MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS P N M R E S O U R C E S • 2 0 0 3 A n n u a l R e p o r t t o S h a r e h o l d e r s 31 Critical Accounting Policies and Estimates Revenue Recognition Regulatory Assets and Liabilities Asset Impairment Pension Plan Self-Insurance Contingent Liabilities 30 The preparation of financial statements in accordance with Generally Accepted Accounting Principles (“GAAP”) requires management to select and apply accounting policies that best provide the framework to report the Company’s results of operations and financial position. The selection and application of those policies require management to make difficult subjective or complex judgments concerning reported amounts of revenue and expenses during the reporting period and the reported amounts of assets and liabilities at the date of the financial statements. The judgments and uncertainties inherent in this process affect the application of those policies. As a result, there exists the likelihood that materially different amounts would be reported under different conditions or using different assumptions. Management has identified the following accounting policies that it deems critical to the portrayal of the Company’s financial condition and results and that involve significant subjectivity. Management believes that its selection and application of these policies best represent the operating results and financial position of the Company. The following discussion provides information on the processes utilized by management in making judgments and assumptions as they apply to its critical accounting policies. Operating revenues are recorded as services are rendered to customers. The Company’s Utility Operations records unbilled revenues representing the estimated amount customers will be billed for services rendered between the meter-reading dates in a particular month and the end of that month. The unbilled revenues estimate is reversed in the following month. To the extent the estimated amount differs from the amount subsequently billed, revenues will be affected. At December 31, 2003 and 2002, unbilled revenues in the consolidated balance sheet included estimates of $58.6 million and $58.5 million, respectively, from the Company’s Utility Operations. The Company is subject to the provisions of Statement of Financial Accounting Standards No. 71, “Accounting for the Effects of Certain Types of Regulation” (“SFAS No. 71”). Accordingly, the Company has recorded assets and liabilities on its balance sheet resulting from the effects of the ratemaking process, which would not be recorded under GAAP for non-regulated entities. Regulatory assets represent incurred costs that have been deferred because they are probable of future recovery in customer rates. Regulatory liabilities generally represent probable future reductions in revenue or refunds to customers. The Company’s continued ability to meet the criteria for application of SFAS No. 71 may be affected in the future by competitive forces and restructuring in the electric industry. In the event that SFAS No. 71 no longer applied to all, or a separable portion, of Company’s operations, the related regulatory assets and liabilities would be written off unless an appropriate regulatory recovery mechanism is provided. Substantially all of the Company’s regulatory assets and regulatory liabilities are reflected in rates charged to retail customers or have been addressed in a regulatory proceeding. To the extent that the Company concludes that the recovery of a regulatory asset is no longer probable due to regulatory treatment, the effects of competition or other factors, the amount would be recorded as a charge to earnings as recovery is no longer probable. The Company regularly assesses whether its regulatory assets are probable of future recovery by considering factors such as applicable regulatory environment changes, recent rate orders to other regulated entities in the same jurisdiction, anticipated future regulatory decisions and their impact, developments in the ratemaking process and the ability to recover costs.  As the Company’s electric rates are fixed, the opportunity to recover increased costs and the costs of new investment in facilities through rates during the five-year rate freeze period is also limited. As a result, the Company defers certain costs based on its expectation that it will recover these costs in future rate cases. If future recovery of these costs ceases to be probable, the Company would be required to record a charge in current period earnings for the portion of the costs that were not recoverable. The Company evaluates its tangible long-lived assets for impairment whenever indicators of impairment exist pursuant to Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of” (“SFAS 144”). These potential impairment triggers would include fluctuating market conditions as a result of industry deregulation; planned and scheduled customer purchase commitments; future market penetration; fluctuating market prices (resulting from changing fuel costs, other economic conditions, etc.); weather patterns, and other market trends. Accounting rules require that if the sum of the undiscounted expected future cash flows from a company’s asset (without interest charges that will be recognized as expenses when incurred), is less than the carrying value of the asset, an asset impairment must be recognized in the financial statements. The amount of impairment recognized is the difference between the fair value of the asset and the carrying value of the asset.  