Calculation of the Suburban Wholesale Water Rates

• Weaknesses in accounting methodologies and unreasonable delays in the timing of Water Enterprise financial audits of suburban wholesale revenue requirements make the Public Utilities Commission's annual revenue requirements uncertain and contribute to unanticipated variances in available resources. As a result, both the Public Utilities Commission's and the suburban water customers' budgets and finances are significantly impacted. For example, in the most recent settlement agreement between the Public Utilities Commission and its suburban water customers, adjustments totaling $3,735,674 were determined to be owed by the Public Utilities Commission to suburban water customers for FY 1999-2000 and prior years. Potential additional adjustments to be made by the Public Utilities Commission for the period FY 2001-2002 forward are still pending because of delays in the completion of the Public Utilities Commission's annual financial statements.
  
  
• The reasons for these adjustments are varied, but are generally due to the Public Utilities Commission having an inadequate accounting structure to capture, record, and report Water Enterprise activities - especially its capital activities - in a manner that is necessary for calculating suburban water customer rates. To compensate, the Public Utilities Commission has developed highly labor intensive processes for capturing costs. These processes are prone to error.
  
  
• Most significantly, the Public Utilities Commission commingles capital expenses with other expenses - such as repair and maintenance - which are typically not capitalized. Because of the different treatment which capitalized and non-capitalized expenses receive for purposes of calculating the Water Enterprise's suburban revenue requirements, these errors can affect the Public Utilities Commission's rate calculations.
  
  
• For example, in a review of FY 2003-2004 activity, the Reservoir Roofs Seismic Upgrades project (CUW624) expensed $3,479,644 for cleaning and repair work in a project phase that also had capitalized expenses, requiring the project manager to track project details outside of the accounting system for purposes of expensing or capitalizing the project costs. Further, at least $2,694,272 of these expenses were incurred in prior years and, therefore, were not expensed timely. Another $154,174 in funds used for a comprehensive inspection and evaluation of water storage tanks was also expensed
  
  
• Additionally, the process by which suburban wholesale water rates and the suburban revenue requirement are calculated and audited delays the finalization of the suburban revenue requirement. Although the Settlement Agreement and Master Water Sales Contract requires that the independent audit of revenue requirements be completed within six months of the year being audited, the FY 2002-2003 and FY 2003-2004 independent audits have still not been completed. Further, the Bay Area Water Supply and Conservation Agency transmits to the Public Utilities Commission extensive letters identifying potential problems in calculating the suburban revenue requirements, which extend the time for finalizing revenue requirements for an indefinite period. Most recently, the Bay Area Water Supply and Conservation Agency has transmitted these letters for problems relating to the FY 2001-2002 suburban wholesale water rates.

History of Water Rate Computation Issues

The computation of suburban wholesale water rates is a highly complex process. The accuracy of the computation is dependent upon the ability of the accounting processes to capture, record, and report Water Enterprise activities correctly. Pursuant to the 1984 Settlement Agreement and Master Water Sales Contract between the City and County of San Francisco and suburban customers, the suburban wholesale water rate is audited annually by an independent auditor. The audit is to be completed no later than six months after fiscal year end. As part of the computation and audit process, the Bay Area Water Supply and Conservation Agency, which represents the suburban customers, conducts its own review of the suburban water rate computation.

Since the initiation of the current suburban wholesale water rate methodology was established in the Settlement Agreement and Master Water Sales Contract, significant weaknesses in the San Francisco Public Utilities Commission's (the Department) accounting processes have been identified by the suburban customers in their on-going review of the annual wholesale water rate computation. Supporting these findings has been the independent audit of the Department's annual financial statements and the independent auditors' management letters identifying weaknesses in the accounting processes. At present, the issues primarily concern capturing the Water Enterprise's capital activities accurately.

