payment is due, the unit may be inefficient in collecting payments from its customers. The inability to convert receivables into cash on a timely basis negatively affects cash flows, and therefore, investment earnings. Situations where the “Days Sales in Receivables” ratio is significantly lower than the maximum number of days allowed may indicate that units have not accrued unbilled receivables at the end of the fiscal year. (See section on unbilled receivables in Memorandum #814.)

    h. Days cash on hand. This ratio provides an indication of the adequacy of an electric system’s unrestricted cash and investment balances. The Electric Fund needs

    to maintain adequate cash and investment balances to enable it to finance its operations, respond to changing market conditions, survive a prolonged economic downturn, or to take advantage of strategic opportunities. A unit whose “Days Cash on Hand” ratio is significantly below the averages presented in this report may find that its cash reserves are inadequate. A below average ratio may be an indication that large transfers have been made to other funds. Also, it may indicate that a rate stabilization fund is not being maintained and/or that sufficient reserves for future capital outlays are not being set aside.

    Table B- Analysis of Transfers to the General Fund by Municipal Electric Systems and Effects on Property Taxes (Note: See “Key to Definitions and

    Formulas” at the end of this table.)

    i. This table shows the actual transfers from the Electric Fund to the General Fund for the last four years in dollars, as a percentage of Electric Fund fixed assets, and as a tax rate equivalent. Because of recent developments in the electric power industry, municipal electric systems may be forced to compete directly with investor-owned utilities in the sale of electric power. To remain competitive, units will need to keep retail rates, especially the rates charged to its critical industrial and commercial customers, as low as possible and to find ways of offsetting the higher wholesale costs of

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    electric power. As a result, units will need to significantly reduce their Electric Fund transfers. The staff of the Local Government Commission recommends that each power agency participant adopt a transfer policy and that transfers not exceed 3 percent of gross fixed assets. (See Memo #814 for LGC guidelines on developing a transfer policy.) In situations where a unit’s transfers are significantly greater than 3 percent of gross fixed assets, the unit may face the need for significant increases in property taxes and/or large budget cuts in future years.

    j. Units with electric systems that are making substantial transfers to the General Fund should determine if their costs of providing general governmental services are in line with the costs incurred by non-electric municipalities of a similar size. To assist in making this determination, Table B includes a computation of what the unit’s tax rate

    would have to be in order for the General Fund to operate without Electric Fund transfers. Also, this table presents the corresponding average tax rate for non-electric municipalities of a similar size. The tax rates presented in the last three columns of this table have been adjusted by multiplying the tax rate by the assessment-to-sales ratio of the county in which a unit is located. (Note: An assessment-to-sales ratio is

    calculated annually for each county by the N.C. Department of Revenue. This ratio is based on a sample of selected real estate transactions within a county and equals the assessed valuation divided by the actual sales price. At the beginning of a revaluation cycle, market values and assessed values for a unit are approximately the same. However, by the end of a revaluation cycle, assessed values are usually much lower than market values. This adjustment makes tax rates between units more comparable, given that units are at different points in their revaluation cycles.) If a unit’s tax rate without