The Company determined that no triggering events occurred during the period in regards to its generation assets. At December 31, 2003, the Company analyzed three turbines, which are currently in storage, with a combined carrying value of approximately $79.1 million. These assets were intended for planned build-outs that have been delayed or canceled. Based on the Company’s various plans to make these turbines operational, the Company concluded that it will fully recover its investment. The Company expects to begin construction utilizing these assets over the next several years. If the Company were unable to realize these plans, the Company would be forced to recognize a loss with respect to the carrying value of these assets depending on prevailing market conditions. The Company will continue to analyze the turbines for impairment in accordance with SFAS 144. There are various claims and lawsuits pending against the Company and certain of its subsidiaries. The Company has recorded a liability when the effect of litigation can be estimated and where an outcome is considered probable. Management’s estimates are based on its knowledge of the relevant facts at the time of the issuance of the Company’s consolidated financial statements. Subsequent developments could materially alter management’s assessment of a matter’s probable outcome and the estimate of liability. Management reviews the amounts recorded for these liabilities on a quarterly basis to ensure that they are appropriate. While management believes that these estimates are reasonable based on the information available, the Company’s financial results could be impacted if actual trends, including the severity or frequency of claims or fluctuations in premiums, differ from the Company’s estimates. Beginning January 1, 2004, the Company began to self-insure certain health care costs of its employees. The Company self-insures for certain medical and dental benefits for active employees and retirees under the benefit programs. The Company maintains stop-loss insurance with third-party insurers in excess of the Company’s self-insured retentions to limit the Company’s exposure per participant, as applicable.  The Company self-insures for certain losses related to general liability, workers’ compensation and automobile claims. The Company maintains insurance with third-party insurers in excess of the Company’s self-insured retentions to limit the Company’s exposure per occurrence or accident, as applicable. The Company’s self-insurance liabilities reflect the estimated ultimate cost of claims incurred as of the balance sheet date. The estimated liabilities are not discounted and are established based upon claims filed, estimated claims incurred but not reported, and analyses of industry and historical data.  The value of the pension plan assets has increased from $326.5 million at December 31, 2002 to $425.7 million at December 31, 2003 including $48.9 million of contributions during 2003. The Company does not expect to make any contributions for the 2004 plan year. Lowering the pension plan’s expected long-term rate of return on pension assets by 0.5% (from 9% to 8.5%) would have raised pension expense for fiscal year 2003 by approximately $1.8 million. Lowering the discount rate by 0.5% would have increased pension expense for fiscal year 2003 by approximately $2.6 million. The discount rate that the Company utilizes for determining future pension obligations is based on a review of long-term high-grade bonds and management’s expectation. As a result of this review, the Company adjusted the rate to 6.5% at December 31, 2003 from 6.75% at September 30, 2002. Based on an expected rate of return on the pension plan assets of 9%, a discount rate of 6.5% and various other assumptions, it is estimated that the pension income for the pension plan will approximate $0.7 million in fiscal year 2004 and $1.4 million in fiscal year 2005. Future actual pension income or expense will depend on future investment performance, changes in future discount rates and various other factors related to the populations participating in the Company’s pension plans. The Company bases its determination of pension expense or income on a market-related valuation of assets, which reduces year-to-year volatility. If investment return is outside a range of 5% to 13% (expected long-term rate of return plus or minus 4%), this market-related valuation recognizes the portion of return that is outside the range over a five-year period from the year in which the return occurs. Since the market-related value of assets recognizes the portion of return that is outside the range over a five-year period, the future value of assets will be impacted as previously deferred returns are recorded.  The Company’s expense for its pension plan approximated $2.4 million for the year ended December 31, 2003, and is calculated based upon a number of actuarial assumptions, including an expected long-term rate of return on the pension plan assets of 9%. In developing the expected long-term rate of return assumption, the Company evaluated input from its actuaries and its investment consultant, including their review of asset class return expectations as well as long-term inflation assumptions. This long-term rate of return assumption compares to the historical 10-year compounded return of 9.86% through the end of December 2003. The expected long-term rate of return on the pension plan assets is based on an asset allocation assumption of 58% with equity managers, 22% with fixed income managers, and 20% with alternative investments that are primarily real estate, private equity, and absolute return strategies. The pension plan’s actual asset allocation as of December 31, 2003 was 65% with equity managers, 25% with fixed income managers, and 10% with alternative investments. The Company reviews the actual asset allocation and periodically rebalances the asset allocation to the targeted allocation. The Company continues to believe that 9% is a reasonable long-term rate of return on the pension plan’s assets, despite the recent market upturn in which the pension plan assets had a gain of 21.0% for the twelve months ended December 31, 2003. The Company will continue to evaluate its actuarial assumptions, including expected rate of return, at least annually, and will adjust as necessary. The Company and its subsidiaries maintain a qualified defined benefit pension plan (“pension plan”), which covers eligible non-union and union employees including officers. The pension plan was frozen at the end of 1997 with regard to new participants, salary levels and benefits. The Company’s policy is to fund actuarially-determined contributions.