The current suburban wholesale water rate methodology uses the Utility Method whereby the cost of capital is not paid for until the related fixed asset is put into service. According to the Department's policies and procedures and guided by Generally Accepted Accounting Principles (GAAP), a fixed asset is put into service when it meets one of the following criteria:

1) It has been accepted by the Department and a notice of completion has been recorded, whether or not the asset is in use;

2) The asset is in use; or

3) At least 85 percent of construction-related costs have been incurred, the tests necessary to determine that the asset is ready for immediate use have been passed, and it is available to operations for use.

When a fixed asset meets one of the criteria above, it is then "capitalized," to use accounting terminology, and the costs can be factored into the suburban wholesale water rate. Pursuant to Generally Accepted Accounting Principles, prior to a fixed asset being put into service, costs are accumulated and reported in an account referred to as "Construction In Progress." Thus, any capital costs accumulated in this account are not recovered from the suburban customers until the costs are removed from Construction In Progress and capitalized. Occasionally, costs may be accumulated in Construction In Progress that do not ultimately result in a fixed asset. When it is determined that no fixed asset shall result, these costs are "expensed," again to use accounting terminology. Costs would be expensed, for example, if a project were abandoned. Maintenance and repair costs typically do not result in fixed assets and should be routinely expensed in the period the costs are incurred. These costs should not be accumulated in Construction In Progress. Maintenance and repair costs are factored into the suburban wholesale water rate and recovered in the period that the costs are incurred as opposed to some future point in time, like capital costs. Thus, whether to capitalize or expense cost is critical to the determination of when that particular cost will be recovered from the suburban customers.

Recent issues related to the suburban wholesale water rate computation mainly involve capitalizing versus expensing Department costs. The Bay Area Water Supply and Conservation Agency identified the following errors in the FY 1999-2000 computation:

• A computation error which resulted in a $1,115,360 equipment purchase captured as both a capitalized fixed asset and as an expense in the wholesale water rate calculation. This computational error also occurred in prior years.
• Expensing of $2,541,749 in prior year design costs of an abandoned joint Water and Power project that were subsequently determined to include costs that should have been:

- Capitalized ($552,544),

- Expensed as a Power only project ($50,000),

- Expensed as a Water only project ($587,658), and

- Retained as Construction In Progress until related assets are capitalized and divided between joint and Power only projects ($393,616).

• Disaster cost reimbursements which were erroneously recorded as grant revenues.

These issues from FY 1999-2000 and settled in FY 2003-2004 resulted in $3,735,674 due to the suburban customers.

In addition to double counting and applying inappropriate classifications, other issues identified in the past include capitalizing fixed assets in the incorrect period, insufficient documentation and record keeping, and combining capital and non-capital activities. As these examples demonstrate, there are many different errors but they all stem from the inability of the Department to capture, record, and report Water Enterprise activities correctly, which impacts much more than the suburban wholesale water rate computation.

The Department's independent financial auditor noted in the management letter for FY 2002-2003 that the Accounting Section did not conduct timely analysis of capital assets. The auditor recommended that capital asset analysis occur quarterly and be documented and reviewed by management. Further, the auditor recommended technical training for Accounting staff. This letter also noted that the Accounting Section inappropriately capitalized an asset that was to be paid for by other City departments as a result from a breakdown in communications. In FY 2001-2002, the management letter noted that the Accounting Section did not capitalize assets that were to be put into service during the fiscal year, again due to a breakdown in communications with project management staff.

Efforts to Address Accounting Process Weaknesses

A settlement agreement with the Bay Area Water Supply and Conservation Agency in the spring of 2004 requires that the Department take several measures to mitigate identified weaknesses. These measures are:

a) Implementation of a Project Control System to track and monitor project scheduling and budgeting.

b) Implementation of an Enterprise Asset Management System to facilitate asset management from the planning stages to construction, operation and maintenance, and finally to disposal.

c) To obtain recommendations from the independent auditors of the wholesale water rate computation on improvements these two systems can make to aid in the rate computation and compliance with the Settlement Agreement and Master Water Sales Contract.

d) To exert its best efforts to structure construction bid specifications to facilitate the allocation of costs to the classifications required by the suburban wholesale water rate computation.

