California Water Service Group (Company) is a holding company with four operating subsidiaries: California Water Service Company (Cal Water), CWS Utility Services (Utility Services), New Mexico Water Service Company (New Mexico Water) and Washington Water Service Company (Washington Water). Cal Water and Washington Water are regulated public utilities. Their assets and operating revenues currently comprise the majority of the Company’s assets and revenues. New Mexico Water was formed in 2000 to provide regulated water services. Utility Services provides non-regulated water operations and related services to other private companies and municipalities. The following discussion and analysis provides information regarding the Company, its assets, operations and financial condition. This annual report, including the Letter to Stockholders and Management’s Discussion and Analysis, contains forward-looking statements within the meaning established by the Private Securities Litigation Reform Act of 1995 (Act). The forward-looking statements are intended to qualify under provisions of the federal securities laws for “safe harbor” treatment established by the Act. Forward-looking statements are based on currently available information, expectations, estimates, assumptions and projections, and management’s judgment about the Company, the water utility industry and general economic conditions. Such words as expects, intends, plans, believes, estimates, anticipates, projects or variations of such words or similar expressions are intended to identify forward-looking statements. The forward-looking statements are not guarantees of future performance. Actual results may vary materially from what is contained in a forward-looking statement. Factors which may cause a result different than expected or anticipated include: governmental and regulatory commissions’ decisions, changes in regulatory commissions’ policies or procedures, the timeliness of regulatory commissions’ actions concerning rate relief, new legislation, electric power interruptions, increases in suppliers’ prices and the availability of supplies including water and power, changes in environmental compliance requirements, acquisitions, the ability to successfully implement business plans, changes in customer water use patterns and the impact of weather on operating results, especially as it impacts water sales. The Company assumes no obligation to provide public updates of forward-looking statements. Cal Water is a public utility supplying water service to 436,700 customers in 75 California communities through 25 separate water systems or districts. Cal Water’s 24 regulated systems, which are subject to regula- tion by the California Public Utilities Commission (CPUC) serve 430,600 customers. An additional 6,100 cus- tomers receive service through a long-term lease of the City of Hawthorne’s water system, which is not subject to CPUC regulation. Washington Water’s utility operations are regulated by the Washington Utilities and Transportation Commission (WUTC). Washington Water provides domestic water service to 13,700 customers in the Tacoma and Olympia areas. An additional 2,300 customers are served under operating agreements with private owners. In November 2000, New Mexico Water signed an agreement to acquire the water and wastewater assets of Rio Grande Utility Corporation. Rio Grande has annual revenue of $1.2 million and serves 2,300 water and 1,600 wastewater customers south of Albuquerque. The acquisition is contingent on approval by  the state’s Public Regulation Commission, which is now expected in the second quarter of 2002. Utility Services derives non-regulated income from contracts with other private companies and municipalities to operate water systems and provide meter reading and billing services for customers. It also leases communication antenna sites, operates recycled water systems, provides meter reading and customer services, and periodically sells surplus real estate. The Company expects the meter reading service it provides in Santa Fe, New Mexico to be assumed by the City of Santa Fe during the first quarter of 2002. Rates and operations for regulated customers are subject to the jurisdiction of the respective state’s regulatory commission. The commissions require that water rates for each regulated district be independently determined. Rates for the City of Hawthorne system are established in accordance with an operating agreement and are subject to ratification by the City Council. Fees for other operating agreements are based on contracts negotiated among the parties. The Company maintains its accounting records in accordance with generally accepted accounting principles and as directed by the Commissions. This section addresses two areas that the Company believes are most important among its accounting policies. Revenue Recognition. Revenue from metered customers