With investors and analysts questioning how the U.S. power and natural gas sector can ever recover its credit quality, Fitch Ratings published a special report on Thursday outlining its views and recommendations on the impact and usefulness of mark-to-market (MTM) accounting, as well as how it uses supplemental disclosures on risk management activities, contingent claims and off-balance sheet obligations.

Fitch noted that the “key within any recovery process is a restoration of faith in the published financial information delivered by the companies themselves. In particular, there is widespread doubt about the accuracy or relevance of mark-to-market accounting, while revelations of round-trip trading have further undermined investor confidence.”

By improving the amount and quality of public disclosure, the “current suspicion that overshadows the wholesale energy sector” could be remedied, according to the report. “While it is a necessary step, more and better disclosure will not alone be sufficient to improve investor sentiment. More informative accounting statements and supplemental disclosure will not turn doubters into raging bulls.” However, said Fitch, a “broader array of information” would make the company “less susceptible to adverse surprises and disappointment.”

Richard Hunter, the managing director of Fitch Ratings, said, “improving the amount and quality of public disclosure is critical in restoring investor and bank-lender confidence in the U.S. wholesale energy sector.” Hunter said “better disclosure in itself is not a ‘silver bullet,'” though, because “the sector will continue to face underlying questions on liquidity and adequate returns on capital — but it will make a significant difference in differentiating the stronger operators.”

On MTM accounting, the Fitch report acknowledged that its application in the financial statements of wholesale energy companies has “complicated interpretation for lay readers.” Ellen Lapson, also a managing director in the Fitch Global Power group, said, “Our analytical ratios are oriented to cash flow measures, and unrealized MTM income is clearly not cash. So, MTM gains and losses are just another non-cash item we strip out in calculating our cash flow measures, in the same way we regularly strip out non-recurring or major non-operational cash items to give a better view of the company’s underlying position.”

However, MTM positions are not ignored by Fitch in the complete analysis. Said Hunter, “Despite the exclusion of MTM gains from our standard credit ratios, the information it gives on the contractual portfolio is valuable.” Within the report, Fitch offers examples of how it analyzes MTM disclosure, and how it outlines the limits.

In its study of a company’s off-balance sheet transactions, the report noted that Fitch reviews the underlying economic basis of the transaction, which could include power prepayment agreements, synthetic leases or tolling agreements.

“Identifying and reclassifying off-balance sheet funding continues to absorb a significant amount of analytical attention,” said Hunter. “Several types of long-term obligations not currently capitalized as debt under generally accepted accounting principles are captured as debt equivalents in Fitch’s research.” The rationale for treating the contracts as debt, and the basis for calculating the debt equivalence also are explained in the report.

The special report is available on Fitch’s web site at www.fitchratings.com on the “Global Power” homepage under “Criteria Reports.” Fitch said it plans to provide a follow-up report after it reviews how its recommendations are viewed by the 25-member Committee of Chief Risk Officers, which was formed to study ways to implement across-the-board changes in accounting by energy companies.

In recent months, Fitch has participated in providing recommendations and feedback to the committee representing the U.S. wholesale electric power and gas sector as they designed new, enhanced financial disclosure formats. Lapson said, ‘We intend to publish a follow-on report that will comment upon the benefits or deficiencies of the new disclosure that companies within this group are planning to implement for their year-end 2002 reporting.’

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