At present, the status of these requirements are:

a) The project Control System has been implemented and, in fact, had already been implemented at the time the settlement agreement was negotiated and finalized.

b) The Enterprise Asset Management System implementation has been delayed as the PUC has gone back to the drawing board to conduct a more thorough review of PUC needs. The project now envisioned by the Department is much larger in scope than originally conceptualized when the settlement agreement was formulated. An Asset Management Manager has been appointed and a project committee formed. The Enterprise Asset Management System project will be evaluated in more detail in Phase Four of this management audit.

c) Pursuant to Generally Accepted Government Auditing Standards (GAGAS), the independent auditors notified the Department on November 30, 2004 that they will not provide recommendations on the wholesale water rate computation due to conflict of interest concerns. However, it should be noted that the independent auditors, pursuant to GAGAS, should have already been making on-going recommendations in a management letter related to this audit given the significant and obvious internal control issues identified in the audit process and discussed further below. According to departmental staff, there has been no follow up activities by the Department to determine how to comply with this specific provision of the settlement agreement given. The Department believes that it understands the process weaknesses and will be addressing them internally through the Enterprise Asset Management System and through the development of capitalization procedures for both the Accounting Section and Project Managers. The Department anticipates that these procedures should be complete by the end of March 2004 in order to avoid the difficulties incurred in last year's financial statement preparation. To the extent possible, these procedures will be reviewed as part of Phase Four of this management audit to determine if they address process weaknesses described in this section. However, the Department is still required to comply with the settlement agreement and should, therefore, work with the Bay Area Water Supply and Conservation Agency to develop alternative measures to satisfy both parties.

d) According to the Department, in conjunction with the Enterprise Asset Management System, there are draft procedures in process for the development of bids which will meet the requirements of the settlement agreement. Again, to the extent possible, these procedures will be reviewed as part of Phase Four of this management audit to determine if they address process weaknesses described in this section.

The Bay Area Water Supply and Conservation Agency met with the Department in October of 2004 to determine requirement status at that time and to facilitate compliance. Despite that meeting, it appears that the Bay Area Water Supply and Conservation Agency has not been informed of the developments in these areas. At the writing of this report, the Bay Area Water Supply and Conservation Agency has notified the Department's General Manager of their concerns and has requested that the Department respond.

Impact of Not Addressing Accounting Process Weaknesses

As noted in the discussion of the FY 1999-2000 suburban rate calculation and subsequent settlement agreement, there are significant impacts of not addressing capital accounting process weaknesses on the computation of suburban wholesale water rates. In FY 2002-2003, the Department expensed $14.3 million in Construction In Progress. In FY 2003-2004, the amount expensed increased to $27.0 million of a total $214.2 million in Construction In Progress. Thus, significant non-capital activities are occurring that are being charged to Construction In Progress, a capital account, which are then later expensed. While not all projects within Construction in Progress are related to or paid for by the suburban wholesale customers, the issues discussed related to Construction in Progress are systematic and impact the calculation of the suburban wholesale water rates.

A review of Construction In Progress expensed in FY 2003-2004 found that the systemic problem of not isolating expenses into meaningful categories in the financial accounting system makes classification of expenses extremely labor intensive and prone to error. The Department must manually determine item by item, what to expense and what to capitalize.

Therefore, one of the most significant issues is the commingling within a project of capital expenses with repair and maintenance expenses, which are typically not capitalized. Ultimately, the concern is that operating expenses which have been paid for with capital funds and classified as Construction In Progress throughout the year may be either inappropriately capitalized or not expensed timely or, on the contrary, capital expenses may be inappropriately expensed or may not be capitalized timely. The following projects with expensed charges in FY 2003-2004 demonstrate some of these issues.

CUW141 - Upgrade J Table Meter

Only the direct material cost for a flow meter was capitalized. $1,827 in other expenses charged to the project, such as labor, supplies and overhead, were expensed. If these costs were incurred to bring the asset into service, which is reasonably possible, they should have been capitalized too.