includes billings to customers based on monthly meter readings plus an estimate of water used since the customer’s last meter reading and the end of the 16 CALIFORNIA WATER SERVICE GROUP CRITICAL ACCOUNTING POLICIES BUSINESS FORWARD-LOOKING STATEMENTS accounting period. The unbilled revenue amount is recorded as a current asset on the balance sheet under the caption “Unbilled Revenue.” At December 31, 2001, the unbilled amount was $7.3 million and at December 31, 2000 the amount was $8.0 million. The amount recorded as unbilled revenue varies depending on water usage, the number of days between meter reads for each billing cycle, and the number of days between each cycle’s meter reading and the end of the accounting cycle. Flat rate customers are billed in advance at the beginning of the service period. The revenue is pro- rated so that the portion of revenue applicable to the current accounting period is included in that period’s rev- enue. The portion related to a subsequent accounting period is recorded as unearned revenue on the balance sheet and recognized as revenue in the subsequent accounting period. At December 31, 2001 and 2000, the unearned revenue liability was $1.7 million and $1.5 million, respectively. Expense Balancing Accounts. The Company does not record expense balancing accounts in revenue until  the CPUC has authorized a change in customer rates and the customer has been billed. Expense balancing accounts include the amount of suppliers’ rate increases charged to the Company for purchased water, pur- chased power and pump tax expenses that are not included in customer water rates. The cost increases are referred to as “Offsetable Expenses” because under certain circumstances they are recoverable from customers in future rate increases designed to offset the higher costs. The Company tracks the cost increases in expense balancing accounts as allowed by the CPUC. At December 31, 2001, the amount included in these accounts was $6.5 million and relates primarily to higher elec- tric costs incurred by the Company during 2001 that have not been billed to customers. At December 31, 2000, the amount in the expense balancing accounts was $0.6 million. For the years 1996 through 2000, the average year-end balance was $1.2 million. To the extent the Company meets the criteria set forth by the CPUC in its interim balancing account recovery procedures, the Company expects to collect the balancing account amounts in future customer billings. The CPUC’s procedures are discussed in detail under the “Rates and Regulation” sec- tion of this report. The Company is uncertain if it will meet the CPUC’s criteria or what portion of the balanc- ing accounts will be recoverable in offset rate increases. Therefore, the Company’s accounting policy is not to record the balancing account amounts until they are included in customer billings. Earnings and Dividends. Net Income in 2001 was $14,965,000 compared to $19,963,000 in 2000 and $21,971,000 in 1999. Diluted earnings per common share were $0.97 in 2001, $1.31 in 2000 and $1.44 in 1999. The weighted average number of common shares outstanding was 15,285,000 in 2001, 15,173,000 in 2000 and 15,142,000 in 1999. As explained below, the decline in 2001 net income resulted from three primary factors: lower water sales to existing customers due to weather conditions, significantly higher purchased power costs and delays in regulatory rate relief. At its January 2001 meeting, the Board of Directors increased the common stock dividend for the 34th consecutive year. 2001 also marked the 57th consecutive year that a dividend had been paid on the Company’s common stock. The annual dividend paid in 2001 was $1.115, a 1.4% increase over the $1.10 paid in 2000, which is an increase of 1.4% over the $1.085 paid in 1999. The dividend increases were based on projec- tions that the higher dividend could be sustained while still providing the Company with adequate financial resources and flexibility. Earnings not paid as dividends are reinvested in the business for the benefit of stock- holders. The dividend payout ratio was 115% in 2001, 84% in 2000 and 75% in 1999, an average of 91% during the three-year period. Operating Revenue. Operating revenue, including revenue from the City of Hawthorne lease, was $246.8 mil- lion, 0.8% more than the $244.8 million recorded in 2000. Revenue in 1999 was $234.9 million. The source of changes in operating revenue were: Dollars in millions 2001 2000 1999 Customer water usage $ (5.7) $ 4.8 $ 14.0 Rate increases 5.4 3.0 3.2 Usage by new customers 2.3 2.1 2.8 Net change  $ 2.0 $ 9.9 $ 20.0 Average revenue per customer (in dollars) $ 552 $ 554 $ 539 Average metered customer usage (Ccf) 363 371 349 New customers added 6,100 5,200 6,700 17 CALIFORNIA WATER SERVICE GROUP RESULTS OF OPERATIONS Management’s Discussion and Analysis of Results of Operations and Financial Condition