Historically, offset rate increases enabled water utilities to recover as a pass-through cost increases for offsetable expenses that were not known or anticipated when customer rates were established  and were beyond the utility’s control. Offsetable expenses incurred prior to the CPUC’s adoption of  the staff’s interim recommendation were frozen as of November 29, 2001 in the balancing accounts.The Company was authorized to track offsetable expenses incurred after the CPUC changed its policy with regard  to regulatory memorandum accounts for potential recovery subject to the CPUC’s future determination of appropriate practices and policies. Because of the uncertainty of collection, the Company’s accounting policy  is to not record the expense-balancing and memorandum account amounts in its financial statements until such amounts are billed to customers. In September 2002, the assigned administrative law judge recommended that the CPUC  adopt as permanent the interim recommendation regarding recovery of expense-balancing and memorandum accounts as described above, but modify the limit on the amount subject to recovery. Under the interim rules, a utility is not allowed to recover any of the balancing or memorandum account balance if it is earning more than its authorized return on equity. However, the proposed modification by the administrative law judge would allow recovery of a portion of the balancing or memorandum account up to the amount by which the Company’s over earning of its authorized rate of return did not exceed the amount in the balancing account.While this recommendation was an improvement over the interim rules currently in place, the Company believes there should be no limit on allowed recovery of the balancing and memorandum accounts. The Company is continuing to present its arguments to the CPUC staff. In December 2002, the CPUC issued a decision that will allow the Company to recover  offsetable expenses tracked in the frozen balancing accounts.The decision provided that recovery of these expenses will not be subject to the interim rules adopted in October 2001.The CPUC is now expected  to adopt permanent rules regarding recovery of memorandum accounts during the first half of 2003.The Company is unable to predict what the final rules will comprise or their financial impact. At December 31, 2001, the amount included in the balancing and memorandum accounts was $6.5 million. At December 31, 2002, the amount had increased to $12.5 million after reflecting collection  of $1.9 million of balancing account power costs during 2002.The increase in balancing and memorandum accounts was attributable primarily to higher electric costs incurred by the Company since 2001 when power rates charged to the Company by electric suppliers, as authorized by the CPUC, increased an average of 48%. Increases in the memorandum accounts are expected to be smaller once current power rates are reflected in customer rates through future GRC decisions and assuming there are no large increases in purchased water  or power costs. Regulated Utility Accounting. Because the Company operates extensively in a regulated business, it is subject to the provisions of Statement of Financial Accounting Standards (SFAS) No. 71, “Accounting for the Effects of Certain Types of Regulation.” Regulators establish rates that are expected  to permit the recovery of the cost of service and a return on investment. In the event a portion of the Company’s operations were no longer subject to the provisions of SFAS No. 71, the Company would be required to write off related regulatory assets and liabilities that are not specifically recoverable and deter- mine if other assets might be impaired. If a regulatory commission determined that a portion of the Company’s assets were not recoverable in customer rates, the Company would be required to determine  if it had suffered an asset impairment that would require a write-down in the assets’ valuation.There had been no such asset impairment as of December 31, 2002. Income Taxes. Significant judgment by management is required in determining the provision for income taxes.The preparation of consolidated financial statements requires the estimation of income  tax expense.The process involves the estimating of current tax exposure together with assessing temporary  differences resulting from different treatment of certain items, such as depreciation, for tax and financial statement reporting.These differences result in deferred tax assets and liabilities, which are reported in  the consolidated balance sheet.The Company must also assess the likelihood that deferred tax assets will  be recovered in future taxable income.To the extent recovery is unlikely, a valuation allowance would be recorded. If a valuation allowance were required, it could significantly increase income tax expense. In  management’s view, a valuation allowance was not required at December 31, 2002. CALIFORNIA WATER SERVICE GROUP 22