CUW191 - Fire and Security Facilities Upgrade

$47,168 in funds were expensed. According to Accounting records, the project manager reported that these costs were related to "project closeout." The final contract payment actually occurred in October 2002 and the majority of project expenses occurred in FY 2000-2001. It is unclear, however, what these costs were and if they related to the capitalized assets and should be capitalized.

CUW240 - Pipeline Rehabilitation Project

$28,353 in prior year charges were expensed because they related to inspection services and, therefore, not expensed timely. Within this project and project phase, $52,929 related to insurance remained in Construction In Progress, yet there are no other expenses in the entire project, all phases, remaining in Construction In Progress. Thus, it is unclear what the insurance pertains to.

CUW228 - Watershed Roads

$60,887 was inappropriately expensed. The costs were incurred for extending a retaining wall and should have been capitalized as a fixed asset. The confusion and misclassification stemmed from the project description in the project status report that noted that watershed roads required periodic maintenance.

CUW624 - Reservoir Roofs Seismic Upgrades

This project has a number of issues due to commingling of expenses. $154,174 in funds used for a comprehensive inspection and evaluation of water storage tanks were expensed. $3,479,644 was expensed for cleaning and repair work in a project phase that also had capitalized expenses, demonstrating that the project manager must track detail expenses in another way rather than with the accounting system. Further, at least $2,694,272 of these expenses were incurred in prior years and, therefore, were not expensed timely.

CUW632 - Sutro Reservoir

$4,219,535 in funds used for cleaning and repair work were expensed. However, in the same project phase, $1,574,488 was capitalized, again demonstrating that the project manager must track detail expenses in another way rather than with the accounting system. Further, of the funds expensed for cleaning and repair work, at least $2,465,724 was incurred in prior years and, therefore, was not expensed timely.

CUW671 - Seismic Protection/City Reservoir and Tanks

The project manager initially reported that the balance in Construction In Progress of $126,261 and incurred in prior years was related to a capitalized asset and should also be capitalized. Subsequently, the project manager reported to the Accounting Section that the expenses in project CUW671 were related to two different projects, CUW624 and CUW640, one of which was capitalized in prior years and one of which was abandoned. The $126,261 which includes $3,580 in miscellaneous supplies was expensed as related to the abandoned project. In this example, the commingling of projects makes it difficult to accurately capture and report not only on expenses, but also on projects.

CUW850 - New Feeder Main

In phase one of the project, $29,598 was capitalized as a fixed asset, whereas $75,235 was expensed. Based on the documentation review, it appears that the direct materials cost was the only cost capitalized and other charges, likely required to bring the asset into serviceE, were not capitalized.

The Department has recently hired two new permanent Accounting Managers and an Accounting Director from outside the Department in positions that have been vacant and filled with acting or part-time personnel. The new management team will have the responsibility for addressing problems in the Accounting Section. According to Department management, one of these new managers will be developing capitalization procedures in the next month or so, based on a survey of best practices at other jurisdictions and given the Department's own unique circumstances. These procedures should include addressing the commingling of activities by revising the accounting structure and its use so that capital appropriations are not used for repair and maintenance expenses. Then, the assumption is that all Construction in Progress would eventually be capitalized unless there are extenuating circumstances, such as abandoned capital projects. The accounting structure, whether through project accounting, index codes or some other configuration, should be developed in such a way as to capture and summarize critical information necessary for the suburban wholesale water rate computation without having to manually review transaction level detail in order to determine expense classification.

As noted above, the Department is evaluating its needs and intends to implement an Enterprise Asset Management System. As part of that project, the Department must further consider its accounting structure. While the accounting structure may be addressed in the new capitalization procedures, the Department needs to evaluate the accounting structure in the larger context of departmental cost centers and management's reporting needs.

The Department should also consider renegotiating the Settlement Agreement and Master Water Sales Contract early and, as discussed in detail in Section 1 of this report, should evaluate moving to the cash method for recovering capital costs. The cash method would eliminate most of the difficulties and manual processes currently required to calculate the suburban wholesale water rate.

Timeliness of Audits and Reviews

The Settlement Agreement and Master Water Sales Contract requires audits of the balancing account and suburban revenue requirements to be completed no later than six months after the fiscal year being audited. Pursuant to Section 6.06 of the Settlement Agreement and Master Water Sales Contract, suburban customers have the right to conduct their own review of the balancing account and suburban revenue requirements and the suburban wholesale water rate computation if they file a letter identifying specific areas for review within three months of receiving the audit report. Section 6.06 of the Settlement Agreement and Master Water Sales Contract states:

"The scope of the suburban review shall be limited to those portions of the Auditor's compliance report as are designated by the Suburban Representatives in a letter submitted by them or on their behalf...within three months after receipt by the Suburban Representatives of the Auditor's compliance report."

For the past six fiscal years, the Department has not complied with the terms of the contract with respect to audit timing. For FY 1998-1999, the audit was completed almost four months after the required deadline. Tardiness increased to almost 15 months for FY 2001-2002. The audits of both FY 2002-2003 and FY 2003-2004 are now delinquent. Further, the audit report has not always been transmitted to the Bay Area Water Supply and Conservation Agency soon after completion of the audit. The delay only serves to extend the process. Detail on compliance with audit and review timelines is provided in the table below.

Table 2.1
Compliance with Audit and Review Timelines
FY 1998-99 through FY 2003-2004

Fiscal Year Ended	Audit Report Due Date	Audit Report Actual Date	Transmittal Date	Time Elapsed from Due Date	6.06 Letters
June 30, 2004	Dec. 31, 2004	Not yet started	n/a	n/a	n/a
June 30, 2003	Dec. 31, 2003	Not yet complete	n/a	n/a	n/a
June 30, 2002	Dec. 31, 2002	Mar. 22, 2004	May 3, 2004	16 months	Nov. 30, 2004 Jul. 19, 3004
June 30, 2001	Dec. 31, 2001	Sept. 15, 2002	Dec. 6, 2002	11 months	Mar. 5, 2003
June 30, 2000	Dec. 31, 2000	Aug. 15, 2001	Dec. 31, 2001	12 months	May 9, 2002*
June 30, 1999	Dec. 31, 1999	Apr. 21, 2000	May 31, 2000	5 months	None

Source: Independent Auditors' Reports and 6.06 letters. Transmittal dates reported by the Department.

* Draft letter was never signed and formalized. Instead, a Demand for Arbitration was filed by the Bay Area Water Supply and Conservation Agency on June 21, 2002.

Despite the contract requirements, the delays have primarily been caused by the practice of the Bay Area Water Supply and Conservation Agency reviewing the suburban wholesale water rate computation concurrently with the independent audit so as to resolve any issues before the computation is finalized. This lengthy processes is exacerbated by the technical issues discussed above. It is problematic that the review and the audit occur simultaneously and that, as noted previously, the independent auditor has failed to note significant and obvious internal control weaknesses in a management letter.

Once the computation is finalized and the audit complete, the only recourse is through arbitration. Demands for Arbitration must be filed within four years, unless the dispute involves the balancing account, in which case the Demand for Arbitration must be filed within 18 months of receipt of the independent audit report. In June of 2002, the Bay Area Water Supply and Conservation Agency filed a Demand for Arbitration for FY 1999-2000. At the same time, the Bay Area Water Supply and Conservation Agency and the Department agreed to extend the date by which the City was required to serve a Notice of Election and Response to the Demand for Arbitration from 45 days to 6 months in order to resolve the issues prior to arbitration. While some of the issues were resolved prior to arbitration, the issues noted above were settled through arbitration in March of 2004, almost four years after the end of the fiscal year in dispute, and resulted in $3,735,674 due to the suburban customers. Of this amount, $2,067,402 is related to FY 1997-1998 and FY 1998-1999 activities. Interest charges totaled an additional $164,160. For FY 2001-2002 and forward, the suburban wholesale water rates are still not finalized.

Additionally, there is some dispute as to the 6.06 letters and the scope of any later inquiry. Section 6.06 of the Settlement Agreement and Master Water Sales Contract states:

"If the Suburban Representatives designate only a portion of the Auditor's compliance report for review by the Suburban Auditor, and the Suburban Auditor's review of that portion causes the Suburban Auditor to believe that other portions of the Auditor's compliance report should be reviewed as well, the Suburban Representatives shall promptly designate such additional portions for further review by the Suburban Auditor by serving notice of such designation ..."

According to the Department, the Bay Area Water Supply and Conservation Agency has filed a 6.06 letter in all but one of the last 20 years. Sometimes, the 6.06 letter identifies an open ended scope, such as the draft May 9, 2002 letter for FY 1997-1998, FY 1998-1999, and FY 1999-2000 which identified "SFWD operating expenses." Thus, the audit process is delayed and even then, when the potential scope of future review is limitless, there is no finality to the computation until 18 months after the suburban customers have received the independent audit report, and then only if there has been no Demand for Arbitration filed.

The lack of timeliness has significant impacts. First, unresolved issues hold both the Department and the suburban customers in a state of flux. Second, any rate changes have a compounding effect. The result is that, from year to year, the suburban revenue requirement is uncertain and has significant variations, which impact both the Department and the suburban customers' budgets and finances. Complying with the timelines set forth in the Settlement Agreement and Master Water Sales Contract and transmitting audit reports immediately upon completion would remove the uncertainty in the rate calculation and the suburban revenue requirement and it would also force the Department and the suburban customers to prioritize and focus on significant issues.

Further, the current process indicates that the Bay Area Water Supply and Conservation Agency has no confidence in the attestation of the independent auditor. In the next contract negotiations, the terms should be set such that either the audit requirements satisfy the Bay Area Water Supply and Conservation Agency or they should be eliminated in lieu of a Bay Area Water Supply and Conservation Agency review. Finally, reasonable audit and review timelines including the transmittal of the audit report, whether conducted by an independent auditor or by the Bay Area Water Supply and Conservation Agency, should be set and they should be adhered to.

Because of the issues noted above with respect to the independent auditor, e.g. the lack of timeliness, the lack of a management letter, and the lack of confidence in their attestation, it is recommended that the Department, in coordination with the Controller's Office, take measures to engage another independent auditor for the FY 2003-2004 audit. The Department should make it clear to the independent auditor that they expect a management letter if the auditor detects deficiencies in internal controls or violations of contract provisions, pursuant to GAGAS.

Conclusion

The computation of suburban wholesale water rates is a highly complex process. The Department's accounting structure does not capture, record, and report Water Enterprise activities, especially its capital activities, in a manner necessary for easily calculating the suburban wholesale water rates. Rather, the determination of capital expenses is a highly labor intensive process and prone to error. The result is an intensive review and audit process that, literally, takes years. This, in turn, leaves significant uncertainty and variation in the suburban revenue requirement and impacts both the Department and the suburban customers' budgets and finances.

Recommendations

The Public Utilities Commission General Manager should:

2.1 Revise the accounting structure and its use to capture at a summary level critical data and information necessary for the computation of the suburban wholesale water rates.

2.2 In coordination with the Bay Area Water Supply and Conservation Agency, determine alternative measures to comply with the 2004 settlement agreement requirement to obtain technical recommendations from an independent source on the suburban wholesale water rate calculation.

2.3 Provide quarterly written status reports to the Bay Area Water Supply and Conservation Agency on the three remaining process improvement areas: the Enterprise Asset Management System, technical improvements as recommended by an independent source, and bid specifications.

2.4 Work with the Controller's Office to engage an alternative independent auditor for the audit of the balancing account and the suburban revenue requirement calculation.

2.5 Work with the independent auditor to comply with the independent audit timelines set forth in the Settlement Agreement and Master Water Sales Contract and transmit completed audits in a timely manner to the Bay Area Water Supply and Conservation Agency.

Costs and Benefits

The Department should incur little additional costs as a result of these recommendations, which should be accommodated within the workload of the two new Accounting Managers, the new Accounting Director, and the Director of Financial Services. The benefits would be significant and would include more accurate and easier accounting of the Department's capital activities and would ensure that any issues are resolved in a timely manner.